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Three Things I Think I Think – Changing My Mind

The last few years have been jarring in numerous ways. They’ve also forced me to reconsider how I help people navigate the financial world. Here are some things I’ve recently changed my mind about.

1) Am I a Permabear? Someone on Twitter was trolling me for being too bearish this year. It’s true – I’ve been bearish all year in large part because my primary macro index, the Discipline Index, has been indicating an underweight stock position all year. It’s consistent with an environment in which valuations remain frothy and macro conditions remain challenging. This likely means that expected future returns are relatively low, especially in equity markets.

The downside of this is that there haven’t been many places to hide this year so even though equities have been terrible, most other markets have also been relatively bad.

Then again, this is all fraught with short-termism. Assessing stock and bond markets over one year time horizons is silly and it’s a big part of why I’ve become a big advocate of my All Duration framework. Compartmentalizing assets over very specific time horizons helps you navigate, wait for it, ALL DURATIONS. What I’ve basically done is created a bond laddering framework that’s applicable to all asset classes. It’s simple, but elegant in my opinion.

But even in an All Duration framework the duration of stocks and bonds can change as the markets change. So yeah, while I am generally optimistic about stocks in the long-run the relative valuations also change and the current environment remains one where equities are relatively risky which means their durations are longer than they are on average and that means they’re risky than they are on average. That, in my opinion, warrants some caution and, gasp, active management.1

In any case, I’ll return to being my usually optimistic self. But I still think there are big risks out there that markets aren’t discounting.

2) Are bond funds bad for behavior? When I worked at Merrill Lynch back in another life we used to only buy individual bonds. I used to buy T-Bonds and Fannie Mae bonds by the truckload. There is something really beautful about buying an individual bond because people know exactly what they’re getting. They know they’ve bought, for example, a 5 year T-Bond that yields 3%. They know they’re gonna get their money back at maturity and they know they’re just clipping 3% per year along the way. The beauty in that is that they don’t worry about the daily fluctuations of the bonds. In fact, most of my bond clients didn’t even know their bonds changed in price every day. They just didn’t care because they didn’t need to. But that’s all changed now with internet trading and ETFs.

And that’s the worry I am becoming increasingly concerned about with bond ETFs. I love, love, love ETFs. They’re arguably the best financial innovation of the last 30 years. But there are two big problems with bond ETFs: 1) most of them are constant maturity ETFs so while the investor will generally know their maturity over a longer constant period the fund exposes the investor to more uncertainty than an individual bond does; 2) because the bond is traded on an exchange that the investor can see every day they expose themselves to the behavioral bias of short-termism by judging the performance every day, month or year.

None of this is unreasonable. I encounter these biases all the time and I sympathize with every person who has them. And I have to admit that no matter how much I explain the underlying operational dynamics of the bond ETFs the behavioral biases don’t get easier to deal with for most people. So…it has me increasingly leaning towards using individual bonds and specific maturity ETFs.

As you likely know from reading my work, I am a huge behavioralist. The sub-optimal portfolio you stick with in the long-run is likely to do better than the “optimal” portfolio you constantly question in the short-term. That’s because you reduce behavioral errors, taxes and fees along the way. So anything that improves behavior will end up improving performance in the long-run and I have to admit that my ideological approach to using bond ETFs is changing….

3) Deflation Remains the Growing Risk. One big thing I’ve changed my mind about in the last 12 months is the risk of inflation. I was an inflationista in 2020 and 2021, but I think the risks are shifting fast. Yes, inflation has remained higher than I expected (I said in 2020 that core inflation would go to 3-4% and it’s gone to 5.4%). But I think 2023 is going to be all about disinflation with the risk that inflation is falling faster than the Fed wants (in part because the economy is weaker than expected).

A core part of that thesis is housing. I didn’t think housing was functional with mortgage rates at 5%. Mortgage rates at 7% are breaking the housing market. But this isn’t just a US problem. In fact, I’d argue it’s a much bigger problem for the global economy as a whole.

Without getting too deep in the weeds, the basic gist of the argument is that there’s housing fragility all over the world and the rest of the world has t o adopt US monetary policy to a large degree because the USA is the dominant reserve currency (basic Triffin Dilemma economics). So the Fed has created this huge asymmetric risk at this point. Even though inflation appears to have peaked at 5.4% in January and the upside risk appears muted (in fact, many real-time indicators of prices are falling rapidly) the Fed seems to be in a big rush to snuff out the risk of the 1970s happening. I don’t see the asymmetric risk there, but I do see a much larger potential asymmetric risk if they crush housing so badly that they pop a global housing bubble and cause bigger problems (many of which we won’t see until it’s too late).

Here’s a wonderful paper talking about this risk in more detail and how housing is globally interconnected now. So yes, US housing doesn’t have to crash in order for a global housing bust to become a very big US problem.

Now, maybe I am underestimating the risk of 1970s style inflation, but I just don’t see it. I think this looks increasingly similar to 2008 as opposed to 1978 and I strongly suspect that we’ll spend most of 2023 talking about fragile housing, disinflation and potentially rising unemployment (perhaps much moreso than the Fed currently expects).

1 – If you’ve been reading this website long enough you already know that everyone is technically “active”, but some people like to berate any form of “active” even if it’s tax and fee efficient….