We were going to take the opportunity in this letter to reflect on 2021 and forecast how we see things in 2022. But then I happened to come across a copy of the new book by Ray Dalio, titled Principles for Dealing with the Changing World Order: Why Nations Succeed and Fail. Mr. Dalio runs the world’s largest hedge fund and is regarded as one of the smartest guys on Wall Street, and Ray has the rare ability to explain his incredibly complex analysis in simple terms. He founded Bridgewater in 1974 and has outlasted George Soros and the Quantum Fund, Julian Roberston and the original Tiger Management, and many other wizards. Simply put, Ray is one of the best money and risk managers in the business.
You may be asking yourself, “Did Caravel sign up as Mr. Dalio’s publicist?” Not yet, but his new book has raised our eyebrows. His analysis is about as troubling for the coming years as it gets. While we don’t share all of Ray’s prognostications, we do share two of his concerns. We believe that these two concerns may be the straws on the camel’s back that may cause the most market pain:
Of honorable mention, he puts a 30% chance of a US civil war between the individual states and the federal government as trust in national elections deteriorates further. This one is more politically charged than we prefer, and we’re going to leave that one for you to discuss with friends and colleagues at your upcoming holiday parties.
We haven’t been worried about interest rates materially rising since 2005-2007 when the US economy printed back-to-back-to-back mid-3% GDP growth. Since 2008, the US Treasury Department, and more specifically the US Federal Reserve, has been trying to generate inflation using lower interest rates and Quantitative Easing (electronic money printing). Our lack of concern surrounding inflation over the last 12 years was due to increased productivity through globalization and technological automation. These forces have kept wages and prices low. In fact, they have kept wages and prices low for almost 40 years. Central Bankers worldwide have had no real impetus to raise interest rates because there was practically no inflation materially. The US Treasury and Fed have wanted inflation since 2008 to help shrink the 311% increase in US sovereign debt. An inflated economy rather than a larger economy. If the financial crisis started their desire to get inflation into the US economy, the pandemic turbo-charged it. The Fed’s rationale is that it’s easier to repay the debt if your economy is larger (you get more notional tax dollars against a fixed liability). With so little inflation, we weren’t freaking out (much) about how much the government borrowed or the mechanism they used to finance it (having their central bank buy it with newly created currency).
So why now? Why is Caravel raising concerns about rising rates and stock valuations? First, we suggest you re-read last November's letter and then add to it these facts:
Secondly, we have been forced to reconsider something we had all but forgotten to worry about – inflation. I haven’t seen it since 1985. We all know it’s here. We have felt it in our labor costs, the goods we are buying, and, if we’re crazy enough, the houses we’re building. Prices are going up by 5% or more. Businesses everywhere are trying to determine if they must raise prices to maintain their profit margins. If you want to see what high inflation does to stock prices, look at a Dow Jones chart from 1967 to 1975. Specifically, Mr. Dalio does not believe last week’s inflation number of 6.8% is here to stay, but he is saying we will still have 3-4% inflation in 3 years! Since we are mentioning intelligent guys, we should also flag Jeffrey Gundlach’s (founder of the Hedge Fund DoubleLine Capital with over $150 Billion in assets) comments this week. “Fed hikes are set to crimp growth, and trouble may come when short-term yields top 1%. Inflation may hit 7% soon,” he said. Two of the smartest guys in the room saying the same thing… coincidence? We think not. The Fed and the Treasury are only charging 1.5% for 10-year money, which can’t continue. A 3.5% ten-year would effectively drop the 1-year forward stock market PE multiple 20%, and that’s before accounting for the impact on corporate earnings. Obviously, these are not positive developments for equities.
The US Treasury is praying that Dalio is wrong, but deep down inside, they know he is one of the best and brightest. He skillfully avoided the 1987 crash and the 2008 crisis using the same process analysis. Mr. Dalio didn’t get to be where he is by accident; rather, he’s been correct when it’s counted. It counts now.
On that cheery note, as is our policy (one that seems unique to our fund), Jeff redeemed $870,000 from his holdings in the fund to pay for the house he and Michelle continue to build. Good fortune came to all the partners in the Caravel Cad fund in 2021. In the spirit of the season, we encourage everyone to remember those who are less fortunate.
We want to sincerely thank our team at Caravel for their contributions to this year’s results.
Finally, we would like to extend our very best wishes to you, our partners, and your families.
We thank you for your continued confidence and capital.
Jeff and Glen
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