Transformity – Looking Ahead to 2022

Today, real yields of negative 4.7% are the second-lowest since 1970, yet the S&P 500 has risen nearly 30% over the past year.

So what is different about the US economy and the stock market today vs. the stock market in the 70s?

As the economist and noted Fed watcher Lawrence Goodman posted in a Wall Street Journal opinion piece last week entitled "How the Fed Rigs the Bond Market", the difference between the 70's and 2021's bond market is the U.S. Treasury bond market has been systematically rigged and manipulated by the Fed's second QE (qualitative easing) since the program started in 2010.

According to Mr. Goodman's research, since 2010, "the Fed's purchases of Treasury debt have funded as much as 60% to 80% of the entire government borrowing requirements on its balance sheet." In other words, Fed QE has simply crowded out private-sector bond price discovery for more than 11 years. The Fed's buying of Treasuries has exploded in scope and scale enough to eliminate normal market "price discovery". By buying Treasuries, the Fed has funded 60-80% of the Federal government's ENTIRE borrowing binge.

$Trillions of QE has kept real "risk-free" yields negative and TINA (there is no alternative to stocks if I'm guaranteed to lose money in bonds) has taken growth stock prices to record highs. The consequence of this blurred line between Fed and Treasury responsibilities—“monetizing the debt”—is monetary inflation. And there are no "bond vigilantes" hedge funds like in the 70s around to short bonds. 

In the last 24 months, the FED has been buying the vast majority of new US Treasury bonds. As the "marginal buyer," the Fed is "price-insensitive"–they place market orders to buy bonds and win the bid every time. That is why we have had no "price discovery" which would lead to higher nominal interest rates, in a normal 6% inflation world. 

The latest data shows the massive degree that the Fed has intervened within the US monetary system. To date during the pandemic, the Fed purchased $1 trillion in Treasury debt, and the Treasury drained $1.6 trillion from its savings account at the Fed (the Treasury savings account is basically all the taxes/tariffs/royalties and other Federal Government income). The unprecedented monetary actions covered nearly all the cost of the entire budget deficit, equal to 12% of U.S. gross domestic product, and nearly all the pandemic-related government borrowing.

Note: Based on monthly estimates, Goodman makes the point that since there was actually a funding surplus for the Treasury this past summer, it's no wonder the 10-year Treasury yield reached a low of 1.17% in August despite high inflation rates–the Treasury Department was parking its surplus dollars in its own 10-year bonds! 

The Fed has made stock investors and homeowners rich (or richer).

Staying long secular stocks in 2022, we are betting Chairman Powell is NO Paul Volker ready to dish out the 21% Fed Funds rate of the late 1970s that was needed to crush runaway price inflation (and crushed the US economy and stock market).

Since 2003, the deflationary forces of the high-speed internet, Amazon/Walmart e-commerce, low non-COLA minimum wages, worker productivity gains, and offshore supply chains held inflation below the Fed's 2% inflation targets. During the pandemic years of 2020-2021, those deflationary forces flipped and became inflationary forces. The FED decided to ignore this 180-degree turn in price inflationary dynamics and came up with the "transitory inflation" narrative/mantra. It's only been in the last few weeks that Chairman Powell has admitted that they underestimated the "sticky" parts of price inflation and energy prices.

NOT fighting the Fed has been our core investment theme and bet since 2011, and I think it's a pretty high-risk bet to start fighting the Fed in 2022 because the Fed Chairman isn't going to "Pull a Volker."

However, we should understand how massive the Fed intervention in the capital markets actually has been via quantitative easing (i.e., the Fed pressing a button and adding newly created dollars to the monetary system via purchases of bonds with electronic bank deposits from the Fed) that has allowed us Transformity Research investors to generate 60%-ish annual yields since 2013 and 15%+ dividends per year while even pre-covid related inflation real bond yields were close to or below zero. 

I'd like to take some of the credit, but as my twin brother Brian likes to say "even a blind 3 legged dog with a note tied around his neck" could make money in stocks with 12 years of negative real (after inflation) yield bonds. 

Welcome to Jay Powell's Magic Gin and Tea Party!
 
In fiscal 2022, less pandemic-related spending will likely mean a smaller budget deficit. Even with Fed purchases ending and the Treasury savings account at the Fed depleted, Goodman estimates that government borrowing with the new Infrastructure Plan and "Build Back Better" could still easily reach $2 trillion, or 8% of GDP.

In addition, the US Treasury will need $500 billion in fresh funding just to rebuild its Fed bank account.

The systemic American inflation genie is out of his bottle and no one has the Volker guts to put him back in. The Fed has no choice but to keep interest rates low and allow inflation to at least erode the value of $trillions in government debt. 

