After the depleting drop off of the last few weeks, this morning we’ve enjoyed a little bit of a rally in the markets. Of course, the famous question is, is this really just a dead cat bounce? Well, markets price in the future, so have they done pricing it in? Really, nobody knows.
So let’s switch the conversation from returns to risk. Today’s world is very much one of risk selection rather than risk avoidance. What do I mean by that? Well, let’s explain by differentiating the different asset classes that are out there and discuss the risk associated with each and every one of them. Your typical risk-free asset is cash. When we talk about putting cash under the mattress, we’re thinking, “Okay, that’s safe.” Of course, if you took $100 in 1920, threw it under a mattress, today, I don’t know what it’s worth, 10, 20 bucks? It doesn’t work.
With inflation, especially at the levels it’s at today, you have a guaranteed permanent loss without any mechanism ever for future recovery. So you could argue over the next 18 months, it’s a modest risk, maybe a two-year window, a risk of 15 to 20% compounded. But that’s no small amount. We talk about a bear market being 20%. We never talk about that bear market never being followed by recovery.
So we go to the next level, and that’s fixed income, the famous bonds. The risk-reward there is a little bit inelastic. What do I mean by that? Interest rate increases negatively impact the value of the bonds. We know that. We also know that it results in an offsetting increase in cash flow, and the two should zero out over the lifetime of the bond. So how do you profit in an environment of increasing interest rates? The shorter the maturity of the bond, the better you are because those bonds are being replaced with higher interest yields.
In today’s world, some of these bonds are north of 4% at the short end. You can’t get that at a bank. They mature and can be replaced. So that’s better than cash, someone would argue by a large margin. Now, yes, short-term bonds and ultra-short bonds can take a hit, but if a short-term bond takes a hit of 3% and is replaced with a 4% yield, you’re looking at a return of a worst case scenario in eight months maybe.
Equities. Well, I talk about equities. I mean stocks, real estate, maybe you own a business. It could be collectibles. Anything that’s an ownership interest and preferably let’s get to a more core, an ownership interest in something that can generate income, stocks, real estate, personal business. Those things when interest rates go up and we go into recession, people tend to anticipate the worst. We’re seeing that in the markets today. We could see more of this. But if there’s one thing we have seen in history, it’s there’s always recovery.
In fact, I’m mildly enthusiastic. As I’ve said before, a recession with less than 4% unemployment is an interesting recession. I think we’re going to have some fantastic opportunities to value average into greater equity positions over the next 12 to 18 months. It’s healthy for the economy to see a revaluation of business, revaluation of equities, revaluation of real estate. Frankly, you have to be asleep at the wheel to not realize these were inflated numbers.
Finally, as an asset class, we have debt. What do I mean by that? I’m not talking about bonds. I’m talking about your debt, margin, mortgage, car loans. Think of debt as a reverse bond. If you’ve got debt at two and a half percent, you should be smiling all the way to the bank. If you bought a house and maybe it was a little overvalued a year ago and you had a 2.75 mortgage, the real estate may dip and recover, but the debt is guaranteed to be supported by that 9%, 8% inflation.
When you look at inflation, consider this, salaries, equities, rents, real estate over time will mirror that inflation. The debt, however, in essence, is being liquidated. So ironically, from an asset allocation perspective, if your interest rate after tax is less than inflation even, but I’d go back a little bit, certainly if it’s less than 4, 5%, you would not want to pay that debt off. That’s not a license to go out and borrow money, because today if you borrow money, especially if it’s 5, 10, 15-year money, it’s going to be a little more expensive than that threshold.
But as an asset class when debt was cheap, it was a great asset class. If you’ve got it, I wouldn’t worry too much about it. Like everything we’re going to get through this. It’s really a period of risk selection. There’s no such thing as risk avoidance in the world we’re in today. For those who are not risk tolerant, that’s very unfortunate. We’re here to help with that risk selection. Remember, as in every other scenario prior, since the birth of this country, this too will pass.
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