Gravedancing On Crypto

Hey, how is the cryptocurrency market doing?

Early June brought us some news. Three big pieces of news in fact.

First, the US Securities and Exchange (SEC) sued US-based cryptocurrency exchange and public company Coinbase for violating securities law by operating an illegal securities exchange. 

Second, the SEC sued Binance, the largest cryptocurrency exchange platform globally, for violating securities law by operating an illegal securities exchange and also for misusing customer funds. The iconoclastic multi billionaire founder of Binance, Changpeng (CZ) Zhao, was also personally charged for securities violations.

Third, the SEC declared 10 additional cryptocurrencies as securities, a designation that makes trading in them in the United States subject to SEC regulation. Interestingly, the two cryptocurrencies in widest usage – Bitcoin and Ether – were not declared securities.

Look, I don’t want to gravedance on the crypto market but –

Ok, fine, I do want to gravedance a little bit.

During the hype times of crypto – especially the 2019-2022 years – I tried my best to never mention crypto because media coverage of crypto was itself a big part of the hype problem. Now, as crypto fades from view, I mostly still don’t want to talk about it, but I feel like there’s some value in a post-bubble post-mortem. If we can understand the phases of bubbles, maybe we can avoid their destructive power in the future? So in that spirit I want to offer some further context on the June 2023 news, what it means, and why I think this is worth understanding. 

Let’s talk about Coinbase first. The company has long represented the most mainstream access point to cryptocurrency for US-based people and institutions. It trades on the US stock exchange, does 80 percent of its business in the US, and continues to have a roughly $13 billion valuation, albeit down from a peak around $100 billion two years ago.

Although many in the crypto world have been passing in order through the five stages of grief over the past year – Denial, Anger, Bargaining, Depression, Acceptance – I would say Coinbase CEO Brian Armstrong is still in the bargaining phase, based on his comments. 

“The whole point of this case from our point of view is to go get regulatory clarity,” Armstrong told CNN in early June, after the SEC sued his company. “Regardless of the outcome of the case, it’s a step towards clarity.” I find his optimism refreshing. Refreshing, and utterly unrealistic. Coinbase makes money charging huge fees to US crypto investors, and that business has to halt now. Best of luck, Coinbase. Best of luck, Armstrong.

Binance and CZ are in a slightly different place as a result of the SEC action. They have operated less directly in the US markets, which in theory leaves them less exposed to the US’ SEC regulation. “We are operating as a fking unlicensed securities exchange in the USA bro” is something Binance’s chief compliance officer once wrote in an email, so they were long aware of the business risks operating here, and didn’t put as many eggs in this basket. With the SEC moving to freeze their US assets and the claim that they misused customers funds, however, Binance’s reputation will be put at risk. 

Reputational risk, you may recall, is what destroyed one of the previously largest cryptocurrency exchanges named FTX, run by wunderkind and one-time billionaire Sam Bankman-Fried, last November. Interestingly, it was a tweet from Binance’s CZ regarding the risks at FTX that started a weeklong long chain of events that culminated in FTX’s bankruptcy.

One thing that’s clear is that few people in the crypto enthusiast world actually trusted Binance CEO CZ. Rather, they seem to think he is just clever and roguish enough to remain beyond the heavy hand of US government regulation. Time will tell whether he is, and what that will mean for his company.

The theoretically great thing about cryptocurrency was that you didn’t have to trust anyone. It was just code. Immutable, mathematical, scientific, apolitical, and non-geographic. Outside of any particular regulatory regime. No trust in a government regime or finance companies required. 

What crypto enthusiasts hate about the SEC action is that it brings the heavy hand of US government regulation down on the free-wheeling markets of this promising area of financial technology. What non-crypto enthusiasts hate is people pumping up fake securities to investors and stealing money, which happens an awful lot in the free-wheeling markets of this promising area of financial technology.

Crypto Winter

In the light of June 2023 developments, I checked in on my favorite source of community cryptocurrency news – the social media site Reddit, where the last year is described as crypto winter. 

A few patterns of reactions seem noteworthy.

Reaction 1 on the Reddit news threads is that this June 2023 SEC action is proof that the US is becoming authoritarian, because authoritarian regimes generally tried to shut down crypto in earlier years. Okay.

Reaction 2 on the Reddit news threads is lots of anger at the SEC for either:

1. Being too late 

2. Being too early  

3. Specifically targeting the little guy  

4. Specifically targeting the whales, but leaving the little guy exposed. 

What there is less of is introspection into the fact that the absence of regulation of financial assets – the thing crypto enthusiasts seem to want – historically correlates to a very high level of fraud. 

