My friend and investor RJ Lewis provoked a discussion on social media this week. He brought up a point made recently by Ray Dalio, the high-profile money manager at Bridgewater Associates. Dalio’s argument is that cash and bonds are unattractive asset classes in today’s environment. He says that in response to COVID-19, the Fed and federal government have so dramatically suppressed interest rates and ballooned the money supply that inflation will soon return with a vengeance. When that happens, he says, investors will be better off owning growth stocks, for instance, that can at least somewhat protect against the expected surge in inflation.
It sounds an awful lot like Dalio is advocating that we pile into the very same stocks that massively outperformed 1) throughout the longest bull market in history from March, 2009, through early this year; 2) during this year’s COVID-19 sell-off (S&P 500 fell 34% from peak to trough); and 3) during the rebound from that sell-off (+26% from the low). To me, he doesn’t really sound like he is advocating a strategy of “buy low!” And in stark contrast to another legend by the name of Warren Buffett, whose company is currently carrying well in excess of $100 billion in cash on its balance sheet, Dalio seems to be largely ignoring the significant risks associated with this severe recession as well as the lofty valuations associated with said “growth stocks.”
Now, you may have also heard other professional money managers talk about the risk of a deflationary spiral. They may have said that notwithstanding the massive job losses and business shut-downs, COVID-19 is likely to have a far bigger impact on aggregate demand than aggregate supply. In other words, the economy will be running at significant excess capacity (ie, the economy is producing more than it can sell). And as we all know from Econ 101, if demand falls faster than supply then prices will not rise, as Dalio suggests, they will fall.
That such great minds can so disagree is unsettling. Who is right? Either of these outcomes seems plausible. And it’s possible we could have deflationary pressures in the near- to intermediate term, followed by inflationary pressures thereafter. The point is that the path of our economic evolution is not preordained and is difficult to predict with much precision. As such, it is tempting but perilous to embrace a path with such conviction at a time when the future is inherently unknowable. Economists John Kay and Mervyn King describe this in their eponymous new book, “Radical Uncertainty.” Author Brene Brown suggests that vulnerability is an uncomfortable, unwelcome constant and should be recognized and incorporated into healthy psyches.
Honest investors need to invest for a future that may have any number of outcomes. Investing weighs risk and reward and is a constantly evolving process. Designing portfolios for a prescribed path is straightforward; for example if interest rates are headed higher, sell dividend payers and bonds. If they are headed lower, buy them. But designing portfolios for any number of inherently unknowable outcomes is not straightforward. It requires a flexible process that can change based on changes in the investment backdrop. By definition, it will almost certainly be imperfect (unless you get crazy lucky). My goal as the steward for many families and institutions is an investment allocation that will endure market struggles, enjoy market gains and should produce solid, long-term results.
Strong balance sheets with limited debt, lots of cash, low dependence on the capital markets, good cash flow and the ability to operate and earn are the core of my pandemic portfolio. Because investors must also be opportunistic, I also seek stocks that are selling at significant discounts to intrinsic value because of an unfairly perceived vulnerability. Because I’m conservative and risk-averse, the airlines and hospitality sectors, for example, are outside of my comfort zone right now. There are investors that will place wagers on which airlines will survive, and some will have stellar returns. Yet there are others that will lose bitterly as businesses fail to continue as going concerns. We do not venture into the thin branches of risk. Will there come a time when there is more clarity in the airline and hospitality sectors and an investment opportunity arises that meets our criteria? Perhaps, but we are far too early in this crisis to make that sort of determination.
Recognizing and accepting the “radical uncertainty” of the unknown is much harder than following a specific prescription or dogma. But it is often the only honest response. Understanding that outcomes are unknowable helps set reasonable expectations and avoids surprised, panicked disappointment. Keep your wits. Have a plan. Know that we are all vulnerable, but history argues that the long-term expansion in the US economy drives stock prices higher. Longer periods mitigate and buffer short-term volatility. Invest with a disciplined, dispassionate plan and have confidence that the Republic and US economy will survive and thrive again.