Special Report - March 6, 2023

Compound Inflation

“Millionaires” are dropping like flies.

According to Fidelity, the leading provider of 401(k) plans in the United States, more than 140,000 Americans who held retirement accounts with over one million dollars last year no longer hold that status.

Where did all the money go? Down the proverbial “inflation” tubes.

Fidelity reported last week that 401(k) account holders experienced an average loss of 20% due to inflation last year. What had been over 440,000 accounts worth more than seven figures has fallen below 300,000.¹ There could be more pain ahead as the Federal Reserve is forced to continue raising interest rates in their losing battle against inflation. Rob Arnott, co-founder of Research Affiliates, warns that the US stock market “crash is far from finished.”

Crash or no crash the damage to most long term investment portfolios has already occurred. Few investors truly understand the long term implications.

It’s our mission to enlighten them.

Virtually all investment theory is based on the simple concept of compound interest. World famous inventor, Albert Einstein, is credited with saying: "Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it."

Einstein was a genius in more ways than one. What he didn’t say but surely understood was that inflation sits on the opposite side of the pendulum to compound interest. While compound interest increases the value of money over time, inflation does the exact opposite. It erodes the value of money over time.

As Einstein pointed out, investors who don’t understand this will continue paying the price.

Many people fail to grasp that losses incurred within the compounding framework necessitate disproportionately large future returns just to break even. This can prove to be a painful experience for long-term investors, especially those with retirement accounts, particularly during eras where financial assets struggle. The compounding effect amplifies over an extended investment horizon, leading to greater benefits. It also means that losses incurred today can have a detrimental impact on compounding over time.

Benjamin Graham, widely considered the father of value investing, wrote extensively about the impact of inflation on investments and the concept of negative compounding. In his book, "The Intelligent Investor," Graham argues that investors should consider the effects of inflation on their investment returns, as failing to do so can lead to negative compounding and a significant reduction in the purchasing power of their investments over time.

This essay seeks to explain the effects of positive and negative compounding within the framework of target date funds and why inflation destroys the benefits of compounding.

You may be stunned by the conclusion.

Part 1. Compounding

There is a scene in the opening of the film The Wolf of Wall Street, where Mr Hannah (played by the brilliant Matthew McConaughey) takes Jordan Belfort (played by a fresh faced Leonardo Dicaprio) to lunch on his very first day at the firm in 1987. After three martinis, Mr Hannah explains to Belfort the true agenda of Wall Street.

Hannah:

The name of the game? Move the money from your clients pocket into your pocket… We don’t create sh&t. We don’t build anything. So if you’ve got a client that bought stock at $8, and it now sits at $18 and he’s all f’n happy, he wants to cash in and take his money and run home, you don’t let him do that. Because that would make it real. No, what do you do? You get another brilliant idea. A special idea. Another situation. Another stock. To reinvest his earnings and then some. And he will every single time because they're addicted. And then you just keep doing this again and again and again.

One may look at the scene and argue that the Wolf of Wall Street represents an extinct version of Wall Street that no longer exists today. Much has changed since 1987. But not everything. It just feels that way because it’s all done in a more civilized way these days.

The goal of Wall Street today is the same as it was back then, to keep us invested. Even more importantly, it's to keep us invested in the things they can take the most commission on. Back then, it was high commission products for individual stock trades. Today it’s all about long term “assets under management” (AUM’S) fees .

We must recognize that Wall Street doesn’t care if we win or lose, just that we stay in the game. If we walk away from the casino altogether, they know they may never get us back. It’s why it’s imperative for Wall Street to tell the public that the right way to invest is to “stay invested.” Even in eras of inflation where it’s virtually impossible for financial assets to thrive.

Enter the Target Date Fund, one of the greatest marketing concepts for financial assets that's ever been created. The selling point behind target date funds is that they will compound, and therefore, grow even more over time.

Compounding is the process by which the returns generated by an investment are reinvested to generate additional returns in the future. In the context of target date funds, compounding can be a powerful tool for investors who are looking to grow their retirement savings over time. As the target date fund generates returns, those returns are reinvested back into the fund, which can then generate additional returns in the future. Over time, this compounding effect can significantly increase the value of the investor's retirement savings.

Benjamin Graham believed in the power of compounding interest and its ability to generate wealth over time. In his book "The Intelligent Investor," he emphasizes the importance of finding investments that can generate a consistent return over the long term, and allowing the power of compounding to work its magic.

Graham notes that the power of compounding can lead to significant growth in investments over time, even with a relatively modest rate of return. He gives the example of an investment that earns a 7% annual return, which he notes can grow to 8 times its original value after 25 years.

We all love the idea of compounding, right? What could be better than compounding in a long-term retirement account, right? Now imagine doing that tax-free? This has been the Wall Street sales pitch to workers who invest in retirement accounts through 401(k) plans.

A 401(k) is a retirement savings plan sponsored by an employer that allows employees to contribute a portion of their pre-tax income to the plan. The contributions are invested in a range of investment options, such as mutual funds, stocks, and bonds, and grow tax-free until retirement. Employers may also make matching contributions up to a certain percentage of the employee's contribution.

These are retirement plans for the worker bee. Wall Street has minted more and more millionaire worker bees in the last decade. According to a report from Fidelity investments, the number of millionaires in 2014 was 200,000. By the fourth quarter of 2021, that number had ballooned to over 442,000.