On the Reddit threads, many claim to be still accumulating their magic beans. 

By the way, the best description of crypto is “magic beans.” If you know nothing else about crypto, remember this: These are invented magic beans that true believers think other people will someday value highly for “reasons.” 

Common reaction 3 is the idea that crypto enthusiasts should protect themselves by moving their magic beans off of centralized exchanges such as Coinbase, Binance, or the now-defunct FTX. Keeping your currency in what they call “cold storage” is the proposed plan, removing them from circulation. This is roughly analogous to storing your data on a non-internet connected hard drive. Or like stuffing your cash in a mattress, or your gold in a lockbox, buried in your backyard. I mean, sure. But, like, hard drive cold storage, mattresses, and backyard boxes are great for preppers, but really not great for spending. Currency loses its central function when it is totally removed from circulation. 

On the Reddit threads, in June 2023 they are not at the depression phase yet.  Mostly they have moved past denial, but are still in the anger and bargaining phase. I would judge they are not yet at the acceptance phase of grief. 

Obviously, I still don’t get it. 

A version of this also ran in the San Antonio Express News and the Houston Chronicle

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Book Review: The Delusions of Crowds by William Bernstein

My finance book of the year recommendation is one that perfectly matches the 2021 markets moment: William Bernstein’s The Delusions of Crowds: Why People Go Mad in Groups.

Over and over again this year I found myself describing developments in financial markets that seem, frankly, nuts. All I’ve done this year, it seems, is write about wacky finance trends. 

Delusions_of_Crowds

If Bernstein’s investing book The Four Pillars of Investing is an all-time finance classic, his 2021 book is utterly timely, anticipating a year of financial delusions.

In The Delusions of Crowds, Bernstein toggles between stories of financial delusions and religious delusions. Both types of madness depend on two common human frailties. One he describes as the “Asch Effect,” based on a social psychological experiment which showed how humans can be convinced of obviously wrong things by the social pressure to conform to the opinions of others. When the religious leader or the financial whiz says something is true, and enough people around us agree, we tend to agree, despite evidence to the contrary.

Another common thread is our ability as humans, in the face of contradictory evidence, to completely discount one set of facts if they conflict with our pre-existing beliefs. When the apocalypse does not arrive on the prophesized date, Bernstein notes, true believers do not necessarily reject the prophet. Insteaed, we listen eagerly for the prophet’s update on the next plausible date for the End of Times, rather than settle our cognitive dissonance through doubt or disbelief. Contradictory evidence is merely an opportunity to double-down on our fervent faith, not change our beliefs. The South Sea bubble, railroad stocks in 1840 Britain, the stock pools of 1929. The Fifth Monarchy of 1666, the seventh-day adventism of 1843, the Y2K mania. Bernstein does not mention the QAnon phenomenon, but clearly this recent movement falls within Bernstein’s historical pattern.

For those looking for a pure financial wisdom book, I should warn that Bernstein spends considerable time on non-financial matters. Specifically, he digs deep into the clear connection between “End Times” prophecies from past centuries and powerful Evangelical movements today. Bible-inspired numerology and prophecy has entranced people for a millennium. Bernstein makes the case that this madness not only follows historic patterns but also represents a current threat. Apocalyptic beliefs linked to what he terms dispensationalist Protestantism infuses our current politics.

Personally, I am somewhat immune to the Asch Effect. On the other hand, I tend to redouble my strongest views in the face of contrary evidence, often to my embarrassment. Which I will now demonstrate for you, in the course of reviewing the goofiest financial trends of 2021. Those trends, with caveats.

Meme Stocks

The Robinhood app and Reddit-Bro inspired investing in “Meme Stocks” like Hertz, GameStop and AMC kicked off in January 2021 with a bang. We should have known then that the entire year would be an unending string of delusions and madness. Most of these rockets have yet to fall to earth as the year ends, again not what I would have expected.

GameStop
Stop The Game. Stop.

Caveat: Spotting undervalued companies unloved by institutional investors was the original plausible investment thesis behind some of these meme stocks. That’s cool but only accounted for the earliest movements toward stock appreciation, before the madness took over. 

