Bob’s Journal for 12/8/22

How FTX’s Leader Telegraphed Its Fall

There’s a lot we don’t know about cryptocurrency broker FTX and its collapse.

But we do know a few key things and one, in particular, indicates failure was very likely at some point. FTX founder Sam Bankman-Fried was an extreme risk taker.

He took more risk than probably anyone who’s ever run a business so large or that attracted so much of the financial world’s attention. In interviews over the last view years, Bankman-Fried explained that one of his operating philosophies was the Theory of Expected  Value.

He said that what he tried to do when making decisions was to calculate the expected value of an action. That projection determined if the move was worth taking.

He said that under his implementation of expected value theory, the best action often was “to go for it.” If there was “some non-zero and non-negligible chance of a really good outcome” then a person should go for the extreme outcome.

Bankman-Fried said he wasn’t concerned at all about risk or the potential of losing. That’s where his application of expected value analysis differed from ones in which I am familiar.

Expected value in traditional analysis is calculated by multiplying the expected return of an action by the probability of success (and failure). Bankman-Fried wasn’t worried about failure, only about “hitting home runs” and having an enormous impact.

That’s apparently why there were no risk controls, risk management, or other structures that would be in place at a well-run investment firm and most businesses. The people running FTX and its affiliates rejected or weren’t familiar with the concept of margin of safety. They liked the idea of investing a lot in something with a 98% chance of failure if the payoff from success was very large.

Some people say they’re dubious that’s what really happened at FTX. They suspect the admissions about extreme risk-taking, lack of controls and mismanagement are the groundwork for a defense against criminal charges. They believe FTX’s leaders will argue they weren’t committing fraud. They were incompetent.

The New Generational Gap Attitudes About Wealth

There are significant philosophical differences about wealth and charity between high-net-worth individuals over age 43 and those ages 21 to 42, according to the 2022 Bank of America Private Bank Study of Wealthy Americans.

The differences in investment strategies don’t fall along the traditional growth vs. value lines. Instead, the older generations tend to invest primarily in stocks and bonds with small percentages allocated to alternative investments.

The younger generations, on the other hand, average only 25% of their portfolios in stocks. They favor alternative investments, including having 15% of their portfolios in cryptocurrencies.

Sustainable investments are another favorite of the younger people. About 72% of those under age 43 surveyed believed that through investments they could have a positive impact on the world. Sustainable investments are made by 73% of millennials but only 21% of older survey respondents.

Charitable giving has perhaps an even greater divide, which should be important to older Americans who have charitable interests they hope will be supported after they are gone.

Only half of younger survey respondents support the same causes as their parents, and 75% said they want to create their own philanthropic identities.

But the survey did find that those younger people who inherited or expect to inherit wealth are more likely to support their parents’ causes than are those who created their own wealth.

The survey reveals something many estate planners already know. Parents and grandparents often make assumptions about what younger generations will do with money they inherit.

The older generations often don’t talk about their wishes, goals and philosophies but hope these ideas seeped into the younger generations over the years. It is better to have discussions over the years that explain your interests and goals.

Value Stocks are Beating Growth Stocks

The normal cyclical change from growth stocks dominating to value stocks dominating might finally be returning.

Historically, growth stocks perform better than value stocks for a period of years. Then, growth stocks falter and value stocks outperform.

But that cycle hasn’t occurred for a long time. After the technology stock crash ended in the early 2000s, growth stocks generally had much higher returns than value stocks. Since the end of the financial crisis and especially following the pandemic crash, growth stocks had extraordinary returns while value stocks hardly could find buyers.

The trend finally reversed in 2022. Value stocks beat growth stocks by the highest margin since 2001.

For example, the Vanguard S&P 500 Value fund recently had a one-year return of 3.94% while the Vanguard S&P 500 Growth fund was down 21.44% over the same period.

A similar discrepancy exists in small company stocks. The Vanguard Russell 2000 Value Index fund is down 5.66% over 12 months. The Vanguard Russell 2000 Growth Index fund is down 20.18% over the same period.

