Double or Nothing
<July 21, 2021>
Once or twice a week my son and I shoot basketball at a local park. During our last session I jokingly said, “I’ll bet you a million dollars I make this three-point shot.” Without hesitation he replied, “A million dollars, you’re on!” As my son encouraged me on by chanting, “Miss it, miss it, miss it,” I aimed, shot, and watched the ball brick off the rim. My son was thrilled. “You owe me a million dollars! You owe me a million dollars!”
I was in deep and needed a solution. And unlike central bankers, I couldn’t instantly print money to cover up my mistakes. I had to think of something fast. Out of desperation, I asked my son if he was open to playing a game of double or nothing. Expecting the same result, he agreed. And he was right! Instead of a swish, my shot made a very unpleasant and unprofitable clank, increasing my debt to $2 million. I asked for another chance at double or nothing, and he agreed, again and again. Before I knew it, I owed my son $64 million before finally hitting a three-point shot!
To make the best of another poor parenting moment, I asked my son what he learned from our experience. He said he didn’t learn anything—he already knew I couldn’t drain the three! I laughed and explained how the experience reminded me of the risk associated with speculating on low probability events. Further, it was a lesson in greed and how large unrealized gains can vanish almost instantly.
As we look across the investment landscape, it appears my son and I are not the only ones playing double or nothing these days. Whether it’s U.S. debt, the Fed’s balance sheet, fiscal deficits, or the stock market, the numbers are staggering and rising—doubling again and again.
The Federal Reserve’s ultra-easy monetary policies have kept interest rates artificially suppressed and asset prices inflated. The market cycle has been extended in duration and magnitude, transforming itself into one of the greatest asset bubbles of all time. What’s amazing to us is the current market cycle has already doubled twice from its inception (March 9, 2009), and only needs to appreciate 20% more to double again. That would make it a triple-double-bubble!
Triple-double-bubbles are extremely rare and dangerous asset bubbles. The South Sea Bubble comes to mind, which was one of the largest financial bubbles of all time. Like most asset bubbles, investors playing the game of double of nothing during the South Sea Bubble ultimately incurred significant losses or lost most of their gains.
As it stands today, the current stock market bubble is “only” a double-double bubble, or a market cycle that doubles and proceeds to double again. Other notable double-double bubbles were Japan’s Stock Market Bubble (1985-1989) and the Technology Bubble (1995-2000) in the U.S. Both bubbles eventually collapsed, leaving investors playing double or nothing with little, if any, full-cycle gains.
The most recent stock market bubble to pop in the U.S. was the Housing Bubble. We consider the Housing Bubble as a double-bubble, or a bubble that doubled once before collapsing and erasing its gains. While double-bubbles may appear mild at first glance, it’s important to remember that the Housing Bubble’s demise almost brought down the entire financial system!
The game of double or nothing can go on seemingly forever, appearing risk-free as long as participants stick around for the next double. The risk, of course, is balances get so large that the “winners” decide enough is enough and opt out of the game.
Can the current game of double or nothing continue? In the near-term, we’re reminded of the best way to make Mr. Market laugh—tell him you know where stocks are headed! That said, we believe the numbers have gotten so large that another doubling would place too much stress on burgeoning macroeconomic and societal strains, such as inflation and wealth inequality. Not to mention equity valuations this cycle have also been playing a game of double or nothing, recently vaulting from expensive to absurd!
Although it’s difficult to know exactly how the game ends, if we had to make a list of catalysts, our top picks would include: inflation (Buy Things), wealth inequality (Hyper Zip Code Inflation), and the enormity of the current debt and equity balances outstanding (The Abominable Snowball).
Near-term, we believe inflation is the largest and most obvious risk. It’s so obvious it tempers our conviction! Meanwhile, the Federal Reserve continues to promote its “inflation is transitory” narrative. We’re not surprised. How many inflation-fighting options does the Fed really have that wouldn’t collapse the stock market and economy? We're not aware of any. And while we’re open to inflation eventually subsiding, as it stands now, we see few signs of it moderating. In fact, we see the opposite.
As bottom-up economists, we continue to closely monitor what the businesses on our buy list are experiencing. Based on our observations, inflation is clearly trending higher with many companies announcing additional price increases that will be implemented during the second half of the year. Although there are too many examples to list, we’ve included some of the more recent management discussions and outlooks related to inflation.
Fastenal Company (FAST): “There's a ton of inflation going on (emphasis ours). There's inflation because of disruption and shipping…it's gotten really expensive to move a container across the ocean. And it takes a longer time than it did 12 and 18 and 24 months ago because of all the congestion at the ports. And so massive inflation going on.”
