Inflation

Do I Invest in Bitcoin?

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Quiz!

What asset is bitcoin most similar to, and why?

  1. Dollars
  2. Bonds
  3. Gold
  4. Stocks
  5. Real estate

Do I Invest in Bitcoin?

Bitcoin was invented in 2009 as a digital currency, and exhibited phenomenal growth so far, raising the question: what growth can we expect moving forward? While it is easy to extrapolate recent growth into the future, it is not always correct. History is full of such examples. Below is an analysis of bitcoin as an investment.

Potential intrinsic long-term growth:

  1. Ongoing value creation: bitcoin doesn’t offer any product or service (unlike companies), or a place to live in (unlike real estate). It is tough to identify value creation in the long run.
  1. Ongoing value destruction: bitcoin cannot lose value through a sharp increase in supply, so not expected to lose value to inflation, unlike the dollar.

Conclusion: There is a potential for 0% very long-term growth beyond inflation.

Today’s pricing: 0% growth beyond inflation assumes that bitcoin is priced correctly today. While there are no useful measures to give it any specific value greater than $0 (it doesn’t produce anything), there is some useful information:

  1. Bitcoin is a software product, and its returns have been correlated with tech stocks (but more volatile). If this correlation sustains, we may be able to draw potential information about bitcoin’s pricing (valuations) using tech stocks.
  1. Bitcoin existed only during the current up-cycle of US tech stocks (since 2009, 15 years). This makes it risky to assume that its past returns will continue. US tech stocks have become extremely overpriced. They have extreme prices relative to intrinsic values (Price/Book). The S&P 500 developed an unusual concentration in tech stocks, as it did before prior crashes. Mid-last month, it reached record overpricing beyond the extreme of year 2000 (potentially, an all-time historic record overpricing). While tech stocks (as presented by the Nasdaq) declined by 78% after that peak, the excess volatility of bitcoin could imply a greater decline.

The future: One of the biggest stated appeals of bitcoin is the ability to avoid losing value to the high inflation created by governments, similar to the stated benefit of gold. Both aim to achieve this benefit through their limited supply (with a hard cap on the supply for bitcoin). This commonality allows us to put the benefit to the test of a very long history of gold.

  1. Recessions: History had more severe recessions under the gold standard, including The Great Depression. With inability to print more money easily, the Federal Reserve (the “Fed”) could not stimulate the economy. In contrast, without the gold standard, the Fed and government were able to stimulate the economy during recessions. As an extreme example, it helped prevent the 2008 recession from turning into a depression. Central bankers and economists are largely unanimous against the idea of returning to a gold standard. If bitcoin becomes too prevalent, the government could set regulations to make bitcoin uncompetitive, or even illegal (as China & Saudi Arabia did).
  1. Spreading recessions: The gold standard linked countries through fixed exchange rates. If a country struggled, people wanted to stop holding its currency. This would lead to a depleting stock of gold for the country. To prevent that, the country raised its interest rate, to make its currency more appealing to hold. Higher interest rates led to reduced economic activity, magnifying the country’s economic struggles.

More topics:

  1. Environmental Impact: Bitcoin mining uses an enormous amount of energy (over 100 terawatt hours last year). While it seeks to use energy at times of low demand, it is a true waste when compared to storage in batteries for later use. Until the world operates on 100% abundant renewable energy (we are far from that), bitcoin has a negative environmental impact.
  1. Limited supply is not a benefit: Bitcoin is designed to have limited supply. This does not imply any rate of growth, if it does not come along with an appeal. For example, if I can find a small rock of an uncommon shape or size, it won’t likely have much value, no matter how rare it is.

Summary: I don’t see bitcoin as an appealing investment in terms of expected returns (inflation + 0%) or risk-adjusted returns (extreme volatility, with very low expected returns). It doesn’t have theoretical reasoning as an investment – it doesn’t generate anything. It also doesn’t have a history of a full cycle, so past returns are still between irrelevant and offering a hint at a potential sharp reversal.

There are plenty of productive investments that generate value beyond inflation, including companies (stocks) & real estate. Their viability is rooted in basic human needs: the desire to get things done cheaply and efficiently (e.g. buying a car from a company instead of building it at home), and the need to have a place to live in (real estate). Of these assets, there are plenty that are priced very reasonably (including value & international stocks).

To answer the question of the title, I do not invest any of my money in bitcoin.

Quiz Answer:

What asset is bitcoin most similar to, and why?

  1. Dollars
  2. Bonds
  3. Gold [The Correct Answer]
  4. Stocks
  5. Real estate

Explanation:

  • Both bitcoin and gold are used as an inflation hedge – the ability to store money without seeing it decline with inflation.
  • Both don’t generate anything on an ongoing basis (though gold has intrinsic value, such as for jewelry, and bitcoin doesn’t).
Disclosures Including Backtested Performance Data

What are Some Pitfalls of Bonds Today, and When will they Subside?

