Thursday, November 26, 2020
Home The Capital In the Land of the Uncertain, Could the Absurd be Sensible?

In the Land of the Uncertain, Could the Absurd be Sensible?

Low rates and lofty stock prices are putting pressure on long term investors. Could alternative assets like cryptocurrencies provide the answer?

“It can’t be done. Your grandfather and his father before him have always been in the whale oil business, and I’ll be damned if any son of mine decides that he wants to go into gas lighting,” and with that Henry Cabot threw down his workmen’s gloves on the whale oil-lit workbench in anger.

Cabot Junior looked at his father helplessly.

Sitting on the docks in Sag Harbor, New York, the Cabots, a whaling family for generations were squabbling near their humble fleet of whaling boats.

But it wasn’t that Cabot Junior was looking for a different life, whaling was rough work but the rewards were immense, it was more that he had a sense his business was in its twilight.

And it was understandable why Cabot Senior was reluctant to give up the trade.

By the mid-19th century, whaling was the fifth largest industry in the United States, and whale blubber boiled in giant pots, was giving light to America and much of the western world.

But by the latter half of the 19th century, the Cabots, as were hundreds of other whalers, found it increasingly difficult to find the whales that they had hunted in abundance in the decades prior.

Whale hunts had to move further offshore, where the small whaling vessels were even more exposed to the rough waters of the North Atlantic and whales could tip them more easily — many a sailor met their literal Moby Dick and didn’t live to tell the tale.

And as the 19th century rounded the halfway mark, the discovery of petroleum and its use in oil lamps, as well as the overhunting of whales to near extinction, meant that the whale industry was well past its prime.

Just before that time, Cabot Junior suggested to an obstinate Cabot Senior that they may want to take a different tact, to consider the unthinkable — oil.

Cabot Junior saw the potential in oil not just as something to light lamps, but with the potential to revolutionize industry — in what way, he hadn’t quite figured out yet, but he had a sense, especially since it would be decades before the invention of the internal combustion engine would see oil displace whales as the dominant fuel.

And that bet on oil, would reinvent the Cabot’s fortunes and revive what would otherwise have been a sinking whaling ship (literally).

Because sometimes, that which is most unthinkable is exactly that which is needed.

New Investment Landscape Can’t Contain Old Investment Theories

Until the unfortunate arrival of the coronavirus pandemic, most investors could rely on pretty predictable correlations between assets to hammer together a satisfactory, if not particularly spectacular portfolio.

But new ways of thinking are needed to invest in pandemic-plagued markets.

And while the investment industry often reminds investors that past performance is no guarantee of future returns, many investors may not have taken that warning to heart.

Because the very definition of insanity is doing the same thing over and over again and expecting a different result each time, traditional portfolio construction experience applied to pandemic-plagued markets, often result in unexpected results.

With high bond prices (reflected in painfully low yields) delivering negative real rates of return and lofty stock valuations, particularly for tech firms, investors have been left spending most of this year scratching their heads to find alternatives.

As the world’s foremost central bank, the U.S. Federal Reserve has adopted a longer-term inflationary stance, many money managers are already warning their clients that they expect to post single-digit returns in the coming five years or so, which means that most portfolios will be slightly worse off than they are today in real terms.

Traditional investment approaches face a two-fold problem — further capital appreciation in both stocks and bonds means that long-held dependencies for returns are no longer given.

While some pockets of the stock market, away from the bright lights of rapidly-growing tech companies offer some relative bargains, they are not for the faint-hearted, and they’re cheap for a reason.

And as for sources of income that are reinvested over time, not only are the most coveted government bond yields near zero or offering negative real yields, fixed coupons for highly-rated corporate debt, such as for Google and Apple, are starting to resemble U.S. Treasuries in their ability to borrow cheaply.

Against this backdrop, investors are left with unenviable choices.

Rock & Harder Place

Do nothing and watch the value of both stocks and bonds erode a traditional 60/40 stock and bond portfolio mix, or look outside of the box at slightly more illiquid or risky asset classes.

Over the past decade, some investors have sought out less liquid assets, including real estate, infrastructure and privately-traded assets such as stocks of private companies or debt that is not traded in the open markets, as well as cryptocurrencies.

It was thought that such assets are somewhat insulated from swings in the value of publicly traded stocks and bonds.

But while a bigger shift towards these alternative assets can be expected, these asset pools just aren’t big enough to accommodate the influx of large numbers of new investors.

Too many people, not enough train. (Photo by Victor Rodriguez on Unsplash)

Consider that the entire market cap of the investable cryptocurrency universe is just US$350 billion, and that’s on a good day, while the market cap of listed companies on the NYSE is estimated at in excess of US$34 trillion, or about 10 times the size of all cryptocurrencies.

And given the naturally deflationary quality of most cryptocurrencies, any significant move by investors to diversify portfolios into the nascent asset class has the potential to dramatically swing the dollar value of such assets upwards, risking a bubble.

Some analysts are already speculating that with just 2.5 million Bitcoin left to mine, a surge in investor demand for Bitcoin could see its dollar-value rise dramatically.

What that does of course is make it more difficult for investors to shift a sizeable chunk of assets into these alternative asset classes, because of their much smaller size compared to public markets.

Longer term, this will limit the impact of any such diversification strategies, because alternative asset markets, including for cryptocurrencies may not have the capacity or the liquidity should deeper-pocketed clients seek to exit their investments in a timely fashion.

Take for instance that as much as 2.4% of all Bitcoin is currently locked away in Grayscale’s Bitcoin Investment Trust, where even a small unwinding of such a large position could crash the price of Bitcoin overnight, especially if trading volumes are thin.

But that could change because of advances in some corners of the cryptosphere, in particular the rise of decentralized finance, or DeFi.

With some dollar stablecoin deposits paying as high as 4.4% per annum for liquidity provisioning (making available dollar stablecoins for loan to other participants), DeFi could be one branch of the cryptosphere that provides some relief for investors looking for a way out of the quagmire that is stocks and bonds.

Whether or not such high yields are sustainable long term is anyone’s guess and the DeFi space itself is not without risk.

Smart contracts, where cryptocurrency pairs (including stablecoins) are held in loan or derivative-type instruments, though audited, are still subject to unknown unknown security risks and vulnerabilities.

But then investors will ultimately need to pick their poison the minute they wander farther afield from the tried and tested stomping grounds of bonds and equities.

Whether it’s private debt or secondary market shares of private companies, in uncertain times, sometimes even the absurd can be the sensible option.

Because if the experience of the whaling industry taught us anything it’s that one era’s irreplaceable energy source could be the next one’s relic.

And while stocks and bonds were the investment fuel of the past century, it may be that they too will one day become the relic of the next one as well — it’s hard to say.

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