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But just like bull markets, scale does not work forever. And just like markets, the turn will result in huge dislocations.

The Need To Think Differently

September 27th, 2022 by Kurt L. Smith
  • We have discussed extensively characterizing this financial market as unprecedented. The bull market for bonds ended in March 2020 and all that was left was for stocks to finish their bull market run as well. This happened at the beginning of this year as we began to see unprecedented market moves in February 2022.

    It is not surprising that last year was one for the ages for asset prices. One did not need to believe the bond bull market was over to enjoy a nice run up in private equity investments. Interest rates were still incredibly low allowing private equity, or leveraged equity, to trounce the performance of other asset classes. The S&P Listed Private Equity Index began 2021 at 168, hitting a high of 240 in November 2021 (per Bloomberg).

    The bond bull market is over, and this is where you need to think differently. First and foremost is the lost ability to sell at worthwhile prices. Those private equity investments that performed so well in 2021, well, let’s just say they’re giving it all back in 2022 as the S&P Listed Private Equity Index recently printed below 150.

    What about those other inflation fighting alternative investments? Real estate investments do not work as well with higher interest rates. Good thing you locked your rate in…except that will not help the investors you would like to sell to. In a bond bear market liquidity tends to go poof, sometimes overnight.

    Bitcoin, gold, and even oil has seen their gains of last year reverse almost entirely. If you are beginning to think there is no place to hide you would be thinking in the right direction.

    The two-year U.S. Treasury note surpassed 4.25% this week. As recently as last December it was trading around only .50%. This has led industry pundits to say we can now earn a return on our cash. Yes, thank you very much, earning a return on our cash is something we have been quite familiar with for quite a while here at The Select ApproachTM.

    Having cash is “suddenly” in vogue after almost all asset classes have experienced price collapses of 10% to 20% or more lately. We continue to find worthwhile bonds for your cash regardless of market conditions. I have prepared for this market for decades. The bull market for bonds and stocks was always going to end. We were just not going to get a much better heads up than the one we have received.

    You need to think differently, and the difference comes in just one word: scale. You are very familiar with scale. Scale is our winner-take-all economy of FAANG stocks. Scale is bigger is better and to the victor go the spoils. Scale is mom-and-pops selling out. Think economies of scale, yes, but with leverage and lots of it. It is the reason we now talk in billions instead of only millions. And, of course, scale is the undergirding philosophy of private equity.

    Scale has given us the mutual fund industry as well as the ETF industry. Scale reshaped the stock market with corporate bonds, junk and otherwise, making this possible. The entire mortgage-backed bond market is due to scale, as are the bank loan market and, my favorite, private equity. If you can quickly invest your billions, or even your millions, scale has been able to help…all with the promise of liquidity. Except scale and liquidity only applies in the bull markets of the past.

    But just like bull markets, scale does not work forever. And just like markets, the turn will result in huge dislocations. Markets go down faster than they go up. I do not know why; they just do. So, while those late to the bull market party these past few years did get to briefly enjoy them, I suggest they move past enjoyment and embrace the end of scale.

    I strongly suggested you sell your bond mutual funds and managed bond investments in my April 2020 letter. That was me staying in my lane. But I also just suggested the bond market would affect the rest of the world, particularly with reference to liquidity.

    I suggest, and strongly suggest, that you determine your exit strategy for your other investments, paying particular attention to those involving scale. Almost all these investments involve a common theme: they must be sold to exit. Months down the road you may look back to today and wonder why you did not do more.

    The bonds of The Select ApproachTM have something a lot of other investments do not have. Primarily, these bonds mature. You can sleep, hopefully well, and they still work because they mature. This is important because as long-term investors you are conditioned to not sell. Perhaps selling is what you need to do to continue being a long-term investor.

    You have been a longtime beneficiary of scale. Without it I doubt we would have ever seen the market heights of asset prices, all asset prices, these past few years. I believe those days are over. But one thing I do know for sure, you can never realize the gains and returns of the many investments of scale without acting and that action is to sell.

    You will not find other similar opinions. We live in a world of scale, particularly in the financial services industry dominated by entities managing not just billions, but trillions of dollars in assets. Scale is integral to their business model, so I expect them to be reactive to market conditions, not the proactive actions as I endorse here.

    City of Hutto, TX

    General Obligation Bonds, Series 2022

    AA S&P AGM Insured (AA- S&P Underlying)

    Due 8/1   Dated 9/1/22 Maturity 8/1/47

    $24,765,000 Sold

    Years   Maturity           Coupon      Yield*

    1         2023             5.00%           2.55%

    2         2024             5.00%           2.65%

    3         2025             5.00%           2.70%

    4         2026             5.00%           2.80%

    5         2027             5.00%           2.95%

    6         2028             5.00%           3.05%

    7         2029             5.00%           3.15%

    8         2030             5.00%           3.25%

    9         2031             5.00%           3.35%

    10       2032             5.00%           3.40%

    11          2033**       5.00%           3.45%

    12          2034**        5.00%           3.50%

    13          2035**        5.00%           3.55%

    14          2036**        5.00%           3.60%

    15          2037**        4.00%           4.10%

    16          2038**       4.00%           4.15%

    18          2040**       4.125%         4.25%

    20          2042**       4.25%           4.35%

    22          2044**       4.25%           4.40%

    25          2047**       4.375%         4.50%

    *Yield to Worst (Call or Maturity) ** Call 8/1/32

    Source: Bloomberg

    This is an example of a new issue priced the week of 9/15/22

    Prices, yields and availability subject to change


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