Cryptocurrency 

These are closer to religion than financial bets or investments. The fundamental correct price of Bitcoin remains zero. That’s the same fundamental price as with all the other crypto currencies I’ve ever heard of. Anyway, hundreds of billions of smart investment capital disagree with me. Since approximately 2013, every time I talk to an audience of folks about investing the first question is always “should I/how can I invest in crypto?” My answer is always the same. Something to the effect of I would sooner recommend lighting one’s paper money on fire flying down the highway at 90 miles an hour. But again, I am clearly the idiot in the room. Up until now I have been wrong, wrong, and then wrong again about Bitcoin.

blockchain_column
Kevin Roose thought he was joking at first

Caveat: I (kind of) understand blockchain technology might be the coolest tech since the invention of the selfie-stick. But cryptocurrencies are not the same as blockchain, and I will continue to disparage the former while being open to the future awesomeness of the latter.

SPACs 

Shall we all invest in an enterprise best described as “an undertaking of great advantage, but nobody to know what it is?” That was the infamous published description of a speculative business advertised around the time of the South Sea Bubble of 1720, a phrase which equally applies to the Special Purpose Acquisition Companies (SPACs) that hit maximum popularity in early 2021. 

Bubble
Picture of South Sea Bubble or really any SPAC you’d like it to be

You put your money into an empty vessel and hope that the named backer finds a private company to take public through purchase. Why wouldn’t you want to put your money into an unknown business that has A-Rod, Sammy Hagar, or Kevin Durant as its backer? Note: That’s both a rhetorical and a sarcastic question.

Caveat: SPAC investors typically get an option to request their money back once an acquisition target gets announced. So, it’s a bit like a free option for the original SPAC backers.

NFTs 

Have people entirely lost their minds? You bought a digital thing and you value it highly because there can only be one copy (or a limited number of copies) of the digital thing? And this is worth $1 thousand or $1 million, or $50 million to you? 

Caveat: Art collecting is always insane when viewed from a finance perspective. Probably best to just leave it to aesthetics and the phrase “There is no accounting for taste.”

Tesla

There are only so many times I can point out how stupid this stock has been in the past, is now in the present, and always will be in the future, for ever and ever, amen. And at each point in time, I have not only been proven wrong, but proven colossally wrong. Like, it’s the wrongest stock-picking call anyone has ever made in the history of making wrong market calls. I feel really great as Tesla shares have zoomed from a ridiculous $100 billion valuation to a ludicrous-mode $1 trillion market capitalization in less than 2 years. But still: Y’all are crazy. I feel extraordinary conviction on this.

Tesla_truck

Caveat: I understand the cars are great. I have no problem with the cars. Just the stock, and its price. And it’s bizarre owner, Elon Musk. Him I have a problem with. But again, I’m the idiot, I admit that.

The most common ending to human delusions, financial and religious, is heartbreak. In finance, however, some bubbles serve the purpose of creating the conditions for future economic innovation. After the wreckage of a burst bubble, we can often see in retrospect how the creative destruction was necessary, or at least that it seeded new growth. This will be useful to remember, when the current crazy ends in tears.

A version of this post ran in the San Antonio Express-News and Houston Chronicle.

Please see related posts:

All Bankers Anonymous Book Reviews in one place

Book Review: The Four Pillars of Investing, by William Bernstein

The NFT Revolution

Tesla – How Do I Hate Thee?

What If You Back The Wrong SPAC?

This Is Your Bitcoin Warning

Stop The Game. Stop.

Post read (795) times.

Backed The Wrong SPAC

Bubble

Nominations are still open for the craziest frothy finance stories of 2021. Strong cases can be made (and I have made them!) for bitcoin and RedditBro GameStop short-squeezes. But maybe the uber example of frothy finances this year are SPACs.

Bubble
Picture of South Sea Bubble or really any SPAC you’d like it to be

Special Purpose Acquisition Companies (SPACs) existed before this current era, but really on the fringy margins of Wall Street. Now they are front and center.

SPACs are known as “blank-check” companies. You buy shares in a company that is just an empty shell. The shell sells 100 million shares for, say $10, raising a billion dollars. In the future – specifically, typically by next year – the managers of the SPAC promise to purchase a private company. At that point you find out what you, the shareholder, own! 

Now, owning shares in a pile of cash worth approximately the pile of cash is ok, I guess. 

