So here it is: as I get older, I feel a growing conviction that Potter got a bad rap. Yes, I’m referring to one Henry F. Potter of Bedford Falls, PA, played to cinematic perfection by the Lionel Barrymore. Since time immemorial, we’ve been pre-conditioned to be hating on Potter: the aged, wheel-chaired, bloodless capitalist who would have, save for Jimmy Stewart’s/George Bailey’s Bailey Building and Loan (BBL), run his quaint little town as tyrannically as anyone this side of Manuel Noriega. Please understand, I don’t much like Potter; doubt I’d want to hang out with him. In addition, I must admit that his theft of that $8 Large from the whiskey-drenched, imbecilic Uncle Billy was not exactly a Major League move.
But let’s face it: when he scoffed at the Baileys, suggesting that shooting pool with a BBL loan officer was, absent other risk assessment methods, an inadequate underwriting policy, he was right. When the ‘29 crash transpired (which, in a touch of Frank Capra-esque flair, emerged on George’s wedding night) and Bailey Building and Loan – inevitably – faced de facto insolvency, Potter made his move. He offered buy up all of the town’s dubious-but-collateralized paper — at pennies on dollar.
If we’re to be truly honest with ourselves, we should admit that many of us would try to do the same.
But Baily stopped him – mostly by begging his depositors to leave their hard earned cash in a failing Savings and Loan – in the process forcing these good folks into incremental hardships at the precise point when the Great Depression was beginning to unfold. And Potter, recognizing the talent of one who had bested him, then very generously offered Bailey a big fat job, a proposal to which, as is well known, the latter responded by telling the former to pound sand.
And isn’t it just possible that the unconditioned love we throw George’s way is less than fully earned? I know: he pulled his brother out of that pond, saved the druggist from poisoning a customer, and shelved his big plans – first to see the world and then put his mark on it — all to take care of business at home. But he employed an African American mammy/maid right out of Central Casting, and treated her like the Uncle Tom character she was. And while we’re at it, 4F in WWII because of a bad ear? C’mon. History shows that hundreds of visibly crippled teens begged and lied their way into active duty. And, when the war ended (by which time the economy had recovered dramatically, and a well-managed BBL should have been on sounder financial footing) 8 skinny thousand dollars of misplaced cash nearly brought his whole business crashing down on its ears, to say nothing of potentially landing Georgie in the Pennsylvania State Penitentiary.
But here George lost his trademark cool. It was Christmas Eve, and, after telling Uncle Billy he wasn’t about to take the rap for him, he went home and actually yelled at Zuzu! He then pondered suicide, but an extended hallucination caused him to rethink his plans. He gathered himself and went back to face the music. When he returned, the whole town has pooled its money together to bail him out, as topped off by that Wainwright dude (from whom he stole his future wife) extending him an unlimited line of credit.
I’ve often wondered how much of that yuletide bounty Georgie boy shoved into his own pocket. Maybe just a little bit off the top for that blondie side piece to whom he gave cash right in front of the bank examiner?
But back to Potter. On the whole, perhaps Bedford Falls should’ve given him more props. Exhibit A: the charming downtown of this quaint little village:
I’ve seen worse town centers. But I doubt that BBL financed all of the construction. In all probability, Potter himself provided most of the funding, and the results speak for themselves. While the Baileys were lighting up their friends with home loans, Potter was busy building up as quaint a little slice of Americana as one could wish free enterprise to underwrite.
Had the Baileys held the paper on this turf, it is likely that they would’ve had to call it in. Who knows if the borrowers could’ve paid? I envision a fire sale and all of High Street falling into rot.
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It seems like eons ago, but in fact it is less than 10 trading sessions since the markets manifested the same look and feel as they must’ve back in ’29, when Potter was ready to make his play. No particular need to regurgitate that unappetizing sequence; suffice to say that investors have since regained a large measure of their equanimity. In fact, the > 4% gains mustered up by our favorite equity indices represents the best weekly showing since (depending upon the index you cite) late 2016 (Trump Bump) early 2013 (Bernanke/QE3 Bump), or late 2011 (the “I don’t remember why” Bump). For a blessed handful of pre-holiday sessions (and bearing in mind that this is President’s Day), it appears that our valuation heartburn has indeed subsided. I’ve read some published reports that attributed the upswing to an enthusiastic round of nut-squeezing, and there is some plausibility to this hypothesis. But my response is: who cares?
Besides, I think there was more at play here than a good old fashion short squeeze. Specifically, with the benefit of contemplation over the intervening couple of weeks, a couple of dynamics emerge with greater clarity. First, after setting multiple records as to the number of trading sessions between 3%, 5% and 10% drops, equities were by some measures overbought. OK; fair enough. But I also believe that – particularly in light of the subsequent recovery, a large measure of the carnage was either catalyzed, or, at minimum, exacerbated, by the unwind of those diabolical short-volatility instruments that were all the rage as recently as Martin Luther King, Jr. Day.
But investors who for some time previous had been breaking the bank by riding a vol train that was a one-way journey to the underworld don’t simply jump out of their sleeper cars, en masse, for no reason at all. So we’d be remiss if our post-mortem didn’t include an examination of the fundamental catalysts that set the whole episode in motion in the first instance.