We’ve all heard the saying, “you are what you eat”, right?

Over the past 15 years, and via the generosity of the central bank's quantitative easing programs, 401(k) plans have plumped up to become fatted cows feasting on low interest rate cornmeal, spoon-fed directly from the Fed.

Wall Street sales pitch...

According to data from Vanguard, How America Saves 2021 report, the most commonly held investments in 401(k) plans are Target Date Funds.² These funds are also known as “lifecycle funds” or “age-based” funds. The idea behind these funds is to provide investors with a simple, all-in-one investment solution that is tailored to their investment timeline and risk tolerance. When an investor invests in a target date fund, they select the fund that has a target date closest to the year they plan to retire. The fund then invests in a mix of stocks, bonds, and other assets based on the investor's target date of retirement.

This allows individual investors with little investing experience to “set it and forget it.”

As the target date approaches, the fund will automatically adjust its asset allocation to become more conservative, with a greater emphasis on bonds and other fixed-income securities, which are generally considered less risky than stocks. This adjustment helps protect investors' retirement savings from market fluctuations as they approach retirement.

At least that’s the Wall Street sales pitch.

According to Wall Street, the key to maximizing the benefits of compounding in target date funds is to “invest early and consistently.” They argue that by investing regularly over a long period of time, investors can take advantage of the power of compounding and potentially achieve their retirement savings goals.

It’s a very self-serving sales pitch indeed. It’s also one that requires investors to stay in the game.

The explosion of 401(k) millionaires over the past decade has been a boon to Wall Street. It has also put pressure on the labor market as more boomers have left the workforce early to enjoy the fruits of their labor. Unfortunately, the fruit is going bad, particularly for those who have yet to change their diet. More than 32% of 401(k) holders are now "former millionaires." Those expecting to get back across the seven-figure threshold may have a very long wait ahead of them, particularly if they continue using the same strategy.

The target date funds which had been the beneficiaries of aggressive multi-year compounding, have fallen on lean times and are calling into question if these funds are actually the right way to invest?

Let’s start with a basic example so we can understand the math. What would an investment of $100,000 that compounded at 7% for a decade be worth after 10 years?

Here is how the math looks year by year:

Year 1: $100,000 x (1 + 0.07) = $107,000

Year 2: $107,000 x (1 + 0.07) = $114,490

Year 3: $114,490 x (1 + 0.07) = $122,504

Year 4: $122,504 x (1 + 0.07) = $131,079

Year 5: $131,079 x (1 + 0.07) = $140,255

Year 6: $140,255 x (1 + 0.07) = $150,076

Year 7: $150,076 x (1 + 0.07) = $160,588

Year 8: $160,588 x (1 + 0.07) = $171,838

Year 9: $171,838 x (1 + 0.07) = $183,877

Year 10: $183,877 x (1 + 0.07) = $196,767

Einstein was right. Compound interest is incredible! A $100,000 investment that does nothing else but earn a 7% compounded annual return will be worth nearly double that in 10 years. No effort required, just let compound interest work its magic.

Ok, so far so good.

Who wouldn’t want to see their future value compounded like this? This is an easy pitch for Wall Street and why the majority of 401(k) holders are invested in target date funds. What this math does not contemplate, and what Wall Street often fails to point out, is what happens should we have a down year or two?

Let’s now take a look at the math in our compounding situation if we have two down years inside our ten-year cycle. For this example, we will assume we lose 20% in year two and 10% in year three.

Year 1: $100,000 x (1 + 0.07) = $107,000

Year 2: $107,000 x (1 - 0.20) = $85.600

Year 3: $85.600 x (1 - 0.10) = $77,004

Year 4: $77.040 x (1 + 0.07) = $82,333

Year 5: $82.330 x (1 + 0.07) = $88,130

Year 6: $88.130 x (1 + 0.07) = $94.480

Year 7: $94.480 x (1 + 0.07) = $101,430

Year 8: $101.430 x (1 + 0.07) = $108,098

Year 9: $108.980 x (1 + 0.07) = $117,180

Year 10: $117,180 x (1 + 0.07) = $125, 990

Whoa!

Just two consecutive down years messes up the entire equation. Under this scenario, we lose $70,000 from our ending value, which is actually worse than it may appear. The 30% of losses in years two and three mean we lose 36% from our overall compounded value ($125,990/ $196,715 = 64%) over the ten-year span.

Now let’s suppose we lose 20% in year eight and 10% in year nine.

Year 1: $100,000 x (1 + 0.07) = $107,000

Year 2: $107,000 x (1 + 0.07) = $114,490

Year 3: $114,490 x (1 + 0.07) = $122,504.30

Year 4: $122,504.30 x (1 + 0.07) = $131,077.55

Year 5: $131,077.55 x (1 + 0.07) = $140,246.39

Year 6: $140,246.39 x (1 + 0.07) = $150,049.06

Year 7: $150,049.06 x (1 + 0.07) = $160,526.30

Year 8: $160,526.30 x (1 - 0.20) = $128,421.04

Year 9: $128,421.04 x (1 - 0.10) = $115,578.94

Year 10: $115,578.94 x (1 + 0.07) = $123,607.99

Our overall net is even worse in this scenario.

Let's now look if we were to lose 20% in year two and then 10% in year eight.