You’re really trusting in the SPAC management’s private-company-purchasing skill. For that reason, SPAC managers like to put famous people on their team to build this trust. Former House Speaker Paul Ryan recently joined the management team of a SPAC run by Mitt Romney’s son. I have strong feelings about the trustworthiness of Paul Ryan, but that’s an earlier column.

paul_ryan_workout
Your favorite SPACbro, former House Speaker Paul Ryan

The weird thing that’s been happening sometimes lately is the fact that shares go up when they are just a pile of cash, without any company purchased yet. Sometimes they go up a little, which is ok if you really believe in the Paul Ryans of the world and their ability to buy undervalued private companies. 

But sometimes they go up a lot. Which is nuts. A SPAC that just bought an electric vehicle startup Lucid Motors in mid-February – a company that incidentally has never delivered a single vehicle to a customer – briefly climbed from $10 a share to above $50 a share. The Venn diagram of overlapping investors who like speculative electric vehicle startups and blank check companies apparently produced this briefly delightful mad rush to own the SPAC at $50 per share, when the cash value of the empty shell was still $10 per share. (They should have put the name bitcoin in there somewhere so that shares would reach $90.)

For historians reviewing the South Sea Bubble era, a classic headslapper description of a proposed venture was that it was “an undertaking of great advantage, but nobody to know what it is.”  Haha that’s always a great laugh for financial historians – and the description is possibly apocryphal – but it is also a true and precise definition of exactly what is a SPAC.

While SPACs are not entirely new, they are definitely the new new hotness on Wall Street this year. SPACInsider.com reports a total of 226 SPAC transactions in the eleven years between 2009 and 2019. It’s been a slow build, with the years 2016 to 2019 seeing upticks of 13, 34, 46, and 59 SPAC transactions per year, respectively. 

In 2020, we saw 255 SPACs announced. 

2021 is shaping up as the year of the SPAC, with 348 total announced in just the first two months of the year.

SPAC

On February 26 2021, the final trading day of the month, 13 SPACs launched. That’s as many in one day last week as we saw in all of 2016. In 2021, everybody loves backing blank check companies, undertakings of great advantage but nobody to know what they are! 

The interesting feature of the South Sea Bubbles of 1720 was that the English press of the time understood that many of the new speculative schemes were somewhere between frauds and lottery tickets. The investing crowd in its wisdom did not seem to care what the press thought. Can you blame them? There was too much money to be made.

From 2004 to 2007 a lot of smart guys enjoyed buying condos in Florida “on spec.” Not to live in, but to flip to another buyer. Sometimes these condos hadn’t even been built or finished yet, so a $25 thousand deposit got you the right to pay $400 thousand for the finished condo. But then those smart guys would flip their purchase option rights for $75 thousand and keep the quick profit because the end price of the unbuilt condo was upped to $450 thousand, and there was no need to wait for the condo to be built in order to cash in. Anyway, some people made money doing this for a while.

In the dotcom bubble of 2000 or the housing bubble of 2008 it is simply not true that people did not find the market ridiculous. On the contrary, people thought that Pets.com was stupid in 2000, as was flipping unbuilt Florida spec condos in early 2008. It doesn’t matter. Other people were making money on it. Up until the point when they didn’t make money anymore.

Now, some froth at the creative end of capitalism is arguably good. If we collectively torch $1 trillion in investment capital on electric vehicles but end up also igniting a technological revolution that slows climate change, that’s maybe fine, even if it is painful for the folks who backed the wrong SPAC. (Incidentally, “Backed The Wrong SPAC” is the title of the first poem in my new book of financial slam poetry/rap that I just started working on right now, today.)

The internet boom of 1999 and 2000 ended in tears for many, including backers of Pets.com and Webvan, but overall that episode of financial frothiness probably helped raise buckets of useful capital for scrappy startups like Amazon and Google.

The same capital obliterated by telecom failures WorldCom and Global Crossing may have helped spur a lot of excessive investment in fiber optic cable. That bandwidth is essential to watching the massive volume of cute cat videos on Reddit that we all now consume.

SPACs are ridiculous investments, but sometimes you have to wait and see whether some financial ridiculousness and tragedy for speculators ends up with a silver lining for the broader economy and society.

And by the way, please do not misinterpret me. Do I mean you should sell your stocks because everything is going to crash? Of course not, never sell. Take the multi-decade view.

But also, please, please don’t buy stupid things.

A version of this post ran in the San Antonio Express News.

Please see related posts:

RobinHood is not your friend

Bitcoin (hopefully for the last time)

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Your Bitcoin Warning

You’ve been writing me a lot lately, wondering about bitcoin. What is this technology? What is it used for? Should you get involved? 

bitcoin_what_is_it_used_for
What is the right price for bitcoin? What are its uses?