We’ve had brief periods of value dominance in the last 20 years, but none was sustained for years as happened in the past.

But this period of value dominance could continue for a while, because the Federal Reserve no longer is supporting stock markets with easy monetary policy.

Growth stocks prosper when there’s a lot of liquidity and little concern about slower economic growth. Growth stock investors like to see forecasts of steadily rising earnings growth.

We don’t have those conditions now. Instead, even the largest technology companies are laying off workers.

It is a good time to break out those old books about value investing.

The Data

The Fed’s preferred inflation measure, the Personal Consumption Expenditure (PCE) Price Index, increased by 0.3% in October, the same amount as in September.

Over 12 months, the PCE Price Index increased 6.0%, down from 6.3% in October.

The core PCE Price Index, which excludes food and energy, increased 0.2% in November after jumping 0.6% in October. Over 12 months, the core index increased 5% through November, down from 5.2% in October.

Personal spending increased 0.8% in October after climbing 0.6% in September.

Personal income also had a strong 0.7% increase in October, following a 0.4% rise in September.

Payrolls increased by 263,000 in November, and the number of jobs created in October was revised higher to 284,000, according to last week’s Employment Situation reports. The unemployment rate remained at 3.7%.

Average hourly earnings increased 0.6% in November and 5.1% over 12 months. Those numbers are higher than the 0.5% and 4.9%, respectively, reported for October.

The 12-month increase in hourly earnings is less than the inflation rate (which has been the case for 20 consecutive months) but still provides support for higher prices on many goods and services.

The ISM Manufacturing Index slumped to 49 in November from 50.2 in October. Any reading below 50 indicates the sector is contracting, and this is the first reading below 50 since May 2020.

The PMI Manufacturing Index also declined in November to 47.7. Likewise, the PMI Services Index for November was 46.2, down from 47.8 in October. That combination brought the PMI Composite Index for the economy down to 46.4 in November from 48.2 in October. For all those indexes, any reading below 50 indicates a contraction.

The Chicago Purchasing Managers Index declined sharply in November to 37.2 from 45.2 in October. That’s the third consecutive month of declines and the lowest level since May 2020.

Factory Orders increased 1% in October, following a 0.3% climb in September. After excluding the volatile transportation sector, orders increased 0.8% in October after dipping 0.2% in September.

Pending home sales declined 4.6% in October, after falling 8.7% in September. Pending sales have declined five consecutive months.

Over 12 months, pending sales are down 37%. That’s the largest 12-month decline on record.

The number of job openings declined by 353,000 in October to 10.3 million, according to the JOLTS (Job Openings and Labor Turnover Survey) report. That’s 2.5 million more job openings than the pre-pandemic peak but 1.5 million less than the all-time peak in March 2022.

There was little change in the number of hires, separations and quits.

New unemployment claims declined by 16,000 to 225,000 in the latest week.

Continuing claims increased by 57,000 to 1.608 million. That’s the highest level since February and the largest one-week increase in a year. Continuing claims are up 20% in the last six months.

The Markets

The S&P 500 lost 0.35% for the week ended with Tuesday’s close. The Dow Jones Industrial Average declined 0.60%. The Russell 2000 fell 1.26%. The All-Country World Index (excluding U.S. stocks) gained 0.85%. Emerging market equities rose 1.64%.

Long-term treasuries rose 5.12% for the week. Investment-grade bonds increased 2.54%. Treasury Inflation-Protected Securities (TIPS) added 2.25%. High-yield bonds gained 0.46%.

In the currency arena, the U.S. dollar declined 1.25%.

Energy-based commodities lost 4.87%. Broader-based commodities fell 5.35%. Gold rose 1.30%.

Bob’s News & Updates

My next book will be “Retirement Watch: The Essential Guide to Retiring in the 2020s.” The official publication date is Jan. 3, 2023. You can make a pre-publication order or learn more about the book by clicking here and here, respectively.

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