Year 1: $100,000 x (1 + 0.07) = $107,000

Year 2: $107,000 x (1 - 0.20) = $85,600

Year 3: $85,600 x (1 + 0.07) = $91,832

Year 4: $91,832 x (1 + 0.07) = $98,210

Year 5: $98,210 x (1 + 0.07) = $105,043

Year 6: $105,043 x (1 + 0.07) = $112,353

Year 7: $112,353 x (1 + 0.07) = $120,156

Year 8: $120,156 x (1 - 0.10) = $102,135.84

Year 9: $102,135 x (1 + 0.07) = $109,294

Year 10: $109,294 x (1 + 0.07) = $117,217.22

Under this scenario above, our terminal value is even worse!

The conclusions should be obvious.

Compounding works only when uninterrupted. When losses are suffered along the process, it dramatically reduces the benefits derived from compounding. As importantly, it also matters when we lose. The earlier the losses occur, the better the long term performance. When losses happen later in the cycle, the net gains can be significantly lower.

Part 2. Target Date Funds

Ok. Now that we have covered compounding let’s get further detail around the target date funds so many 401(k) investors use. These funds come with wonderful calculators where we can type in our age, the number of years we wish to continue working, and the annual amount we intend to invest over time to provide future value that we can expect to retire on.

We’ve all seen them, right?

One of the more popular retirement calculators can be found on bankrate.com. For the purposes of an example, and to highlight the truth, I filled out a retirement calculator online and took a screenshot for our review.

For my calculation, I assumed that we would begin with a $100,000 investment and add $10,000 per year for a total of ten years. The “annual rate of return,” like virtually all target date fund calculators, auto-populated 7%. More on this later.

After inputting these simple variables and with just the click of a button, the target date fund calculator projected we will have $340,064 in ten years. This looks pretty great, right? But is this the likely future?

We must first consider that in the above scenario we have invested a total of $200K. Don’t forget, we started with a $100k balance and then added an additional $10k per year for ten years. The whopping $340K number is based on a total contribution of $200,000. Not on $100,000. This little trick provides psychological momentum as it future paces, and future programs worker bee investors.

Who needs Mr Hannah on Wall Street when you’ve got the target date fund calculator spitting out such big future numbers?

How does this math jibe with reality?

We believe investors should pay more attention to the disclaimer, “past performance does not indicate future results” than to the future promises made by these target date calculations. These models are based on historical averages and the math that stocks and bonds will return a blended average of 7% per year over time.

But will they?

Fidelity’s report explained that 401k investors lost an average of 20% last year. This is the definition of a bear market. A bear market is typically defined as a decline of 20% or more in the stock market from its recent peak.

An important question to consider is, how often do bear markets occur?

According to Ned Davis Research, there have been 34 bear markets in the S&P 500 since 1900, which averages out to about one every 3.5 years on average.³ J.P. Morgan Asset Management reports that there have been 23 bear markets (defined as a decline of 20% or more) in the S&P 500 since 1926, which averages out to about one every 5 years. A study by Vanguard found that between 1980 and 2016, there were 10 bear markets in the S&P 500, which works out to about one every 6 years on average.⁴

The frequency of bear markets can vary depending on the time period being analyzed and the criteria used to define a bear market. It’s fair to say that, based on history, we get two bear markets every decade that last about a year on average.

Once again, let's take a look at the math. Below is the calculation that assumes an initial investment of $100,000, an annual contribution of $10,000, with a 7% annual return in an account that suffers through a bear market (drop of 20%) and lasts 12 months in years two and eight.

Year 1:

Beginning balance: $100,000

Contribution: $10,000

Investment return: $7,000

Ending balance: $117,000

Year 2:

Beginning balance: $117,000

Contribution: $10,000

Investment return: -$23,400 (20% loss)

Ending balance: $103,600

Year 3:

Beginning balance: $103,600

Contribution: $10,000

Investment return: $7,252

Ending balance: $121,852

Year 4:

Beginning balance: $121,852

Contribution: $10,000

Investment return: $8,531

Ending balance: $140,383

Year 5:

Beginning balance: $140,383

Contribution: $10,000

Investment return: $9,828

Ending balance: $160,211

Year 6:

Beginning balance: $160,211

Contribution: $10,000

Investment return: $11,225

Ending balance: $181,436

Year 7:

Beginning balance: $181,436

Contribution: $10,000

Investment return: $12,721

Ending balance: $204,157

Year 8:

Beginning balance: $204,157

Contribution: $10,000

Investment return: -$40,831 (20% loss)

Ending balance: $173,326

Year 9:

Beginning balance: $173,326

Contribution: $10,000

Investment return: $12,132

Ending balance: $195,458

Year 10:

Beginning balance: $195,458

Contribution: $10,000

Investment return: $13,682

Ending balance: $219,140

This is a dramatically different result than what our calculator promised.

In fact, in the above scenario, we would have personally contributed $200,000 of the total $219,140 terminal value. This is not an average annual return of 7%. This equates to an average return SEVEN TIMES LOWER of just 1.21%.

The number above actually oversell’s reality.

According to data from S&P Dow Jones Indices, the average decline in the S&P 500 during bear markets since 1929 has been approximately 35%, not 20%, with an average duration of approximately 14 months, not 12 months.