But also, what is the right price for bitcoin? Is it a buy or a sell here? As of this writing, a bitcoin costs roughly $50,000, up from $10,000 a year ago. Could it go to $200,000? That’s only 200% up from now. It’s gone up 500% in the past year. So sure, why not? $200,000 sounds great.

That’s,,,not a prediction. 

What do I think is the fundamental right price for bitcoin? I’d say, roughly, zero? I truly think zero is the fundamental correct price. But it could take a while to get there.

Now, blockchain – the innovative technology of which bitcoin is the best known example – may have real uses. I’m open to that idea. Blockchain allows for anonymous, distributed transactions which can be verified between parties that neither know nor trust each other. Theoretically, blockchain obviates the need for government regulation or third-party verification. 

Applied to money, bitcoin – using blockchain technology – theoretically allows us to remove transactions from the purview or limitations of existing financial infrastructure.

Dollars, the theory goes, involve pesky government issuers, unreliable central banks, and the meddling institutions of the existing global finance system. To its proponents bitcoin – using blockchain technology – is like money unshackled by politics, regulators, and borders. 

To be clear. I totally disagree with the need for unshackling. I think dollars are awesome. I even buy stuff and services with them! I’ve honestly never felt limited by dollars, except obviously by the amount of them that I control at any given time. By contrast, I believe bitcoins are – at their essence – useless. A useless fiction, and therefore a fraud. I prefer my fictions to be useful.

What is the real-world use of bitcoin? Bitcoin is not a useful store of value in the way that dollars are. Anything that can soar 500 percent in the past year – as Bitcoin has – can also drop 80 percent the following year. Or the following month. That makes it entirely inappropriate for “storing value.” 

Could bitcoin be delightful as a pure gamble, like buying a lottery ticket? Sure. But no sensible person advocates lottery tickets as a store of value.

The South Sea Company was created by charter in 1711 with a mandate to engage in an implausible business, in a far off place, that none of its British investors had ever seen. It was just exotic and mysterious enough to capture the whiff and elan of possibly unlimited wealth. It enjoyed the imprimatur of the government of England, and for a time legitimately traded in English government bonds. Shares began at 100 British pounds, but reached 1,000 pounds a decade later. Fortunes were destroyed shortly thereafter, when the laws of financial gravity returned. We return to this cautionary financial story over and over because – while no two bubbles are alike – history does rhyme.

South_Sea_Bubble
South Sea Stock (log scale)

Bitcoin has all the makings of collective financial madness. Magical thinking! A difficult-to-grasp mysterious technology! Breathless media coverage of its ever-increasing price! Celebrities who might be buying it! 

Bitcoin’s only plausible real-world use cases – as a medium of exchange rather than a speculation – are tax evasion, foreign-exchange-control evasion, drug dealing, prostitution, child-pornography, assassinations, arms-dealing, illegal gambling, and ransomware for computer hackers. As I have yet to engage in any of these activities, I have yet to find an actual use for bitcoin in my own life. But your mileage may differ, no judgment.

Incidentally, bitcoin is probably not even anonymous. One of the features of the blockchain is that all transactions are infinitely traceable and reproducible. That’s the plausible key to blockchain technology’s usefulness in the future – that all transactions and counterparts create a permanent record, visible to all counterparts. 

But that feature of permanence undermines anonymity. A blockchain-sophisticated FBI should be able to see exactly who sold you bitcoin, and who in turn you sold bitcoin to. Your drug deal or tax evasion with bitcoin was not as anonymous as you thought it was after all! Haven’t you ever watched movies? This is neither business nor legal advice, but do you know what is anonymous, instead? A suitcase full of unmarked, non-sequential dollar bills.

Should you take my word for it on bitcoin? I can only warn you about my similar strong feelings in the past and how that worked out.

In the one and only market call I have ever made in this space in 7.5 years, I said Tesla was a terrible stock in 2015

It promptly quadrupled in value. So I reiterated my hatred for that stock’s price in early 2020.

My bold call clearly triggered the value of that stock to septuple over this past year. You’re welcome.

I just mention this to say, you should probably speculate in the opposite direction of whatever I advocate, including, especially, about things like bitcoin. Bitcoin is far, far, stupider than Tesla shares will ever be. Naturally, Tesla announced last month that it had speculated with its corporate cash by acquiring $1.5 billion in bitcoin. Because LOLs. And YOLO. And FOMO. 

