MK Glassman

Hello everyone and welcome to today’s episode of “From the Desk Of,” our podcast about life and all things financial. Today, we are here to discuss the fourth quarter Wealth Management Quarterly, “Long, Dark Shadows.” And I am here with Allen Gillespie, our Chief Investment Officer and President. So, Allen, why title this Wealth Management Quarterly “Long, Dark Shadows”?

Allen Gillespie

In natural light, long shadows appear in the winter when the axis of the earth is pointed away from the sun. Halloween with its ghosts, jack o’ lanterns, and shadows fittingly announces winter’s approach. So, beyond the solstice points, long shadows appear at dusk and dawn, the opening and closing of the day. Shadows, therefore appear at turning points. Long shadows obscure clear views, but they disappear over time as the world turns. And like our natural world, the financial markets have shadows along with people and objects which create them. Shadows remind us of a common theme that I try to share with our Wealth Management Quarterly readers: in that, things in life and markets are not always as they appear. Financial market shadows appear at inflection points, obscure clear views of the future, and appear almost uniquely designed to frighten investors. Shadows get investors to either buy the wrong things or buy the right things at the wrong time. As a result, it’s useful to learn more about shadows, particularly the long, dark shadows currently wandering about our financial landscape.

MK Glassman

So, what are those dark shadows or turning points that we’re seeing in the financial markets?

Allen Gillespie

Well, as I sat down to write this particular Wealth Management Quarterly, the Israel/Hamas war broke out. It’s a conflict that’s been going on for a long time, which now is casting a long, dark shadow over our world. What I found interesting financially is prior to the attack, the November 23rd oil contract had persistently risen from $69.73 at the end of June to a peak of $95.03 by the end of September, topping just days before the Hamas attack. So, how financial markets discount events like the attack, the Ukraine War, 9/11, it’s an interesting area of study in event trading, but there are a lot of academic papers and regulatory structures related to it that really grew candidly out of 9/11, our Patriot Act, things like that. At the time, Donald Rumsfeld, the former Secretary of Defense, was famous for saying:

 “There are known knowns. There are things we know, we know. There are known unknowns, that is to say, there are things we know we don’t know, but there are also unknown unknowns. There are things we know we don’t know.”

Now, it kind of drew a comical response, but I do think the economic literature and the markets understand and discount the nuances of that differently. So, for example, the Hamas attack was unknown except to insiders who might have been buying that November oil contract, so, during the planning stage. But now it’s a known by the market. So, the oil market actually topped just prior to that event as it became known what was going on. So, because that specific event had passed, the energy market had already topped. Given sort of the differences, I think, economically, between Hamas’s military capabilities and Israel’s defensive capabilities. Economically, if we kind of consider just the ability to make war, if you will, Hamas is estimated to have 30,000 to 40,000 members and fighters with, you know, a subgroup of that being more trained, has no Air Force, no Navy, or military vehicles. Meanwhile, the Israeli Defense Forces are estimated to have, you know, 169,000 active-duty members, reserves of 465,000 members, tanks, heavy infantry vehicles, jets, helicopters, subs, and nuclear arms. Thus, from a military capability standpoint, Hamas is capable of small-scale surprise terror-type plots, if you will, on soft targets. But larger governments like Israel can make more sustained policy decisions. And so, the way the market will handle what I call “plots” versus “policy” are quite different. Plots the market will obviously react, but it won’t be sustainable. But from an economic standpoint, when we see changes in policy that drive it, then those become more material.

MK Glassman

So, what do you think those policy decisions might be and how do you see that impacting our markets?