Here is what our math looks like when we consider actual historical averages:

Year 1: Balance $100,000, with a 7% return, results in a balance of $107,000

Year 2: Add $10,000, but with a loss of 35%, the balance drops to $70,050

Year 3: Add $10,000, with a 7% return, the balance increases to $82,705

Year 4: Add $10,000, with a 7% return, the balance increases to $96,284

Year 5: Add $10,000, with a 7% return, the balance increases to $110,919

Year 6: Add $10,000, with a 7% return, the balance increases to $126,768

Year 7: Add $10,000, with a 7% return, the balance increases to $143,991

Year 8: Add $10,000, but with a loss of 35%, the balance drops to $96,193

Year 9: Add $10,000, with a 7% return, the balance increases to $110,865

Year 10: Add $10,000, with a 7% return, the balance increases to $127,162

As we can see, after ten years of investing using historical averages, our target date fund would lose roughly 32% of our total invested and have an ending value of only $127,162 and not the $200,000 we actually invested.

This is sobering math, and why the big question on everyone’s mind should be how does Wall Street support their predicted 7% annual return?

Well, despite their disclaimers, it’s based on past results. This, it turns out, is the historical average.

One commonly cited source to find the historical average is the annual "Stocks, Bonds, Bills, and Inflation" (SBBI) Yearbook, which is published by Morningstar. This yearbook provides historical data on the returns of various asset classes, including stocks, bonds, and inflation, and is often used by financial professionals to analyze investment performance and construct portfolios.

“Over the long-term (e.g. 30+ years), a well-diversified portfolio consisting of a mix of stocks and bonds has provided an average annual return of around 6-8%.” They then add the disclaimer, “However, it's important to note that this return can vary significantly from year to year, and there may be periods of time where the portfolio experiences negative returns.” ⁵

In order to achieve the 7% average return, particularly when we see a bear market every five years, we must have years that experience extraordinary gains. Losses of 20% need to be offset by massive years of 30% gains. Losses of 35% need to be offset by positive years of 55% gains. These opportunities exist in disinflationary eras and when P/E multiples are in the lower range. However, what the 7% average return assumption fails to consider is what our future returns will look like when markets are historically overvalued.

The Warren Buffett Indicator (WBI), also known as the Market Cap to GDP ratio, is a financial metric used to evaluate the overall valuation of the stock market. The indicator compares the total market capitalization of all publicly traded companies in a country (i.e. the total value of all stocks) to the country's Gross Domestic Product (GDP), which is the total value of goods and services produced within a country's borders in a given period.

Warren Buffett, the renowned investor and CEO of Berkshire Hathaway, popularized the use of this indicator as a way to assess whether the stock market is overvalued or undervalued. He made an argument that when the ratio is high (anywhere above 115%), it may indicate that the stock market is overvalued, may be due for a correction, and is predictive of lower long term investment gains.

While the indicator is not intended to be a timing mechanism, it’s particularly helpful for long-term investors. The times in history when this indicator has been elevated have been followed by decades of volatility and loss.

In October 1929, the indicator soared to highs of 140%. In March of 2000 the indicator grew to highs of 150%. Each of these years then marked a future decade of volatility and decline.

The indicator reached its highest levels in the fourth quarter of 2021, when the ratio was around 214%. It's why so many market experts believe that we may be headed for another lost decade. Today, the measure sits at extremely high levels of 165%. This is above where it was in 2000 and 1929, and, according to Buffett’s argument, does not bode well for long-term investment returns over the next decade.

Part 3.

Inflation Correlation

We believe that today's target date funds may only be targeting one thing for the extended future, unsuspecting investors' money.

There’s a second factor contributing to what will likely be poor returns in the coming years; inflation. We must appreciate that we have not experienced an inflationary environment like the one we are in today in over 40 years. This presents challenges for the target date fund invention which have only been around for thirty years.

According to the report from the Investment Company Institute (ICI), the first target date fund was introduced by Barclays Global Investors (now part of BlackRock) in 1993, and was called the LifePath fund.⁶ The report also notes that target date funds became increasingly popular in the 2000s as more employers began offering them as a default option in 401(k) plans.

How will these funds perform in an inflationary future?

The Great Devaluation highlights that during inflationary periods stocks and bonds become highly correlated. Since target date funds hold stocks and bonds, and because both often suffer losses during inflationary periods, then it stands to reason that the target date funds which invest almost exclusively in stocks and bonds will get hit the hardest should inflation remain elevated.

One study by the Federal Reserve Bank of St. Louis analyzed the returns of stocks and bonds during periods of high inflation in the United States from 1948 to 2016. The study found that during periods of high inflation (defined as years with an inflation rate above 6%), the average annual return of stocks was 0.3%, while the average annual return of bonds was 2.3%. By comparison, during periods of low inflation (defined as years with an inflation rate below 2%), the average annual return of stocks was 11.4%, while the average annual return of bonds was 4.2%.⁷

If we plug in these numbers, which are based on inflationary periods, into our retirement calculator and use the rate on a 60/40 portfolio from the Fed data, we get a blended average return of 1.1%, a dramatic difference to the 7% annual return Wall Street automatically plugs in.

Here is what happens to our calculator at a 1.1% average return.

The set-up bodes terribly for future returns.