“Cost pressures remain high…which will require us to institute further material price actions in the period. The marketplace is still receptive to price actions…”
UniFirst Corp (UNF): “As I'm sure many of you are aware, we are operating in an increasingly inflationary environment. The cost of labor as well as other business inputs are clearly on the rise. In addition, we expect and have begun to experience a rebound of several costs that trended significantly lower during the pandemic such as merchandise, healthcare, energy, travel and others.”
“…we call it the inflationary environment. And as costs rise, whether it's with labor, energy, fabric costs or any other inputs that are currently being impacted by, call it, the inflationary environment, we will work with our customers to pass along cost where we can.”
“As we look ahead beyond our fourth quarter into fiscal 2022, we expect that the increases in these costs as well as the inflationary impact on labor and other business inputs will pressure our margins.”
Oil-Dri (ODC): “And we certainly can explain what's going on with the margin pressure...cost increases...I haven't seen this since Hurricane Katrina back in August of 2005 when natural gas went through the roof.”
“So I think we're seeing it everywhere. Supply chains are being squeezed, materials are being -- demand is exceeding supply, i.e., prices are going up. And so we are obviously working very hard to get increases to offset these. But fell woefully short in the quarter.”
“Unfortunately, these gains were outweighed by significantly higher commodity, freight and other manufacturing costs which reduced our gross margins. We implemented price increases to offset these costs, but many of our customers require 60 to 90 days’ notice for price adjustments. Since costs continue to rise, we anticipate implementing additional price increases in the coming months.”
United Natural Foods (UNFI): “However, we have received notice from many suppliers indicating they will be taking price increases in the coming months. So we expect inflation to have a larger impact on our business leading into fiscal 2022.”
In addition to the companies we follow, we’re experiencing inflation in our everyday lives. Although there are again too many examples to list, there was one price increase I experienced last week that rattled our household. One of our family’s favorite dinner option is The Fresh Market’s “Little Big Meal,” informally known as the meal deal. It’s a partially prepared meal that feeds a family of four for only $20. Or I should say, it was $20. After picking up the meal deal last week, I noticed the price increased to $25, or a 25% increase! If inflation is transitory, does this mean the meal deal will be returning to $20 soon? I won’t be holding my breath!
While we don’t like paying higher prices, we don’t blame The Fresh Market for passing on rising costs. Like most businesses in an inflationary environment, they are simply trying to protect their margins and livelihoods. It’s interesting. The Federal Reserve and equity investors want asset inflation to continue, yet they don’t want the real-world inflation required to maintain corporate profitability. It’s difficult having it both ways. And that goes for government spending as well. While it’s nice to be able to distribute stimulus checks and run record fiscal deficits, we shouldn’t be surprised by the resulting labor shortages, supply disruptions, and rising cost of living.
As signs of policy-induced imbalances grow and become more difficult to defend, we believe the days of consequence-free money printing are over. Instead of adjusting to the heightened risk of quantitative easing ending, investors appear to be doing what they’ve been conditioned to do over the past decade: shake it off, parrot the Fed’s narrative, and ride the stock market higher without concern. In effect, the game of double or nothing continues.
As absolute return investors with a full-cycle objective and strong distaste for overpaying, we have little interest in playing the game. Instead of crowding into what we believe is the most overvalued equity market of our careers, we are patiently positioned and preparing for future opportunity. While hanging around and playing double or nothing looks like fun, we’ve been around long enough to know how this game ends—with a clank, not a swish.
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Market Cycle: A market cycle is a period of time that consists of both a bull and a bear market.
Triple-Double-Bubble: A stock or asset market cycle that doubles, doubles again, and doubles for a third time, representing at least an 700% increase since inception of the cycle.
Wilshire 5000: The Wilshire 5000 Total Market Index is the broadest stock market index of publicly traded American corporations.
S&P 500: The S&P 500 Index, or the Standard & Poor's 500 Index, is a market-capitalization-weighted index of the 500 largest publicly-traded companies in the U.S.
Price to Sales: The price to sales (P/S) ratio is a valuation ratio that compares a company’s stock price to its revenues. It is an indicator of the value that financial markets have placed on each dollar of a company’s sales or revenues.
Nikkei 225 Index: The Nikkei 225 is a price-weighted index composed of Japan's top 225 blue-chip companies traded on the Tokyo Stock Exchange
Nasdaq: An index that indicates price movements of securities in the over-the-counter market. It includes all domestic common stocks in the Nasdaq System (approximately 5,000 stocks) and is weighted according to the market value of each listed issue.