Allen Gillespie

Well, right now, because of the hostage situation, we don’t fully know how Israel might respond. I mean, clearly, part of the policy seems to be, you know, prepare and see if there can be a negotiated release of hostages. And then we don’t quite know what Israel’s full response will be, and then what the subsequent other governments how they’ll respond to Israel’s response. We know both U.S. and China have sent Navy ships to the area. Obviously, you know, they’re within the range of modern hypersonic missiles from Russia. So, you know, I will say it creates a certain amount of tension in the area, but Benjamin Netanyahu, Israel’s Prime Minister, did equate it to Israel’s version of 9/11. So, I think it’s natural to assume the IDF will conduct a ground war in Gaza. Now I’m of the mind that much of the fighting will actually occur in tunnels below. Hamas is said to have a very large tunnel network, so a lot of the fighting might actually not make it to Twitter feeds, might be in the shadows, if you will, and underground. So, just because we’re not seeing headlines and stuff on the surface doesn’t mean it’s not going on. In my research from an economic standpoint, I think the bigger concern is after the Yom Kippur War in ‘73, the oil states did conduct an embargo against Israel and its allies related to energy. They were able to raise the price of energy or crude oil by about 200% over the course of about a year. To put that in perspective, that would be like oil going from about where it is today, $85, up to the $200.00 area. If it were successful on the same scale, obviously that would negatively impact consumer spending. High prices though, would encourage substitution and conservation. But I really think it would take a “policy” versus a “plot” type of event to potentially drive that. And one of our concerns about what would make that policy more effective is that U.S. strategic petroleum reserves have been roughly cut in half over the last two years. And those were really built in response to what happened in the 70s. And yet we’ve really cut our inventories on that front.

MK Glassman

So, what portfolio changes should investors consider due to the shadows of war?

Allen Gillespie

Inflation is the big one. Inflation is a hidden tax. So, during wars both taxes and inflation tend to go up as governments work to finance themselves. And inflation does distort prices and obscures the abilities to observe real value. So, many times you can see prices go up but the real purchasing power that that represents is going down. So historically, for example, stocks may pass that through, but people’s purchasing power may still be going down at a faster rate. So, in that regard, I do think investor time horizons are really important. Or some investors ask the question about should they hedge against the inflation in their portfolios?

MK Glassman

So, should they be buying gold now?

Allen Gillespie

Uh, you know, how should investors hedge inflation? Should they buy gold? These are probably the most common questions we received from clients. And I do believe precious metals like gold are reemerging from the shadows to be safe haven assets. So, in that regard, I do think gold potentially has a role in client portfolios, depending on their specific goals and objectives, financial needs, wealth, and time horizon. You know, but gold is not a substitute for stocks. I mean, they both react to inflation, but they do it slightly differently from each other. You know, gold is a substitute for money. So, in that regard, it’s more immediately responsive. When governments print a bunch of money and confidence in governments go down with uncertainty related to war and things, gold will frequently be a more immediately responsive asset. Stocks represent ownership in a company, right? And the difficulty is companies have contracts and the time frame on those contracts may vary. For example, if you have three-month contracts, you can reprice your goods and services very quickly. But say you’re in an office building lease in real estate, you might have five years to go or 10 years to go, so it can take different businesses different amounts of time to catch up and reprice their goods and services. But then over long periods, they tend to outgrow. So, the net result of stocks are historically, a much higher returning asset than gold, but they’re not necessarily immediately as responsive to specific types of inflation or events. And so, that’s why the investor time horizon is so important. People with long time horizons typically will still be better off in stocks, even if the immediate performance isn’t as good as gold, right? So, that’s kind of the tradeoff. And each investor has a slightly different situation, which is why we don’t make broad-based calls and we have to look and work with each client individually to understand their particular situation. But I do think gold is reentering the discussion. Because at the end of the day war is expensive, particularly for the losing side, and sometimes for both sides. And you know, just to give you some examples of that, Russia lost the Cold War and their currency collapsed in 1998. You know, World War I kind of everybody lost. Germany’s currency went into a hyperinflation and even the British pound eventually lost its world reserve status and sterling reputation. You know, as the U.S. was perceived to have lost. You know, our currency gained because we are perceived to have won World War II. But as we are perceived to have lost in Vietnam, the value of the dollar dropped relative to gold in the ‘70s. So, war most definitely can influence the value of a currency quite significantly.