Considering our existing inflationary environment, coupled with today’s extremely high market valuations, it's fair to assume that our target date fund a decade from now could be closer to $217K, not the $340K these Wall Street calculators promise.

The last highly inflationary decade was the period from 1971 to 1981. We must recognize that the cost of a postage stamp in 1971 was only 8 cents. A decade later, the same stamp cost 20 cents. If we apply this to our purchasing power, while our nominal terminal value may be roughly $220,000, our actual purchasing power after that highly inflationary era was 50% less.

This is what Ben Graham refers to as negative compounding. Graham emphasizes that negative compounding can be a significant risk for investors, as it can erode the purchasing power of their money and reduce the value of their investments. He notes that investors should be aware of the effects of inflation on their investments, and should aim to find investments that can generate a real return that exceeds the rate of inflation.

But isn't that the real problem?

Keeping us invested using historical averages is the real trick of Wall Street. The math they use simply doesn’t work during inflationary eras. If Wall Street were forced to include the negative compounding impacts of inflation in their models, nobody would want to invest in a target date fund.

Wall Street is “permitted” to give investment advice where we at Brentwood Research are not. Do not be fooled. If we must endure another inflationary era, or if we have a more normal era with two bear markets during a ten-year span, the target date fund will likely only line Wall Street’s pockets, not yours.

"Keeping us invested" allows Wall Street to continue to charge their assets under management fees every year. Worse still, the fees within these target date funds are often higher than those provided by other funds. These particular funds often have higher fees because they are “actively managed” and require ongoing adjustments to maintain the target asset allocation. A 2018 report by the Investment Company Institute (ICI) found that target date funds had higher expense ratios than other mutual funds, in part due to the additional costs of active management and ongoing rebalancing.⁸

According to the Wall Street Journal in an article published in 2019, How to Pick a Target-Date Fund That Isn’t Right for You, “some target-date funds are quite expensive, partly because they are actively managed and invest in underlying funds that charge their own fees." ⁹ What’s even worse for the investor is that many target date funds “have multiple layers of fees because they hold other funds.”

As we see it, higher valuations, higher inflation, and higher fees add up to a very difficult road ahead for the typical 401(k) investor investing in target date funds.

Part 4. What About Bonds?

Do bonds look like the right option?

A bond is a debt instrument that is issued by a government or corporation to raise capital. When an investor buys a bond, they are effectively loaning money to the issuer, who agrees to pay the investor interest on the loan over a set period of time, known as the bond's term.

Bonds typically have a fixed interest rate, called the coupon rate, which is paid out to the investor at regular intervals, such as annually or semi-annually. At the end of the bond's term, the issuer is obligated to repay the principal amount of the bond to the investor.

Bonds are often used by governments and corporations to finance large projects or fund ongoing operations. They are generally considered to be less risky than stocks, as the fixed interest payments provide a predictable source of income for the investor. However, bonds can still carry risks, such as the risk of default if the issuer is unable to repay the principal or interest on the bond.

Bonds are traded on the bond market, where their value can fluctuate based on changes in interest rates, inflation, and other market conditions. Bonds can be bought and sold by individual investors or held in mutual funds or exchange-traded funds (ETFs) that specialize in bonds.

But are bonds truly less risky?

Let’s start with what has occurred in just the last 12 months. A year ago our Federal Reserve was doing QE and our fed funds rate was at 0%. Today we are reducing the balance by $95 billion a month and the fed funds rate has risen to 4.5%.

Our long-term bond investor who invested $100,000 one year ago in the 10-year Treasury was offered a yield of 1.73%. The yield on the 10 year Treasury hit 4.06% on March 2nd.

If we were to buy a 10-year Treasury bond that pays a fixed rate of 1.73% and then sell it after one year when the prevailing rate in the market has increased to 4.06%, we would incur a loss. The exact amount of the loss would depend on a few factors, including the price you paid for the bond, the price we sold it for, and the length of time until maturity and the future slope of the yield curve.

While it’s not possible to predict exactly how much our bonds will lose value in the future should bond yields continue to rise, we know that last year, the ETF "TLT", a proxy for the 20 year Treasury Bond, lost 32% of its value. Anyone holding bonds as an alternative to stocks needs to be aware that should yields continue higher we will suffer losses in the terminal value of the bond.

For the first time in over 15 years, interest rates are now at levels that compete with equities. Money market funds that hold only cash are now offering over 4.5%. The six-month treasury bill offers a yield of 5.14%. Regular Joe’s are paying attention.

I was waiting in line at the grocery store this past week and overheard a man tell his wife, “interest rates are now at 5% honey, that’s pretty hard to beat.” You know when you hear it at the supermarket it’s a mindset that is reaching the masses. It’s also probably an indication that it’s not great timing.

Is now the time to reallocate everything into bonds? It all depends on the future path of inflation.

Keep in mind that it was just 14 months ago the Federal Reserve promised an extended period with extremely low inflation. They expected their fed funds rate wouldn’t hit 2.5% until the year 2025.

The dot plot image below was published in December of 2021. That’s what they promised then.

Source: https://www.bloomberg.com/news/articles/2021-12-15/the-fed-s-new-dot-plot-after-its-december-rate-meeting-chart?sref=0zBpH5VA

Here’s what has actually occurred.

The chart below represents the Fed’s most recent dot plot projections. Notice that just 14 months ago the Fed expected their overnight rate to only be 1.5% in ‘23. Instead, the fed funds rate today sits at 4.5%.