The only bet that makes sense in 2022 is to ride the Fed fueled equities pony… that real yields (after inflation) will remain shockingly negative and allow long-duration secular growth stocks with 80% gross margins and commodities like metal and rent-seeking real estate to remain the most powerful wealth-creating force every seen. 

In the world of $100 trillion of negative-yielding global sovereign debt, the United States is still the best house on a very ugly block.  

What would change our portfolio structure? One concern for 2022 is IF “slow-flation” (aka secular after inflation stagnation) brings persistent price pressures and robust nominal growth and 3%+ 10 year Treasury interest rates, then long-duration secular growth favorites could lose their macroeconomic tailwind simply because their future estimated yearly earnings per share would get discounted at 3%+ per year instead of 1.5% to equate the present value of those earnings per share 5-10 years out. 

If US Treasury bond owners decided to sell their US Treasury Bonds (which is highly unlikely since the negative real after-inflation returns on the other major sovereign debt are significantly worse), we'll make radical changes in our portfolio mix. That would bring about a bond market shit show starting with variable-rate mortgages and bonds.

But again, wildly unpredictable financial-market volatility would restrain growth and job creation in a country healing from a once-in-100 year pandemic–and the Fed Put (stock market intervention) and QE 3.0 is only the proven playbook the world's largest Central Bank can play. 

The bad news is that if and when we have another global financial crisis, the fallout could be even more damaging to leveraged debt markets, and eventually, even the Fed will not have enough QE bullets to save us. (But hey–let the 40 million new YOLO and FOMO Zoomer investors on social media deal with that…)

Thus in the United States of 2022, we will have both monetary inflation–too much money chasing too few goods and services–and we will have post-pandemic year-over-year labor wage inflation. 

Insufficient available skilled labor pushes wages higher and higher and wages ARE NOT TRANSITORY. In fact, in the recent John Deere Union labor strike, labor settled with JD management on a very sweet deal; an $8500 restart bonus, 10% raise immediately, and other benefits. But the shocker was John Deere UAW labor ALSO got "Cost of Living" adjustments aka COLAs starting in 2026.

Key Point: In the 1970s, 28% of the American workforce was unionized and ALL union contracts had COLA deals. With the oil embargo and energy prices skyrocketing, a CPI inflation feedback loop exploded and higher COLAs caused higher EMBEDDED cost inflation, which triggered higher COLA labor costs which formed a negative cost/wage feedback loop. New higher wages don't get lowered, unless there is a deep recession. 

Also, 10,000 Americans turn 66 every day till 2030 and qualify for maximum Social Security (unless they are rich enough to not take checks till they are 71 and earn a 24% bonus in their monthly checks)–and Social Security HAS COLA adjusted benefits for 65+ plus million beneficiaries who get a check every month. Congress will have to raise the employee/employer contributions–which serves to TAKE more money out of the American paycheck–and everyone paying in will want a higher salary or hourly wage to compensate for lost buying power especially with price inflation raging. 

America and Americans are slowly learning how to live with endemic Covid. 82% (228 million) of Americans are partly vaccinated anb 71% are fully vaccinated. Almost every full-grown adult knows someone who has died of Covid or is now suffering long-haul symptoms for life–that reality for many overcomes their political identity. Lord knows how many anti-vaxxers have reached natural immunity (it is the unvaxxed that now comprise 80%+ of hospitalizations and deaths in the USA).

We politically polarized Americans are slowly accepting the fact that the Covid shots are not perfect, they're but more like flu shots which need to be done every year. Fortunately, the Pfizer and Merck anti-viral therapeutic pills are breakthrough remedies for minimizing Covid infection death and long haul symptoms. 

Core Ultra Growth Buy List

We're adding Salesforce.com CRM today–the original all cloud software play–to our "Core Ultra Growth" buy list, with a price under $306. (CRM closed Friday, Nov 24 at ~ $289.) We think its 25% CAGR is unstoppable over the next 3-5 years and believe additional tuck-in acquisitions, like its Slack.com deal, will expand CRM's global dominance in the enterprise customer relationship management SaaS space.

Next Up: Part II: Our Favorite Secular Growth Super Sectors and Favorite Secular Growth Stocks for 2022 

We will publish our FULL Ultra Growth Sectors and Stocks portfolio picks over the next few days for subscribers in addition to reemphasizing our core game over Digital Transformation Dominators Meta (FB), Adobe, Apple, Amazon, Microsoft, Google, Spotify, Taiwan Semiconductor, and Salesforce.com, now FAAAMGSST, with update buy under prices.