Tesla CEO Elon Musk’s explanation for this speculation: “Bitcoin is almost as bs as fiat money. The key word is ‘almost’.”

[Ah, yes, such wisdom! What mysterious sagacity from 2021’s newest richest man in the world! Take all my money, please, you carnival-barking promoter of fictions!]

Bitcoin – Also not a very efficient use of power!

Never underestimate the power of greed and magical thinking to keep things irrational longer than you can stay solvent. Welcome to the monkey house.

Cryptocurrency enthusiasts like to point out that traditional “fiat” money like dollars, unmoored from a metallic base like silver or gold, is based on a collective fiction. In that sense, would-be sophisticates (and Musk) argue, the collective fiction of bitcoin is no worse than dollars. 

Rai_Stones_of_Micronesia
Rai Stones. Better than gold?

Gold is also a collective fiction, albeit one a few thousand years old. Shells have made for a collective fiction in the past. The rai stones of Micronesia were a collective fiction. What even is money?

US dollars are also a collective fiction, except for the true fact that my government demands, and accepts, dollars for taxes. As far as I can tell, this is the basis for fundamental value in a currency. What my government accepts in taxes.

A convenient currency is more useful than barter. My local, state and federal governments do not currently accept extremely well-reasoned and delightfully funny finance writing as a means of discharging my tax obligations. I need to first convert finance columns to dollars, which my government then does accept.

When President Elon Musk declares in 2028 that we can and must make tax payments in bitcoin, then – and only then – will I agree that bitcoin has any fundamental value. It may well go to $200,000 (and beyond!) for all I know in the meantime. Unless and until Musk runs for President, I expect a zero value future for this particular collective fiction.

A version of this post ran in the San Antonio Express News.

Please see related posts:

Tesla is awful (January 2020 edition)

Tesla is not going to make it (2015 edition)

Hater’s Guide To Tesla (August 2020)

Never Buy Gold

Never Buy Timeshares

Never Buy A Variable Annuity

Bitcoin, Blockchain, and Bullocks

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Ask an Ex-Banker: How To Fight Upcoming Inflation?

homebuyer

A reader wrote me recently:

“Given the staggering debt of the United States and Congress’ seemingly laissez-faire attitude and impotence towards addressing it, I am starting to be concerned about the value of U.S. currency. Historically, wars and corrupt governments have led to hyperinflation in other countries where the costs of goods and services skyrocket. The likelihood of this happening in the U.S. may seem remote but it is not impossible. Are there ways for individuals to protect themselves from this?” — Dom D. From San Antonio

I really like this question. Dom recognizes our unprecedented current debt situation and the unfortunate parallels with other countries where hyperinflation followed. I have no idea what’s going to happen.

If it’s comforting, hyperinflation would require a failure by the Federal Reserve to do its job. The Fed withstood the last few years better than most institutions. But, yeah, increased inflation seems increasingly likely for the reasons Dom named. So what to do?

federal_reserve_seal
The Fed has to fail for hyperinflation to happen

Something to remember about inflation is that if the underlying economy is unchanged but the amount of available currency doubles, it is reasonable to assume that the price of things approximately doubles. This is bad when we have to pay for things. It is not necessarily bad if the price doubles of things that we already own. Things that you could own, which should double in price if the supply of money doubles, include real estate and stocks. As a result, these make for very good inflation hedges.

So the first great way to hedge against inflation is to own a business, or preferably many businesses. Some insist on the hard way to do this.1 I would like to focus everyone’s attention on the lazy way – my preferred way – which is to own hundreds or even thousands of businesses through a single low-cost diversified stock mutual fund. In an inflationary environment, successful businesses raise prices in response to their higher costs. Successful businesses adjust dynamically to earn profits despite inflation. 

Similarly it is reasonable to expect – all else being equal – that a stock worth $100 today will be worth $200 tomorrow, if the amount of currency doubles overnight. One explanation for the record rise of the stock market in the last few months – the one I find most plausible – is that the Fed has dramatically increased the supply of currency in the economy. The record stock market rise is probably a specific form of inflation hitting one very visible corner of the overall economy.

