Berkshire or Standard & Poor's?

Good morning. Unhedged is back in full force. Nvidia used up all the oxygen last week, but don't sleep on Eli Lilly. Strong earnings fueled by weight-loss drugs have pushed the stock up 32 percent this year. Citi expects Nvidia and Eli Lilly alone to account for a quarter of S&P 500 earnings growth in 2024. How does everyone feel about this rise? Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Berkshire and S&P 500

If your entire investment portfolio has to be in either the S&P 500 or Berkshire Hathaway, which is the better option?

With my colleagues Oliver Ralph and Eric Platt, I posed this question to Warren Buffett, chairman of Berkshire, in an interview five years ago. His response:

I think the financial result will be very close to the same. . . If you want to join something that may have a slight expectation for the best [performance] From the S&P, I think we may be the safest.

In his latest annual letter to shareholders, which appeared over the weekend, Buffett says something similar but not identical:

[We] They have no potential for eye-catching performance. . . Berkshire should perform slightly better than the average U.S. company and, more importantly, should also operate with a materially lower risk of permanent loss of capital.

Buffett writes that one reason for these modest expectations is that his company is now so large—6 percent of total equity in the Standard & Poor's 500—that no companies in the United States or abroad are large enough to succeed. It has a meaningful impact on Berkshire's earnings, (b) can be reliably valued, (c) has trustworthy and competent management, and (d) is available at a reasonable price. There are no big moves left to make. A similar story applies to buying stakes in public companies. Berkshire is a large conglomerate of high-quality companies that will endure.

But shouldn't quality make a difference? That is, shouldn't the safety that Buffett cited in the recent letter and in the 2019 interview give the company an advantage? If an asset has less risk with the same level of return, you can just leverage it so that it has the same risk and a higher return. You can own Berkshire with some borrowed money.

But note that in its most recent statement Berkshire is making the comparison to the “average U.S. company,” not the S&P 500. The difference is important because the average company may go bankrupt; The S&P 500 never will. Some members of the indicator will fade, but others will rise. Their diversification makes them substantially safer than the average member from a capital preservation standpoint. Buffet's more recent claim is more modest than the older one.

I don't want to read too closely the wording of either statement, but I think we should at least take Buffet's word for it: There's really no reason to expect meaningful outperformance from Berkshire over the long term. It's very big. Their ability to provide expensive capital to stressed companies in moments of crisis must be balanced with the pressure on returns from low leverage and their high cash holdings in good times. Buffett doesn't make his promises so he can over-deliver. He's just being honest.

Berkshire bulls might object that the company has performed slightly better than the S&P since 2019: 15.7 percent annually versus 14.1 in the S&P. This 1.6 percent difference, if compounded over time, could lead to something meaningful. But remember that in the decade leading up to 2019, Berkshire underperformed by the same small but important margin. It probably doesn't matter, from a long-term returns standpoint, whether you own Berkshire or S&P.

So why should Berkshire exist? When it's possible to own a virtual mega-conglomerate for just a few basis points, what's the point of an actual mega-conglomerate? Here we move into uneconomic territory. Institutions are important: they can create trust, connect people to each other, and transmit wisdom and values. Berkshire is such an institution in American life, and I think it brings a lot of non-economic benefits. In 2019, my colleague Oliver Buffett asked whether he should put a Berkshire fund or an S&P tracker fund in his young son's college fund. “I think your son would learn more by being a Berkshire shareholder,” Buffett replied. There is something in that, even if it cannot be directly translated into wealth.

Inflation and money supply

Most economists didn't see inflation rising in 2021. Even those who were right that the pandemic economic cycle was different, like Goldman Sachs' Jan Hatzius, were very optimistic about inflation early on. Likewise, the few who correctly predicted higher inflation, such as Larry Summers, were very pessimistic about how entrenched inflation would be. Inflation is not well understood, and it is illogical to predict.

However, look at the chart below. It shows a measure of year-over-year money supply growth versus the Fed's preferred measure of core inflation. If you had simply followed what the rapidly expanding money supply was telling you, you would have seen inflation rise perhaps ten months ahead of schedule. And I had been worrying about inflation for a year and a half before Jay Powell said it was “maybe a good time to retire” the “temporary” label:

Monetary theory, the idea that changes in the quantity of money lead to inflation, is no longer favored in economics. However, the frightening accuracy of the money supply in predicting the inflationary bout of 2021 has stimulated interest in thinking about money again. As Martin Wolf wrote in 2022: “Just as the financial crisis showed that banking matters, this inflationary rise shows that money matters. . . . We cannot steer the economy by the money supply.” [but] We can't ignore it either.

Was this conclusion premature? The money supply did not expand in isolation. This coincided with massive fiscal stimulus efforts and a global supply chain impasse. These factors alone may plausibly explain why inflation rises and then collapses. The importance of the money supply is not self-evident.

In new research, two Dallas Fed economists, Tyler Atkinson and Ron Mau, downplay the importance of money. Their hypothesis is simple: if money matters, then measures of its growth should be able to predict inflation better than crude forecasting based on inflation lagged 12 months earlier. If money-based expectations cannot outperform crude extrapolation from the recent past of inflation, what's the point?

As it turns out, money-based expectations fail to outperform lagged inflation. Since 1969, they have done about 11 percent worse in forecasting core personal consumption expenditure inflation over the next 12 months. Sometimes money-based predictions perform much worse, too. As the chart below shows, the money supply in 2011 was pointing to deflation, while inflation expectations only remained accurately close to 2 percent:

(One data note: Readers are probably most familiar with M2, which is the classic measure of money supply. The problem with M2 is that it aggregates very different types of “money.” Interest-bearing CDs are treated in the same way as interest-bearing CDs. Instead, the Dallas Fed authors use Devizia metrics, which weight types of payments based on how similar they are to cash and thus how much they contribute to economy-wide liquidity.

Atkinson and Mao acknowledge that money-based expectations slightly outperform lagged inflation if you only look at post-2020 data. Why might that be? They offer no explanation, but former New York Fed Chairman Bill Dudley did. In his interview with Unhedged last year, Dudley told us:

M2 will be linked to the shift from QE to QT. But if you look at the growth of M2 after the global financial crisis, you saw a lot of quantitative easing, and you saw rapid growth in M2. There was no inflation, and there were no consequences for growth. M2 has little to do with economic activity.

People don't understand how the Fed's operating model has changed. Quantities of money don't really matter that much. What really matters is the interest rate the Fed sets on reserves.

In other words, in a world where liquidity is everywhere, changes in the money supply are little indicative of the availability of credit. Whatever connection there may have been in the pre-QE world no longer exists. So the best explanation for the link between money supply and inflation after 2020 is that it is largely coincidental.

A sophisticated model could extract the signal from money supply data. We're not saying it doesn't matter at all. But for investors interested in a quick temperature check of the economy, the money may not have much to offer. (Ethan Wu)

One good read

McKinsey proves, once again, that it is not good at managing geopolitical conflicts of interest.

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