Source: https://www.bloomberg.com/news/articles/2022-12-14/fed-downshifts-to-half-point-hike-sees-5-1-rate-next-year?sref=0zBpH5VA

Many at the Fed now expect the fed funds rate to hit 5.5% this year. This is a whopping 400 basis point miscalculation.

What’s more alarming is that the Federal Reserve continually adjusts their dots higher for longer. While today’s “longer term” prediction for central bankers remains 2.5% only now by the year 2026 instead of 2025, we must recognize that these projections will continue to change. The Fed will continue to be wrong. Too many unsuspecting investors could lose money following their projections.

...the Federal Reserve is either crazy, or they are liars...

How could the central bank have been so wrong on inflation? Don’t they have over 400 economists exclusively devoted to maintaining price stability?

We believe that the Federal Reserve is either crazy, or they are liars.

It was crazy for them to expect that their monetary policies, when coupled with trillions of dollars in fiscal stimulus, wouldn't create inflation. Our book The Seven Simple Laws of Inflation explains why a 5th grader with a basic understanding of math could have predicted inflation. When we print more money than we grow our GDP, we get inflation. Debt growth has averaged 7% while GDP growth has averaged closer to 2% in the last decade.

The Federal Reserve understands this. Our belief is that inflation has been the true goal of the Federal Reserve all along. If this is the case, they’re not crazy, they’re liars.

Why would the Fed want inflation that runs high? It's the only way to pay off unpayable debt, with dollars that are worth less.

Regardless if they are crazy or they are liars, we believe there is little upside in believing anything the Fed promises from here on out. Either they don’t know, or they don’t want us to know. One thing we can be sure of is that whatever they say about inflation today will change tomorrow.

Pay attention to the bigger picture. We are entering a time when the central banks are losing credibility. Recent economic data now has many Federal Reserve officials considering 50 basis point hikes in the coming months. This is the definition of lost credibility. We expect this trend will continue as central banks struggle to contain the inflation they themselves have created and are forced to yo-yo between attempting to preserve their economies, or their currencies.

How will this impact longer-dated bonds?

It all depends on the future of interest rates. If the Federal Reserve is correct, and rates are near the terminal rate, and rates from there do actually fall over time, treasuries could provide great competition to equities.

If we assume a $100,000 investment in a 10 year treasury bond at a 5% coupon rate, where from years three through ten interest rates fall by an average of 0.25% per year leaving us with an ending terminal bond yield of 2.75%, the value of the bond after 10 years equals $164,430. After adding the ten annual coupon payments which amount to $50,000, we would have a terminal value of $214,430. This amounts to an average annual rate of return of 7.74% per year.

This is why disinflation is so good for stocks and bonds. Rates that fall over time juice our annual returns.

On the flip side, if we look at the same investment of $100,000 in a 10 year Treasury, but interest rates were to rise by 0.25% on average from years three through ten we get a dramatically worse result.

Our bond in this scenario after 10 years has a terminal value of $87,336. When we add our 10 coupon payments of $50,000, we get a total return of $137,336. This amounts to an average annual rate of return of only 3.38% per year.

Neither of the above scenarios consider the future purchasing power of the U.S. dollar. If the dollar falls in value over the next decade, our purchasing power after 10 years may be substantially less then the adove scenarios nominally suggest.

Can you see why investors are so freaked out by inflation? A 5% rate today only becomes a good rate if interest rates stay the same or fall over time. If the opposite occurs, our 5% rate is worth less.

So where are long-term rates headed?

This is the most challenging question to answer for long-term investors.

A recent CBO Report predicted that our government will accrue another $19 trillion in deficits over the next decade, bringing our total national debt above $50 trillion.¹⁰ The natural questions are who will lend us money, and at what rate will they require to do so under this scenario? It sure would seem that investors may require a higher yield to compensate for the fiscal irresponsibility. It feels even more likely that the dollar will weaken significantly as well.

It’s why we believe that longer-dated bonds are too risky and offer no true security for the long-term investor.

Part 5. Negative Balance Of Payments

It’s no secret that we believe that we are sitting within The Great Devaluation which ultimately leads to a monetary reset.

How that occurs, and through what mechanism we cannot predict.

What we can know is that when we have reached similar circumstances in the past, and the dollar has become too strong relative to commodities and gold, it has forced the hand of our government to weaken the dollar. These moves have been “emergencies” and have come suddenly.

A tell-tale sign? Our country’s negative balance of payments.

A negative balance of payments occurs when a country imports more goods and services than it exports and must use foreign currency to pay for the difference. This puts pressure on the country's currency and can lead to devaluation.

Our negative balance of payments was a main catalyst for the Great Depression. To address this issue, President Roosevelt issued Executive Order 6102 in 1933, which required U.S. citizens to turn in their gold holdings to the government in exchange for paper currency. The government then used the gold to stabilize the currency and reduce the negative balance of payments.

President Richard Nixon's decision to close the gold window 38 years later was also related to a negative balance of payments. At the time, the U.S. was facing a balance of payments deficit due to the costs of the Vietnam War and domestic inflation. Foreign governments and central banks were increasingly concerned about the value of the U.S. dollar and began to exchange their dollars for gold. President Nixon announced on August 15, 1971, that the U.S. would no longer exchange dollars for gold at a fixed rate. This effectively closed the gold window and ended the Bretton Woods system, which had established the U.S. dollar as the world's reserve currency and tied it to the value of gold.

will emergency measures be necessary again?