MK Glassman

So, we’ve talked about the shadow of war. It’s pretty long and dark shadow there. What else can you teach our readers about economic shadows?

Allen Gillespie

The big thing is shadows aren’t always negative, particularly as they recede, right? So, during the 2008 crisis, market participants have regularly referred to non-bank lenders as “shadow banks” and their managers as “shadow bankers”. Shadow banks are really just pools of capital that many regard to act like banks and provide many of the services as banks, but without a banking regulatory framework. And that lesser degree of regulation gives them more flexibility. And the reason for that is because shadow banks have investors. They don’t have depositors. So, the FDIC is not on the hook to make anybody whole here. So, a basic sort of shadow banking function is prime rate money market funds, right? So, as inflation drives interest rates higher, people obviously are earning a lot more on their cash balances through prime rate funds, which make short term loans to high quality borrowers. So, it’s a way of earning a little bit of excess return on cash, which is not a bad thing. So, not all shadow banking is bad and as you sort of move up the risk scale, obviously you get the mutual funds, hedge funds, you know, which are regulated but just under, not the banking code, under different securities code sections. And they may provide business loans or, you know, real estate. And obviously because of the change in rates and restrictions on banks, you know, these pools of capital candidly are a little bit more flexible. And because they’re not leveraged, they can actually take a little bit more risk. But in some ways, they’re not as risky because they don’t have the leverage. So, what that allows them to do is, say there’s a property or something that was mispriced, they can go in there and work to restructure that transaction or that business in a way that a bank just doesn’t have that luxury. So, private credit is probably one of the hotter areas of finance at the moment. It’s something we’re just starting to do our research on potentially for clients. But yeah, so, shadows aren’t always negative. And then also I think cryptocurrency is in the process of making its mainstream appearance from the shadow banking system. We have the trial going on Sam Bankman-Fried, but I think a lot of his shadowy activities and shenanigans are now being exposed. And so, what we’re seeing on the one hand is they’re now being pursued, you know, in court, and meanwhile the SEC is starting to open up pathways for more established firms like Fidelity, and Wisdom Tree, and the like to offer products. In fact, we just recently became able to offer Bitcoin and Ethereum through Fidelity for our clients.

MK Glassman

Are there any other economic shadows that we see fading?

Allen Gillespie

Demographically, I think the economic shadows are getting a lot shorter. Since the financial crisis of ‘08, boomer spending, we have a lot of baby boomers, but their spending, sort of lifestyle spending, peaked really coincided with 2007, 2008, as they got past age 50. Household spending tends to peak at about age 50, when the kids are just about to leave the house. But once they’re gone, household spending tends to drop. And I think that’s been a real headwind for the economy for a long time, for about 15 years. But we’re now at the point where millennials are coming along. The millennials, there’s a lot of them. They’re in their early 30s. Meanwhile, there aren’t a lot of X-er’s. And the low point of Generation X was around 1973, which was 50 years ago. And so, if you can imagine, alright, we’re supposed to have this robust economy, but we don’t have many 50-year-olds to spend much money. But from this point going forward, things, you know, gradually improve because of the number of millennials now early in their career. So, I do think the demographic shadows are very much receding and will continue to recede, you know, for a long time, for the next 18 to 20 years, honestly.

MK Glassman

Hopefully, we’ll see some light. So, any final thoughts on today’s economic shadows?

Allen Gillespie

Shadows, I would just remind everyone are a natural part of the natural world. And so, they’re also part of our financial world and they’re longest at inflection points, right? So, the risk and reward and relative values are always most extreme at those points. And so, the environment reminds me a little bit of the Charles Dickens famous opening line in A Tale of Two Cities,

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way—in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.”

So, they’re certainly investing shadows lurking. But shadows do fade, and as a friend recently stated “with investments, the best time to invest it would have been 20 years ago and the next best time is now. There’s never a bad time to invest in making the world a better place.”

MK Glassman

Thank you, Allen. And thank you to all of our listeners and we will see y’all next time.

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