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Quiz!

Which of the following statements are true? (There may be multiple answers.)

  1. Short-term bonds are attractive today, given their high interest payments.
  2. Short-term bonds are appealing whenever there is a large upcoming expense.
  3. Short-term bonds enjoy low volatility.
  4. Long-term bonds are attractive today, given their high interest payments.
  5. Long -term bonds are appealing whenever there is a large upcoming expense.
  6. Long-term bonds enjoy low volatility.

What are Some Pitfalls of Bonds Today, and When will they Subside?

Bonds offer much higher interest payments these days compared to 2 years ago. They are appealing for various uses. They are especially useful if you prefer/need to moderate the volatility of stocks. When deciding on a bond allocation, it is worth paying attention to the following pitfalls:

  1. Short-term bonds: After inflation and taxes, it is tough to get substantial income, and often the net real income is negative. For example, a bond paying 4%, to a person with 25% income tax rate, nets 3% income. With inflation of 4%, this leads to a -1% return. Tax-free municipal bonds address the tax penalty, but at a price of lower income, that also faces the inflation headwind. It is not a reason to avoid using them, but important to be aware of the issues when deciding on the allocation.
  1. Long-term bonds: Long-term bonds sometimes (not always) enjoy higher income but face an additional problem: the risk of rising interest rates. Historically, once inflation reached a 9% level, as happened last year, it took a median of 10 years to go back to normal.  So, without any bad luck, the bond becomes a risky investment for extended periods. The price of a 20-year bond paying 4% per year changes by 13% for every 1% change in interest rate. Compounding the declines for a 4% rate increase causes about a 40% decline. If you hold the bond to maturity you avoid the interest rate risk, but still have inflation risk. In addition, there are more compelling investments for long-term holding periods.

When would the risk of long-term bonds go down. Once Core PCE inflation (the measure that the Fed tracks) gets closer to 2%, the Fed may feel confident enough that it completed addressing the high inflation, and will more likely stop raising interest rates. While there are many factors affecting interest rate decisions, this is a prominent risk factor for bondholders.

Note that this article only pointed out a couple of risks of bonds today and is far from a comprehensive review of bonds. There are many types of bonds that are appropriate for different uses at different times.

Quiz Answer:

Which of the following statements are true? (There may be multiple answers.)

  1. Short-term bonds are attractive today, given their high interest payments.
  2. Short-term bonds are appealing whenever there is a large upcoming expense.
  3. Short-term bonds enjoy low volatility. [Correct Answer]
  4. Long-term bonds are attractive today, given their high interest payments.
  5. Long-term bonds are appealing whenever there is a large upcoming expense.
  6. Long-term bonds enjoy low volatility.

Explanations:

  1. While high interest payments are more appealing than low interest payments, you need interest payments materially above inflation to give appealing after-tax growth or income. Other investments can do this job better.
  2. Not knowing anything else, this statement is true: short-term bonds are appealing when there is a large upcoming expense. There is an important exception to this statement: when the total withdrawal rate (including the unusual expense) is low enough, it is possible to enjoy the benefit of stocks while supporting the unusual expense, as long as the investor is perfectly disciplined. Some large expenses can be broken down to a series of smaller expenses, alleviating the need for bonds. Examples are student loans and mortgages.
  3. Correct: Short-term bonds indeed enjoy low volatility.
  4. Long-term bonds seem attractive today, given their high interest payments, but they can decline in the face of rising interest rates.
  5. Long-term bonds are not appealing for large upcoming expenses. They can decline significantly in the face of rising interest rates, as seen in 2022.
  6. Long-term bonds fluctuate a lot more than short-term bonds with changes in interest rates. They have lower volatility than stocks, but not always low volatility.
Disclosures Including Backtested Performance Data

Dispelling a Myth: Stock Valuations are Always Lower with Higher Interest Rates

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Quiz!

Are Extended-Term Component (ET) valuations lower or higher when interest rates are higher?

  1. Lower
  2. Higher

Dispelling a Myth: Stock Valuations are Always Lower with Higher Interest Rates

When interest rates are higher, there are 2 implications for stock valuations (Price/Book):

  1. Negative: Future earnings get discounted more, justifying lower stock valuations – what people expect. This effect is smaller for value stocks that are valued more based on near-term earnings.
  2. Positive: The reason for higher interest rates tends to be higher inflation, which represents higher prices charged by companies. Higher income to the companies justifies higher valuations.

