Further Thoughts on Sea Change

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• But the bottom line I keep going back to is that credit investors can access returns today that: are highly competitive versus the historical returns on equities, exceed many investors’ required returns or actuarial assumptions, and are much less uncertain than equity returns.  Unless there are serious holes in my logic, I believe significant reallocation of capital toward credit is warranted.

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• “What do you consider to have been the most important event in the financial world in recent decades?”  Some suggest the Global Financial Crisis and bankruptcy of Lehman Brothers, some the bursting of the tech bubble, and some the Fed/government response to the pandemic-related woes.  No one cites my candidate: the 2,000-basis-point decline in interest rates between 1980 and 2020.  And yet, as I wrote in Sea Change, that decline was probably responsible for the lion’s share of investment profits made over that period.  How could it be overlooked?

• Finally, there’s what John Kenneth Galbraith called “the extreme brevity of the financial memory.”  Relatively few investors today are old enough to remember a time when interest rates behaved differently.  Everyone who has come into the business since 1980 – in other words, the vast majority of today’s investors – has, with relatively few exceptions, only seen interest rates that were either declining or ultra-low (or both).  You have to have been working for more than 43 years, and thus be over 65, to have seen a prolonged period that was otherwise.

• In Sea Change, I listed several reasons why I don’t think interest rates are going back to that period’s lows on a permanent basis, and I still find these arguments compelling.  In particular, I find it hard to believe the Fed doesn’t think it erred by sticking with ultra-low interest rates for so long.

• If the declining and/or ultra-low interest rates of the easy-money period aren’t going to be the rule in the years ahead, numerous consequences seem probable: economic growth may be slower; profit margins may erode; default rates may head higher; asset appreciation may not be as reliable; the cost of borrowing won’t trend downward consistently (though interest rates raised to fight inflation likely will be permitted to recede somewhat once inflation eases); investor psychology may not be as uniformly positive; and businesses may not find it as easy to obtain financing.

• I’ve been thinking lately about the fact that being an investor requires a person to be somewhat of an optimist.  Investors have to believe things will work out and that their skill will enable them to wisely position capital for the future.  Equity investors have to be particularly optimistic, as they have to believe someone will come along who’ll buy their shares for more than they paid.  My point here is that optimists surrender their optimism only grudgingly, and phenomena such as cognitive dissonance and self-delusion permit opinions to be held long after information to the contrary has arrived.  This is among the reasons why they say of the stock market: “Things can take longer to happen than you thought they would, but then they happen faster than you thought they could.”  Today’s sideways or “range-bound” market tells me investors possess a good amount of optimism despite the worries that have arisen

• A recurring theme of mine is that, even though many people agree that free markets do the best job of allocating resources, we haven’t had a free market in money in roughly the last two decades, a period of Fed activism.  Instead, Fed policy has been accommodative almost the entire time, and interest rates have been kept artificially low.  Rather than letting economic and market forces determine the rate of interest, the Fed has been unusually active in setting interest rates, greatly influencing the economy and the markets.

• Many articles about the problems at Silicon Valley Bank and First Republic Bank cite errors that were made in the preceding “easy-money” period.  Rapid growth, unwise inducements to customers, and lax financial management were all encouraged in a climate with accommodative Fed policy, uniformly positive expectations, and low levels of risk aversion.  This is just one example of a time-worn adage in action: “The worst of loans are made in the best of times.”

• That is, they may have violated a basic rule in investing: “Never confuse brains and a bull market.”

• And, importantly, these are contractual returns.   When I shifted from equities to bonds in 1978, I was struck by a major difference.  With equities, the bulk of your return in the short or medium term depends on the behavior of the market.  If Mr. Market’s in a good mood, as Ben Graham put it, your return will benefit, and vice versa.  With credit instruments, on the other hand, your return comes overwhelmingly from the contract between you and the borrowers.  You give a borrower money up front; they pay you interest every six months; and they give you your money back at the end.  And, to greatly oversimplify, if the borrower doesn’t pay you as promised, you and the other creditors get ownership of the company via the bankruptcy process, a possibility that gives the borrower a lot of incentive to honor the contract.  The credit investor isn’t dependent on the market for returns; if the market shuts down or becomes illiquid, the return for the long-term holder is unaffected.  The difference between the sources of return on stocks and bonds is profound, something many investors may understand intellectually but not fully appreciate.