Is There a Glut of Capital?

On Anti-Bubble Economics

The primary thesis of my investing strategy over the last few years has been that of the “anti-bubble” liquidity flywheel. While we differ in specifics with the author, who unfortunately was over-exposed to “value” Russian stocks — we hold that societies outside of the Western European cultural lineage, except maybe Japan, Singapore, and Korea, and thus high levels of culturally tolerated corruption are uninvestable by foreigners — his concept seems valid, that every bubble that floods one sector with unaccountable liquidity starves another sector with badly needed capital, and like the homely girl at the dance, such sectors provide the best experience for outside, non-controlling shareholders, as management’s natural tendency to loot and graft is disciplined by a greater need to attract capital and make good on their stock options.

We identified the energy sector as one such anti-bubble once it became apparent that Covid lockdowns were mostly an unsustainable scam in late 2021, and returns since that time have been pleasing. We still didn’t trust management further than we could throw them, so positioned ourselves in royalties or royalty-like producers (Canadian oil sands) and midstream distributors focused on delivering current income.

However, it’s good to question one’s assumptions as we approach historically unprecedented equity valuations. Critically, what we are not seeing, yet, is a degree of anti-bubble, stupid obvious value consistent with past bubbles.

The Ghost of Bubbles Past

There seems to be a decline in the quality of anti-bubble value opportunities over time. After the Nifty-Fifty bubble of the early 70s, Warren Buffett could famously buy companies for less than their cash on hand. During the 2000 bubble, TIPS traded at a 4+% real yield, so desperate were investors for exposure to money-losing tech trash like Pets.com or AOL, while gold traded for ~$200, much lower than its production cost, and “old economy” stocks were a decent, sometimes astounding value. I remember in particular being tempted, as a poor college student, to buy RJR Tobacco which featured a 20% dividend yield around 2000-01. I wasn’t paying as much attention to the 2007-8 bubble, but high-quality tech companies like Google and Apple in particular were trading for very attractive valuations as real estate went crazy. Today, value opportunities, while attractive, do not seem to offer the same broad discount in very high-quality businesses as in bubbles past.

How might we account for this decline? I can think of a few reasons:

1. Information Flow for Investment Opportunities

Perhaps most significant is the freer flow of financial information. Buffett had to send requests in the mail to the SEC to receive copies of various companies’ financials in the 70s. It’s very plausible that the distribution of financials ensures better market efficiency in undervalued sectors, in that more eyes are watching for opportunities and more cross-pollination of value theses means there’s more of a lower bound for their prices.

An implication of this is if capital is indeed more plentiful than it was historically, then both crashes and recoveries should happen more quickly. That seems to have happened during the Covid crash, both the fastest bear and bull market turnaround in history and it seems to have happened in the occasional mini-panics and corrections in the past few years. Algorithms exit quickly and because there is ready capital that can be accessed after an exit, they re-enter when valuations are attractive enough to hold through an extended drawdown, which makes those drawdowns shorter than they were historically.

2. Inflation Risk Due to Money Printing

In both the 2000 and 2008 bubbles, there was a very real risk and a brief experience of deflation. Bill Clinton and a Republican Congress had delivered government surpluses for several years, and the Federal Reserve tried to maintain some modicum of credibility in the 2008 crisis by letting a few firms fail. However, the extended recovery after 2008 convinced them they had acted too slowly, and perhaps more cynically, they had hurt too many of their friends and rewarded the prudent too richly. Further, investors rarely profit from thinking about the very long-term, and in the short term of these two bubbles, it was very profitable to sit out the market in cash, waiting for opportunities, with mild inflation and even brief deflation of consumer goods, and very high deflation of assets like real estate.

Now, however, the arithmetically certain warnings of the prophets of the national debt vis-a-vis entitlements, and accelerated by the foolishness of Covid money printing, are now upon us and relevant to short-term investing decisions. No one believes the Federal Reserve will actually follow the Taylor Rule and break the back of inflation, and some question if they can with permanent trillion-dollar deficits and both parties resistant to entitlement reform. While investors have been perhaps a bit too optimistic about the timing of rate cuts, they do seem to be coming much sooner than a serious approach to inflation would entail.

Anyone who sits in cash, once rates are cut below inflation, will be guaranteed to lose purchasing power each year. And with politically certain money printing into the future, investors are eager to position themselves in inflation-protected assets, notably equities, commodities, and real estate, before the currency further debases.

In other words, the value trade is more crowded than it would be in past bubbles because of inflation hedging. This is perhaps why the oil price has struggled. Somehow management, who by drilling too many holes in the ground destroyed billions in value in the 2010s keeps finding ready capital to do it all over again with just a tad more discipline. This reinforces the wisdom of top-line, not bottom-line, exposure through royalties and midstream toll-booth-type investments. Management always gets paid more by growing headcount and revenue, not making absentee shareholders rich with fiscal discipline.

3. A Relative Glut of Capital Compared to Historical Scarcity

A popular X personality, VB Knives, enjoys documenting “mass affluence” and “post-scarcity.” Despite the romanticization of previous eras, we really are wealthier than we’ve ever been as a society. On the lower end globally, Hans Rosling has documented the end of extreme poverty worldwide, and I’ve noted before that obesity is now more of a global health problem than starvation.

If wealth is subject to declining marginal returns, what happens as everyone becomes wealthy by historical standards? We would expect, I should think, that people would pursue leisure at the margin, rather than production and consumption. Covid in particular seems to be a cultural watershed moment that broke the back of the Protestant work ethic and its malignant manifestation of workaholism.