The second great hedge against inflation is to own real estate in advance of inflation. For starters, try to own your home. And then live in it for a long time. The price of your home should appreciate roughly at the rate of inflation. That’s the definition of a good hedge. Let’s say, for example, you own a home today worth $250,000. And then we suffer a patch of 10% annual inflation for ten years. Your house at the end of 10 years will be worth a little over 648 thousand dollars. Compound interest math uses the same formula as inflation math.

homebuyer
Homeownership is good

Now, here’s an even more interesting twist on inflation hedging via home ownership. The triple lindy inflation hedge, if you will. Are you ready for it? 

Do you have a long-term fixed-rate (let’s say, 30-year) mortgage on your house?

Ta da! You did it. You are amazing. Have you ever thought about being a hedge fund manager? 

Here’s why this is an amazing inflation-hedging tool. Using the previous example, as your home value leaps upward over 10 years of 10% annual inflation from $250K to $648K, your 30-year fixed rate mortgage decreases dramatically, both in nominal and real terms. Using a standard 30 year amortization schedule, your mortgage would pay down from $200K to $162K during the first ten years. At the end of ten years, a $162K amount of debt on a house worth $648K is actually pretty easy to handle. You moved from owning $50K in home equity to $486K in home equity, nearly a ten-times increase. 

Also, just as money isn’t worth as much following inflation, debts are also not worth as much in an inflationary future, so $162K in debt is not as big a deal in that future as it would be today. In other words, being a borrower during an inflationary period is actually a powerful inflation hedge. (Provided, of course, your debt has a fixed rather than variable interest rate.)

By owning your home with a mortgage, you’re a fancy inflation hedger, and you didn’t even know it.

Next, what should you specifically not do if you anticipate future bouts of inflation?

Do not buy fixed income products for any investment purposes. Traditional fixed income investment products include bonds, bond funds, annuities, and CDs. Inflation absolutely wrecks the value of these fixed income investments. Even money market funds, savings accounts, and cash could be considered fixed income, just with an extremely short (same day) maturity date. If your net worth or income is in any of these fixed income products, inflation will unfortunately destroy your wealth.

gold_as_an_inflation_hedge
Not an inflation hedge I endorse!

Next, do not buy gold as an inflation hedge. Gold is a pretty but useless metal sold by preying on the fears of unsophisticated financial minds. I understand you don’t believe me, because of all those plausible sales pitches on your video screens, but it’s true.

Also, do not buy bitcoin as an inflation hedge. Bitcoin is a fake currency, neither useful for buying beer nor paying taxes. It has no legal use case and produces no wealth, except for people hyping you to buy it, based on the greater fool theory of speculation.

In sum, own your own home, own some businesses either directly or through the stock market, and if you must borrow, then borrow at a fixed interest rate. Avoid the standard inflation-hedge scams.

Bitcoin
Avoid Bitcoin

What I really like about the previous two sentences is that in anticipation of heavy inflation – and I can not emphasize this strongly enough – you should pursue the exact same investment actions I would advise to anyone who is not anticipating a future bout of heavy inflation. 

Did you catch that? It’s important. Do exactly the same prudent things you should always do.

Finally, is Dom’s scenario likely to come to pass? I don’t know. Neither does anyone. Pundits who predict the economic future with certainty are fools or confidence men to be deeply distrusted. 

I have personally (but silently) expected significant inflation since aggressive interest rate drops in September 2001. I’ve been wrong every time. 

Although, maybe not. Come to think of it, my home value and my stock index funds have suffered quite a bit of inflation over the past twenty years. Haven’t yours?

A version of this ran in the San Antonio Express News.

Please see related posts:

Homeownership is great, including as an inflation hedge

Bitcoin and Bullocks

Never Buy Gold

ETFs and Mutual Funds

Trump_federal_reserve
This guy…would have happily caused hyper inflation if he thought it served his short-term political or narcissistic interests

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Never Buy Gold

goldA significant portion of the Financial Infotainment Industrial Complex dedicates itself to selling you gold, as an investment.

Resist.

I have already written about the three other horsemen of your personal financial apocalypse: variable annuities, times shares, and bitcoins.

The commonality of these four horseman is that they are sold to credible people as “investments” when they are really the opposite of investments. All four act as a drain on your net worth.

Gold fails the fundamental test of what constitutes an actual investment.

What do I mean by the “fundamental test” of what makes an investment? I mean that unlike true investments, gold produces no cash flow. The birds-and-the-bees of compound interest is like this. Money begets money. True investments make you money because over time they reproduce little baby monies, which over time, reinvested, grow up to be big monies. That’s what positive cash flow means.

what_if_I_told_youThe way to value real investments is to measure future positive cash flow.