My main recollection (though 2 weeks ago is a long time for me to visualize) is that the confluence of some inflation appearing on the horizon, and its potential impacts on borrowing costs were the factor(s) that set this train wreck in motion in the first place. Well, a portion of this hypothesis achieved corroboration when, earlier in the week, the CPI/PPI numbers were released. Both clocked in higher than expected, in the process providing incremental evidence that maybe, just maybe, some upward pricing pressure has presented itself in sustainable fashion. But, reviewing these metrics, did investors resume their fear-induced fire sale of stock holdings? They did not. Instead, they bought, and managed to bring flagging indices back into solid positive territory for what thus far has been an interesting start to 2018.
Thus, if we accept our stated hypothesis that the recent blow-off, while much-needed, was not necessarily an indication of aggravation to come, then we are left to contemplate what’s really going on here, which, in my judgment, comes down to a handful of related issues:
1) Are recent trends sufficient to embed higher inflationary expectations into the investment ethos?
2) Whatever the ultimate answer may be to 1), is the longer end of the yield curve truly headed for higher elevations?
3) If the answer to 2) is yes, can equity valuations survive and/or thrive at higher yields?
For better or worse, I have no useful opinions to convey with respect to 1). Inflation is a tricky thing, rendered all the more confusing because (as those who suffered through the indignities of economics training are painfully aware) it is inflationary expectations, not inflation itself, that drives economic outcomes. I won’t lie, this distinction has always confused me – often to the point of distraction. Moreover, in eerie parallel to the current unhinged national political debate, I can find any number of intelligent, well-trained and otherwise reasonable fellows and gals that will passionately argue that we are headed towards a Weimar-like cycle of intensifying price increases, while other such worthies are convinced that we are still in the early innings of a deflationary death spiral. So I don’t know, and for what it’s worth, I give up on 1).
In terms of 2), I do see signs that the rates will indeed rise to higher levels than many of you have experienced in your lifetimes. Just to put matters in perspective, when I applied for student loans to finance that graduate education referenced above – the one which left me so confused about this whole inflation/expectations thing, the rate was 9%. I was encouraged at the time borrow as much as I could, because, let’s face it, rates would never be that low again.
It hardly bears mention that I enthusiastically embraced this advice.
But in terms of the near-term glide-path of yields, my views are as much influenced by supply trends as they are for demand for debt instruments. Every time I check, our Treasury is upping the size of its auctions, and I don’t see that particular pattern changing. As mentioned last week, their friends at the Fed are selling their paper just as the Treasury G-men are issuing more of it. Next week, for instance, >$250B of new bills, bonds and notes hit the market – all in the space of 3 days. If that long-since repaid, debt-financed grad school extravaganza was worth anything, it means that in a market where demand may be decreasing, and supply is flooding the markets, prices should go down. Further, in the perverse world of Fixed Income, this means yields rise.
So count me as a “yes” on 2).
What remains, therefore, is an examination of 3): whether or not our capital markets can operate effectively at higher yield thresholds. While this remains to be seen, I’m patriotic enough to believe that a nation that endured, just in the last 100 years, two World Wars, a Great Depression, a Great Recession, not one, but two, Justin Timberlake Super Bowl appearances, and Fergie’s dubious NBA All-Star Game Anthem rendition, can weather the hardship of elevated rates on debt instruments. Heck, like many of my advanced age, I might even welcome such a change. I’ve no mortgage debt and don’t own a credit card. I do, however, have some money in the bank that is thirsting for the blessings of a return above microscopic levels.
Thus, I’m inclined to believe that within reasonable ranges, equity market participants should not be overly fearful of higher rates in the debt complex. And thus far, recent selloff notwithstanding, Corporate America appears to be on something of a roll. Q4 earnings, now 4/5ths complete, are projecting out at a 15% increase – highest in nearly 7 years. Guidance for the remainder of ’18 looks to be the strongest in more than 2 decades. Small Business Optimism, after flagging for a few months, is again on the rise:
I do remain flummoxed by the flagging fortunes of the United States dollar, which continue to wither – irrespective of what happens with either equity or interest rate markets:
Now, I don’t want to alarm anyone, but I am wondering if there might not just be a titch of politics embedded in this chart. While a lower value on the Dead Prez might increase the bite out of your wallet taken in association with your purchase of Lederhosen, Saki or Cornish Hens, it will undoubtedly offer an export boost to our heroic but often oppressed corporations.
And after all, what are we here for if not to support the intrepid efforts of the guys in the suits that occupy the C-Suites?
In general, I expect that risks, if not returning to their unobservable levels that characterized most of the last 18 months, are unlikely at any rate to rise again to the levels experienced in early February. As such, I sanction any incremental exposure you may wish to assume, provided that you have done your homework, thought carefully, and execute with due attention allotted to the details.
And as for Potter, I suspect he might be a buyer here. But I doubt he would “go whole hog” as he attempted to do on George’s wedding night. Instead, he’d be keeping his eye out for some bargains, and, finding them, would be quietly adding to his asset inventories. But here I’m just speculating, because the clear inference to be drawn at the end of our feature film is that he was run out of town.
George Bailey and his heirs are now the presumptive big dogs in Bedford Falls, PA. Lending standards at BBL have also presumably tightened up, and none of that would’ve happened had not Potter been there to bring some rationality to the otherwise goofy proceedings. In the future, if we are indeed to have wonderful lives, we may not wish to precisely emulate his methods, but we may do well to that the maxim of by low/sell high remains a virtue, and that flawed men like George Bailey don’t rise to the level of heroism without the elevating presence of those of Potter’s ilk.
TIMSHEL