By closing the gold window, President Nixon hoped to prevent further depletion of the U.S. gold reserves and stabilize the value of the dollar. The decision had significant implications for the global economy and marked the end of the post-World War II era of fixed exchange rates. It also paved the way for the adoption of floating exchange rates and a more flexible monetary system.

These two times in history are both linked by one common denominator; extremely negative balance of payments.

This is the exact situation we find ourselves in again today.

As our dollar has grown in power, particularly while other G7 countries have struggled due to the pressures of the war in Ukraine, our balance of payments has gone ballistic. The goods and services deficit for the United States last year was $948.1 billion, up $103.0 billion from what was already a whooping $845.0 billion in 2021.¹¹

We would do well to understand the longer term correlations between a negative balance of payments and the directional strength or weakness of the U.S. Dollar.

According to the United States Census Bureau, the highest trade deficit before our recent explosion was in 2006, when the trade deficit reached $762.7 billion. At that time, the United States imported significantly more goods and services than it exported, leading to a large and growing trade deficit. During the next five years (Nov ‘05 through Nov ‘11) the dollar index (DXY) fell from 92 to 77 and gold prices rose 279% from $459 to $1746.

Since then, the trade deficit has fluctuated over time, reaching a low of $371.6 billion in 2013. Notice that our lower negative payments in 2013 led to several years where our dollar would increase in value. The DXY was at 80 in November of ‘13 and would rise to 100 by November of ‘16. As the dollar strengthened, gold prices fell from their ‘11 highs by more than $600 to $1306 by November of ‘16.

To be clear, there is no direct long-term correlation with the DXY and the price of gold. Most people are unaware that the DXY was at 105 in the year '00 when gold prices were $250 per ounce. The DXY is at 105 today and the price of gold is more than $1800. Dollar strength is relative. What we strongly believe is that our negative balance of payments is a screaming indicator that the dollar is likely headed much lower, either gradually or suddenly.

We are at extreme levels of dollar strength relative to our trade partners today. It’s led to the greatest negative balance of payments our country has ever witnessed. Our manipulated “strong dollar” has put our country in a precarious situation similar to 1933 and 1971.

Will emergency measures be necessary again?

Extreme trade deficits coupled with extreme budget deficits have historically required extreme actions. It’s why the odds for a restructuring have rarely been higher.

The reality of a monetary reset isn't new and has happened twice in the last 90 years. We expect another one soon. These past crises were caused by significant imbalances in the balance of payments, occurred at times when our budget deficits were exploding higher and ultimately required a devaluation of the U.S. dollar.

If this were to occur again, we believe that gold would be the best asset to hold. Remember that while we are no longer on a gold standard, gold is still the standard by which our currency is measured. Gold is priced in dollars. If the dollar weakens, it will take more dollars to buy the same amount of gold. It’s why long-term investors must consider a healthy allocation to gold.

Our country is currently facing significant fiscal and trade imbalances. We're also witnessing increasing geopolitical tensions.

Our suggestion when considering politics is to shift the focus away from disagreements and instead prioritize areas of bipartisan agreement. It is important to pay close attention to the rhetoric used by politicians.

Rather than focusing on what we disagree on, focus instead on where there is bi-partisan agreement. Do pay attention to the rhetoric coming from Presidential candidate Vivek Ramaswamy and other politicians. The presidential platform allows his ideas to be broadcast to the mainstream. Ramaswamy and other politicians are now calling for “a complete decoupling from China.”

A few days after the above tweet it was announced that the United States had officially determined that Covid was born in a lab in China. The rhetoric against China has only intensified since.

It’s official: Covid was born in a Chinese lab. As President I will extract reparations from the CCP, using our debt as a lever. I will impose sanctions on CCP officials & open criminal investigations into US feds who knowingly evaded the ban on GOFR research to fund it abroad.

– Vivek Ramaswamy

Don’t be surprised when the collective mindset becomes to “use our debt as a lever.”

How would that play out if we did?

China holds nearly $1 trillion in U.S. Treasuries. Should they dump them all at one time and they were to flood the market with our debt, we could see interest rates soar. It’s why Ramaswamy’s tweet was immediately followed up on by billionaire Bill Ackman who argued that while Ramaswamy was right about using everything in our arsenal against China, he also points out that using our debt as a lever could bring tremendous harm to our economy.

But this has already occurred.

Ackan’s argument that “we can never use our debt as a lever” completely ignores that one year ago this week, we announced that we were freezing Russia's dollar reserves. If that’s not using our debt as a lever than what is?

The negative balance of payments is a significant concern that could potentially lead us into a third world war. Moreover, it indicates why the dollar is likely to weaken significantly over time.

Part 6. The Self-Directed IRA

During periods of inflation, stocks and bonds tend to become highly correlated and are adversely affected. We believe this reduces the appeal of target date funds. Therefore, while passive investing has created numerous millionaires in recent years, the investment strategies that worked in the past may not be sufficient to create tomorrow's millionaires.

So where should 401(k) investors put their money? Let’s start with where these target date funds don’t invest currently.