If you don’t want to get more technical than the birds and the bees, skip this next paragraph.

To get a bit technical for a moment, the fundamental value of every investment is the sum of all of its future cash flows, discounted to the present day. This is how to value private businesses, as well as publicly owned stocks, based on future re-invested profits and future dividends. This is how to value bonds, based on future interest and principal payments. We similarly calculate the value of commercial real estate, based on the expectation for future rents.

Gold, by contrast, produces nothing. No cash flow. No baby monies. It just sits there, a non-fecund lump. In fact, gold in physical form – like all other commodities – has negative cash flow, because of storage costs. You should reasonably expect a negative return over time on your long-term gold holdings, all else being equal.

But now you might be thinking that you’ve heard people, or at least seen people on television, talking about making money investing in gold. Gold certainly fluctuates in value, which can create the illusion of an investing opportunity. But it’s a speculator’s illusion, a gambler’s trick. It’s based on expecting other people to become fearful about the state of the world, which for a short time can make the price of gold go up. The little silver ball of a roulette wheel, similarly, consistently lands on either black or red, and you can observe people making Never_buy_goldmoney over a short period of time by correctly guessing the future color.

The key is not to look at how gold (or stocks, or bonds, or real estate) performed over the last few weeks or last few years. Rather, the key is to look at gold’s long-term results, in order to overcome any distraction we may suffer from short-term fluctuations.

Professor Jeremy Siegel – author of the finance classic Stocks for the Long Run offers the definitive take down of gold as a long-term effective asset class, especially when compared to real investments like stocks or bonds or real estate.

According to Siegel’s time series, one dollar invested in stocks in 1802 would be worth $706,199 by the end of 2012. One dollar in long-term bonds would be worth $282. Meanwhile, one dollar in gold would be worth just $4.50.

But what if you think of gold not so much to grow your money, like an investment, but rather simply to hedge against inflation? That’s also important to consider, for two reasons. First, because Siegel also notes that one dollar hid under a mattress in 1802 would be worth just 5 cents by 2012, its value eroded by inflation. Second, many gold-purchasers view their shiny metal not as a way to earn a positive return, but to guard against inflation.

But again, this lacks the historical view.

To hedge against inflation, you need the value of the thing you’re buying to increase in value at least as much as inflation erodes your money. But if a dollar only buys one twentieth of what it bought 200 years ago, then earning gold’s real return of 4.5 times isn’t enough.

If you really want to keep pace with inflation, buy real estate and stocks. Unlike gold, these actually do increase in value as fast as inflation. A company that sells a successful product can increase prices to keep pace with inflation, and can even earn a profit in the face of inflation. Own the company through its stock, and you too can outpace inflation handily with your investments.

Owning your own house, interestingly, is an effective inflation hedge. The price of homes, in aggregate, generally increases in line with inflation.

Some people buy TIPS – inflation-adjusted bonds from the US Treasury. I wouldn’t, but that’s at least a rational decision, with a positive cash flow, under inflationary conditions.

What if you had a $100 million investment portfolio? Should you buy some gold then? Ok, maybe. I don’t endorse it, but sure, you can afford to buy a wide variety of experimental assets without cash flow for diversification – including art – and maybe a diversified basket of commodities. Go ahead and buy collectible beanie babies while you’re at it. You can afford the loss. It won’t do you any good, but who am I to argue? You’re the one with the $100 million.

But what about the fact that during times of extreme financial crisis – like we last experienced in 2008 – gold prices soar. Didn’t gold prove its hedging value then? Yes, I can’t deny that gold prices temporarily responded to financial panic, mostly because other people and institutions buy into the fiction that gold is a “safe haven” appropriate for the financial, or zombie, apocalypse. You had a couple of weeks for feeling smug, but I know you’ve lost money on your gold investment since then. The medium and long-terms prospects for gold are always terrible, because gold is primarily a psychological trick played upon the scared and financially naïve. Don’t participate. Its fundamental value is as fictional as the Walking Dead. Nobody wants your lumps of shiny metal when the undead approach. You would be better off with backup power generators, baseball bats, and canned goods as an investment.

The only apocalypses are the ones happening in your head, and to your net worth.

A version of this post appeared in the San Antonio Express News and Houston Chronicle.

Please see related posts:

Never Buy A Time Share

Never Buy Variable Annuities

Never Buy Bitcoin

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