Extended-Term Component (ET), a portfolio that emphasizes deep value stocks, is impacted more by the positive effect. The chart below shows a positive relationship between the Fed Rate and valuations (P/B) for ET, since 1999. With today’s rates at 5.25%, the range of valuations is raised, making current valuations (P/B = 0.87) close to the low end of the range (of: 0.73 to 2.08). If history repeats itself, it could point to more upside potential.

Adding to the good prospects, the Fed’s preferred measure of inflation is holding steady for a 5th month, with a slight increase last month to 4.7%. This is more than double the Fed’s target of 2%, adding pressure on the Fed to keep raising rates. With headline inflation peaking at 9.1% last year, and historically interest rates rising above peak inflation, it is possible for interest rates to peak above 9.1%, which is about 4% higher than today. If interest rates peak higher than today, valuations may also peak higher, adding to the positive forces.

Notes: Future ranges can be different, and there is no guarantee that future interest rates will be higher. Small note: the 6% rate column (the last one) is impacted by limited data.

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Quiz Answer:

Are Extended-Term Component (ET) valuations lower or higher when interest rates are higher?

  1. Lower
  2. Higher [Correct Answer]

Explanation: See chart and explanation in this month’s article.

Disclosures Including Backtested Performance Data

What is the Impact of High Inflation on Stock Returns?

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Quiz!

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations.
  2. Growth stocks.
  3. Value stocks.

What is the Impact of High Inflation on Stock Returns?

We are experiencing very high inflation, last seen in the early 1980’s. What is the Impact of High Inflation on Stock Returns?

  1. Negative: It hurts stocks, by reducing stock valuations (Price/Book) to reflect a lower value of future earnings. It hurts growth stocks with high valuations especially hard. Examples are S&P 500 and Nasdaq.
  2. Positive: It ultimately helps stocks, because high inflation = higher prices => higher earnings for the companies.

The bigger the spike in inflation, the more stocks are likely to decline in the short run, because the negative forces can be greater than the positive ones. Once stock valuations adjust to higher inflation and higher interest rates (that are used to combat inflation), the positive impact tends to be much stronger, especially for value stocks.

Key takeaways:

  1. When inflation spikes, you should be especially cautious of stocks with very high valuations. Now the largest tech stocks are priced extremely high, something familiar from past cycles. In the 1970’s, we had the nifty-fifty, also called “one-decision” stocks. Counter to expectations at the time, they crashed badly despite being the most prominent of US stocks (https://en.wikipedia.org/wiki/Nifty_Fifty). Stock returns adhere to the formula, price = book value x (price / book value). If the valuations (price / book value) are very high, even the best company in the world can see its stock price drop.
  2. Value stocks (with low valuations, or price / book-value) are better positioned for high inflation, for 2 reasons: (1) Immediate: there is no big correction necessary to valuations; (2) Ongoing: more of their earnings are from the near-term, with a smaller needed discount to future earnings.
  3. Even value stocks can be expensive at times. For example, US Large Value stocks are currently very expensive (but still less than the S&P 500 and Nasdaq). In stark contrast, non-US Value stocks are priced low.

Quiz Answer:

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations. [Correct Answer]
  2. Growth stocks. [Correct Answer]
  3. Value stocks.

Explanation:

  1. While value stocks tend to have low Price/Book, sometimes an entire collection of stocks becomes expensive, including value stocks. A current example is US Large stocks.
  2. Growth stocks tend to have earnings far into the future, that need to be discounted by high interest rates (the tool used to combat high inflation).
  3. Value stocks are priced lower and have nearer-term earnings that not impacted as much by higher interest rates. The increase in income (along with inflation) can become the dominant force.

See article for more explanations.

Disclosures Including Backtested Performance Data

Tipping Point for Value?

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Quiz!

Which factors may contribute to value (low Price/Book) outperformance moving forward? (There may be multiple answers.)

  1. A change in sentiment.
  2. Rising bond interest rates.
  3. Expectation for inflation.
  4. Very low valuations.
  5. Very low valuations relative to growth (high Price/Book) stocks.
  6. Economic recovery from the pandemic.
  7. The best option out there.

Tipping Point for Value?

Last year will go into the history books given the pandemic. But another, less noticed, rare thing happened. Growth stocks, those with a high price relative to the company’s book value (P/B), or intrinsic value, went from very expensive to extremely expensive – a level barely second to the late 1990’s. While they’ve become more expensive for a while, there was a big spike in unprofitable small growth stocks. Last time we had a spike even close to this magnitude was around 1999. This is very reassuring for Value stocks, because often a long-lasting trend ends in a big spike in the direction of the trend, followed by a sharp reversal. For value stocks in the US, last time the reversal meant a 50% outperformance in a mere 2 years.