People got used to at-home leisure, and at-home leisure is fairly cheap. Lonely Boomers on a pension can easily buy enough food to feed their unemployed sons in the basement playing video games and then discover they rather like the company more than the additional money. Of course, that entertainment is more addictive and pleasing than ever doesn’t help light fires in people to earn more to consume more. Netflix and God knows whatever other degeneracy available through a $99/mo cable modem costs the same regardless of hours consumed.

To some degree, to produce and consume is a cultural phenomenon. It takes some amount of ambition and discipline to enable the former. And while the rest of the world is being liberated from grinding poverty, it’s possible, just as our declining culture is settling for more leisure and idleness, they will find even lower setpoints.

This is perhaps even more true when digital degeneracy is among their first experiences of affluence. Imagine America at say the economic development level of 1900, which is approximately that of Africa today, and our young people suddenly receiving smartphones full of unlimited porn, video games, stupid “binge-worthy” TV shows, and social media. We might expect such poison to stunt our economic development despite having a highly productive Protestant culture. The damage would be worse among less wealth-optimized cultures. Many might be content with a level of economic development that fills their belly, protects them from the elements, and otherwise maximizes their leisure to enter the dopamine screen dream world. This lack of desire to advance economically would reduce the long-term demand for capital in those places nominally most in need of it.

As I will discuss more in a subsequent post, while I am a long-term optimist, these technologies, and post-scarcity generally, probably represent a major evolutionary event in human history and could take a few generations to get sorted out, where those most prone to fake fitness signals are winnowed from the gene pool. In the investable time horizon, however, this process could retard the demand for capital from the pre-mass-addiction world.

Mass affluence also increases the amount of capital available to invest. Conspicuous consumption reflects excess income relative to the necessities of life, and more excess income also creates excess investment capital. The gigantic AI science experiment, where capital expenditures now demand they create an actual digital god to see any reasonable return, is arguably an epiphenomenon of excess capital relative to the past. The marginal returns and capital requirements of creating slightly better software and hardware are sufficiently low that they must swing for the fences for breakthrough technology. Now, they could return that excess capital to shareholders, but that’s no fun for management, especially when there’s no external discipline in sector market capitalizations.

To summarize: a) wealth and consumption are subject to declining marginal returns and thus demand for goods, and the productive assets that capital provides to make them, might be declining as people choose leisure, b) leisure is cheaper and more addictive than ever, and digital consumption is very capital light, which might increase the preference for leisure at lower levels of economic development, especially in cultures most alien to the Protestant work ethic, and c) mass affluence means even more capital seeking returns as demand for physical goods slows at the margin.

Taylor, the anti-bubble theorist, seems to agree, though more sanguine on the societal implications of digital vs. physical innovation:

There are several reasons why capital may be getting less scarce that have little to do with central banks. Some of these are likely merely cyclical, but some may also prove to be structural.

The world (or the developed world at least) is heading into something of post-industrial era, where a lot of tangible capital is no longer needed to drive growth in productivity. Innovation is instead happening in technology, software, and services, etc, while incremental consumer demand is for relatively intangible services/experiences/entertainment, rather than 'stuff'. These two factors are together reducing the demand for new tangible capital stock.

In bygone eras, economic growth was capital intensive. The industrial revolution required significant heavy investment in factories, railroads, electricity networks, and the like, to supply an under-serviced and growing middle class with a wide range of consumer goods and capital-intensive services (e.g. electricity). But the information/technological/services revolution we are currently in the midst of is relatively ‘capital light’. This can be readily observed from the balance sheets of the Googles and Facebooks of this world. These businesses don’t have or need a lot of fixed assets.

Contentment With Returns

Given all of these factors, it seems wise to be content with those relatively safe single-digit real returns that are available. The miracle of compound interest ensures that even small returns add up to something large over time.

Take, for example, our “reference security,” NTG, a closed-end fund that trades at a discount to NAV and owns a portfolio of income-distributing, safe midstream energy assets generally agnostic to commodity prices. Its current dividend yield is 8.95%, which should keep up with inflation, and serves mentally as our “cost of capital.” Discounting for the top tax bracket on investment income of 41.8%, its effective after-tax yield is 5.2%; it’s actually a good bit better than that, as depreciation pass-throughs eliminate about half of the tax liability, and most of the taxable income are qualified dividends taxed at 23.8%. Not bad, but certainly nothing like the opportunities Berkshire had in the 70s. It is amazing opportunities like this exist in the public markets when Class B apartment complexes involving a lot more hassle and illiquidity are trading at 5% pre-tax cap rates.

I remember meeting a guy one time who was so proud of his triple-net portfolio of Dollar General stores, which locked him into a ~4% return, with rent escalation much below current inflation. I got the feeling that he really liked talking about being a big “landlord,” despite the fact that he basically owned a bond backed not by the US government, but by a tenant whose bankruptcy or semi-bankruptcy “restructuring” could be ruinous to the value of his properties (landlords with long-term leases are mostly screwed in bankruptcy court compared to other creditors), as most triple-nets’ market rent would take a serious haircut if not for that one specific tenant. An abandoned Walgreens store isn’t worth as much in monthly rent to anyone but Walgreens.

Owning a tiny slice of a fund that owns larger slices of pipelines no one knows about but power our economy at a fundamental level is much less interesting and ego-gratifying than “owning” tangible stores across rural America. I’m always happy when I observe other people being irrational, as it makes it less likely that I’m the crazy one.

The danger, though, is assuming something like a general crash could never happen, and talking up our position. The art of investing means always questioning assumptions. There may come a time when a defensive cash position is short-term rational, and anything beyond short-term is rather expensive in opportunity cost, but it bothers me that I can’t specify what that would look like — a non-falsifiable belief is always dangerous. However, the nice thing about investing in liquid markets is the freedom to change theses and exit cheaply when they do.