According to a 2020 survey by Willis Towers Watson, the average allocation to commodities, including gold, in target date funds was just 3.3% of total assets. Morningstar, a leading investment research firm, notes that "the use of gold and other precious metals is still rare in most target-date funds, and tends to be a small allocation at best. Vanguard, one of the largest providers of target date funds, offers a range of funds with varying asset allocations, but does not include a specific allocation to gold or other precious metals in any of its target date funds.

The return for gold over the last 52 years has been quite variable:

1970-1980: 19.8% (inflationary decade)
1980-1990: -3.6%
1990-2000: 0.6%
2000-2010: 17.9% (inflationary decade)
2010-2020: 8.3%
2020-2030: ??? (inflationary decade)

Periods characterized by high inflation and war have historically led to bullish markets for tangible commodities such as gold. Additionally, gold is often viewed as a safe haven asset during times of market volatility, providing significant tailwinds for its performance.

it's why we recommend holding physical gold...

If 401(k)’s don’t offer solutions for gold, and yet gold is a good asset to own in today’s environment, what should retirement investors do?

Many 401(k)’s offer ETF’s that hold gold. Unfortunately, due to the fee structures and the types of assets these particular funds often hold, the long term performance can wildly underperform holding physical gold itself.

GDX is amongst the most popular ETF’s tied to the gold market. It follows the performance of the top gold miners. Since its inception, GDX is down 28%. Physical gold in the same time has risen from $513 per ounce to $1838, an increase of 258%.

It’s why we recommend holding physical gold, particularly within long-term retirement accounts.

Over the past 23 years, physical gold has outperformed the equity market by a large margin. Investors who have put $100,000 in gold at the start of the century have seen more than a 6X return. Investors who have put their money in the equity markets have seen less than a 5X return, and this includes dividend reinvestment.

Unfortunately there are virtually no 401(k) plans that allow investors to hold physical gold. This should come as no surprise. Physical gold does not need an active manager. If Wall Street were to offer physical gold inside their 401(k) plans they would not likely be able to justify the fees they take to manage these plans.

It’s why if you want to own physical gold, you will need what’s called a Self-Directed IRA.

A self-directed individual retirement account (IRA) is a type of retirement account that allows investors to have greater control over their investment choices. Unlike traditional IRAs, which often limit investments to stocks, bonds, and mutual funds, a self-directed IRA allows investors to invest in a wider range of assets, such as real estate, private equity, and precious metals.

One of the best features of holding gold inside a self-directed IRA, and another benefit that tilts the playing field away from Wall Street is that the fee structure for holding gold inside a self-directed plan is a flat storage fee and not based on assets under management. While 401(k) millionaires could pay 1% in overall fees to own gold funds in their existing retirement plans and could pay upwards of $10,000 or more per year in assets under management fees, those owning physical gold in a self-directed plan would pay just a few hundred dollars.

Investors who opt for a self-directed IRA must take full responsibility for conducting due diligence on potential investments and for ensuring that all investments made are in compliance with IRS rules and regulations, and why you will want to work with the best.

We recommend Advantage Gold, winner of the Trustlink Award, as the highest rated precious metals dealer in the country seven years running and who specializes in self-directed IRA’s.

The image below is a snapshot from the most recent Bear Traps Report which succinctly makes the case why gold prices could soon rise between $2500 and $3000.

Bear Traps Report - 3/1/2023

Part 7. Conclusion

So what should long term investors do? Our conclusion offers seven basic guidelines for how to think about the next decade.

1. The future will not look like the past. The massive amounts of QE unleashed on the markets over the last 15 years is a faucet unlikely to be turned on in the near term horizon. QE can only come again should financial markets collapse. We believe that level on the S&P 500 would have to fall to 2800 points before the Fed would step in again with more QE. This would mean another 40% drop from here.

2. Stop trading. Too many investors, having experienced growth in their accounts for years all fueled by the generosity of the Federal Reserve’s QE, are filled with hubris that they can beat the market and are applying traders' mindsets to accomplish their long-term goals. Stop. Traders are losers, bottom line.

3. Accept that nobody is coming to save us. We will not get a warning from the Federal Reserve. They will not tell us that they have no clue how to handle inflation. They will continue to promise that “bringing it down” is their number one priority. Don’t believe them. If they really wanted inflation down they would raise interest rates well above CPI levels. They do not want to kill inflation, they want to create more of it.

4. Learn more about: how inflation really works, why it becomes embedded, and how transitioning from a global economy to one more bifurcated due to geo-political risks and potential war are good indicators that inflation will get worse not better. We recommend reading our most recent book, The Seven Simple Laws of Inflation, which provides a simple and precise outlook for the coming years.

5. Recognize that stocks and bonds become very correlated during inflationary periods.

6. Consider the longer term impact of our de-globalization and near-shoring.

7. Recognize that our twin deficits are massive. It’s an ominous leading indicator that the dollar could witness severe pressure in the coming years. We are not alone in this risk. All G-7 currencies are in a similar situation and why a global monetary reset seems more probable today than at any time in the last 50 years.

While nobody has a hold on the future, we at Brentwood Research have been expecting inflation. Our book, The Great Devaluation, which was published in 2020, is a great place to start for anyone seeking the bigger picture. TGD predicted an entire decade where all currencies would be devalued.

A free copy is available here.