And Regime Change Gets Underway

[Phil Hildebrandt] Well, hello Ralph and welcome back to our podcast for the third quarter, Thoughts on the Current Environment. You titled this piece Regime Change Gets Underway. What do you mean by that?

[Ralph Segall] Good to see you, Phil. It’s been a long three months. What I was trying to get across in the last newsletter was that a regime change in the financial markets was getting underway. And as the returns we saw for the quarter are showing, that change has begun with a big bang. What we meant by that is that the period of zero level of interest rates, of inflated valuation levels for stocks, is probably coming to an end. We brought out some of the reasons why we thought that was the case, and we suggested that the new regime change is going to be a different set of conditions for the financial markets. It’s going to look very different than what’s been going on for the last 12 years, and we want to get people starting to think about what they ought to be looking for.

[Hildebrandt] You talked in here about the fact that when you get into these transitional periods, volatility is usually one of the symptoms that you see, and the way that we process that volatility is different than, say, an individual investor.

[Segall] That’s true because a regime change implies that all the ways that you had of behaving before might not work this time or what you thought would happen won’t be the same going forward. For us, that’s really not been the case because our investment philosophy and the process we employ in all of our strategies is always the same. We’ve never deviated in 27 years. The names that we come up with as attractive securities will change but how we chose them doesn’t. And so what this leaves us with are facing investors who might be losing track of where they are, panicking in the process. And that gives us the opportunity to buy things, buy stocks or bonds, that we want to own at valuations that we find very attractive.

[Hildebrandt] Yeah, this is definitely one of those times where the emotions of an individual investor are not their friend and the discipline that we, you know, employ to process information like this really benefits our clients. We’re definitely seeing a rapid rise of inflation. You mentioned that in your previous piece as well and its impact on the valuation of financial assets. Can you talk about that?

[Segall] Sure. There are two old principles that come to mind, one of which is that inflation is forever and always a monetary experience. And the second one is that the best cure for high prices is high prices. And what I mean by that is that the regime change part of those two comments is that the Fed, the central banks of the world, have finally been forced to acknowledge they can’t keep printing money to keep interest rates down. They can only use interest rates to fight inflation. The issue that’s coming up though, is that they’re going to overshoot in the other direction, I fear, as well. And I don’t think inflation is going to be or we still have the chance, let me put it that way, to keep inflation from getting itself embedded. Let me give you two observations about that. The first one is that for the prices of goods, commodities like oil or wheat or iron or copper that have futures markets that trade actively, what you’ll see is that the highest prices are right now in the spot market. There are indeed shortages of stuff for people to be able to use right here and now. But the price of oil for delivery in three years isn’t ranging around $110, $120 a barrel. It’s more like $65 or $70 a barrel. So that the markets, the futures markets, are telling you that some of this is going to get fixed by itself. The real concern that I think the central banks have is that inflation that gets embedded into contracts, and those can be real estate leases, or rents if you will, or labor contracts with an employer that run three to five years, those are the things where the central banks have to act so that inflation doesn’t embed itself in those contracts and you get a vicious cycle rather than the virtuous cycle that we’ve been in for a while.

[Hildebrandt] You also talked about the impact of what you described as the affairs of the day, the war in Ukraine, supply chain, COVID, political turmoil. And in previous newsletters, you’ve talked about population growth on just global economic growth. So what you’re I think you’re implying here is that not only those factors you just described with regard to monetary policy, but there’s also sort of economics and societal things out there that are kind of teaming up to slow global growth that should also help the process you just described.

[Segall] I think you hit on something. You have to distinguish between, in our book, factors that are long term in nature and factors that are transitory. Population growth is long term and population growth around the globe is headed south. It’s been doing that for a long, long time. And that isn’t going to change. The size of the workforce that’s available out there is already known. It’s been known for, we know the size of the workforce for the next 15 years coming up. Productivity growth is slowing, too. The transition away from fossil fuel is going to cause a lot of inefficiency for a while, and we just have to get through that. But the more top of the news stories like the war in Ukraine or like any of the

[Hildebrandt] Supply chain.

[Segall] And supply chain issues, all of those will resolve themselves. And what they will do is either accelerate or slow down the pace of the regime change that we say, being that we see, being driven by these long-term, slow-twitch fundamental forces we see at work.

[Hildebrandt] So but the combination that you talked about with higher prices and, you know, the enemy of higher prices is higher prices and then those societal things, the ultimate impact you’re talking about though is it’s not likely we’re headed towards a double-digit type of interest rate environment.

[Segall] We don’t see double-digit interest rates out there for a variety of reasons. One, we don’t think if the Fed is successful or continues to follow the policy they’ve embarked upon of raising rates, we don’t think inflation will embed itself. It’s not going to zero, back to zero, at any point. They’re not going to reverse and go back to an easy money policy. So that we’re going to see an environment down the road in which interest rates anchor as they historically have. The 10-year rate ought to be around the real great rate of growth plus a little bit of quote-unquote normal inflation. So when interest rates get to that level, we’ll find the ability to price assets out there to be more believable, more durable. And from there, we’ll then be able to or think about the opportunities for growing profits, which we think is a big problem for the corporate sector in the next four or five years, and that’ll allow us to price financial assets like stocks more appropriately. What kind of earnings growth can they produce? What levels should those earnings be valued at? And we’ll be back to what I was referring to as more quote-unquote normal markets.

[Hildebrandt] Yeah, that’s a good place to segue into our conclusion here. You’ve got a few charts in this newsletter that you know, kind of the poster children of the impact of the bearish market. And it’s a little bit of a humble brag that we don’t invest or didn’t invest in any of these things. But you got meme stocks and SPACs and Bitcoin, and just being vastly, you know, revalued here. Give us, as a way to send us out of this podcast here, just give us a couple thoughts.

[Segall] Those charts that we picked were examples, we think, of the kind of phenomenon that occur at the end of a bull market, particularly a really speculative one where the valuations just simply can’t, don’t make any sense and investor enthusiasm carries them to value these things at enormous valuations that you can’t justify at all. We just picked, there were a lot of them we could choose from, we just picked four and called them our poster children for what can happen when enthusiasm and too much money and too much greed all come together. It’s a toxic brew.

[Hildebrandt] Yeah, and just to end here, I think that’s probably to me the secret sauce of what we do is just keeping that true north point, never losing sight of it, sticking to what we do throughout those periods and avoiding those kinds of mistakes. So, thanks again, and we’ll talk to you in another quarter.

[Segall] Take good care.