There are a number of logical reasons to see a reversal at this point:

  1. A change in sentiment: The reversal already started a few months ago, long enough for people to take note, and start treating it more like a new trend than noise.
  2. Expectation for inflation: Two forces are leading to an expectation for higher inflation: (1) Dramatic government stimulus; (2) The Fed planning to hold interest rates low until after inflation overshoots the typical target. Bond prices already started declining reflecting this expectation.
  3. Very low valuations relative to growth (high Price/Book) stocks: With the valuations of growth stocks going so much higher relative to value stocks, growth stocks became much more dangerous. People took note and started shifting towards value stocks.
  4. Economic recovery from the pandemic: Value stocks tend to outperform at times of economic recovery.

Note that value stocks outside the US have much lower valuations than US stocks – near record difference, making them even more appealing. As always, there could be surprises, and it is important to structure your financial picture to account for them.

Quiz Answer:

Which factors may contribute to value (low Price/Book) outperformance moving forward? (There may be multiple answers.)

  1. A change in sentiment. [Correct Answer]
  2. Rising bond interest rates. [Correct Answer]
  3. Expectation for inflation. [Correct Answer]
  4. Very low valuations.
  5. Very low valuations relative to growth (high Price/Book) stocks. [Correct Answer]
  6. Economic recovery from the pandemic. [Correct Answer]
  7. The best option out there. [Correct Answer]

Explanations: #4 is only partly correct. In the US value stocks are not low relative to their historic average, though they are very low relative to growth stocks. Outside the US, valuations are clearly low.

See article for more explanations about the correct answers.

Disclosures Including Backtested Performance Data

What Happens When Interest Rates & Inflation Rise?

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Quiz!

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.

Look for the answer below and read this month’s article for a discussion.

What Happens When Interest Rates & Inflation Rise?

Optimism about the pandemic’s direction led to expectation for inflation along with rising interest rates in the past month.  The direct impact of inflation and rising rates is damage to stocks & bonds.  This is especially true for growth (high P/B) stocks that obtain much of their value from earnings far into the future – earnings that are less valuable, the higher the inflation.

Beyond the initial reaction, value and Emerging Markets (EM) investments tend to do very well from conditions like today.  The closest example is the behavior of Extended-Term Component (ET) in 2003.

Extended-Term Component (ET) Behavior with Expectation for Higher Interest Rates and Inflation
6/9/2003 2/26/2021
ET P/B 0.93 1.01 (lower equivalent given the profitability tilt since 2014)
Time since recent low 8 months 11 months
10-year treasury rates Increased fast (2% in 2 months) Increased (1% in 7 months)
Federal rates went up starting 1 year later (6/30/2004) ?
Federal rates went up by 4.25% in 2 years! ?
Dollar High and declining High, and peaked recently
ET gained An additional 449% in 4.5 years ?

Every case is different, and I don’t necessarily expect a repeat gain of 449% in 4.5 years.  This information shows that rising rates have not been bad for your investments historically.

Note that in the example above, growth stocks also did very well, but their valuations were substantially lower than today.  Between the positive forces of the economy and stimulus and the negative impact of extreme valuations, it is tough to predict gains or declines for growth stocks.

While I cannot predict future returns, there are a number of factors that would lead me to optimism for both EM and Value investments in upcoming years.  Here is some logic:

  1. Interest rates reached record lows in recent months, and there are mounting forces for higher interest rates and inflation.  This hurts growth stocks, making value stocks more attractive on a relative basis.
  1. During economic recoveries, cyclical value stocks tend to do especially well.
  1. The dollar is relatively high, and has plenty of room to go down, increasing the value of non-US investments.
  1. An economic recovery from the pandemic would lead to a benefit for stocks in general, especially ones that are not already priced high.  The discount of value stocks relative to growth stocks is still at a real extreme.
  1. Beyond value vs. growth, EM Value stocks are priced extremely low relative to US Value stocks.

While the 2003 example above seems most relevant, a more recent situation of rising rates was 2016-2017, where ET enjoyed a 99% gain in about 2 years, within weeks after the Fed started raising rates.  To emphasize, no specific result is guaranteed, but fear of rising rates hurting EM and Value stocks would not be rooted in past experience.

Quiz Answer:

What typically happens to stocks when interest rates & inflation rise?  (There may be multiple answers.)

  1. Stocks go down.
  2. Stocks go up.  [Correct Answer]
  3. Growth (high P/B) stocks go down.
  4. Growth (high P/B) stocks go up.  [Correct Answer]
  5. Value (low P/B) stocks go down.
  6. Value (low P/B) stocks go up.  [Correct Answer]

Explanations:  In general, stocks tend to go up when interest rates & inflation go up, reflecting an expanding economy.  Value stocks tend to outperform growth stocks, as the higher rates & inflation hurt the value of future earnings.  Note that the valuations of growth stocks are extremely high at this point, so it is tough to project their future.

Disclosures Including Backtested Performance Data