What about rapid growth in fundamentals? Well, over the past two decades, S&P 500 revenues and U.S. nominal GDP have grown at just 4% annually.

John P. Hussman, Ph.D. (October 2021)

If you want to know where we are in the economic cycle, I drove past a homeless man in a wheelchair in Baltimore wearing new Nike Air More Uptempo 2020s.

These shoes cost $200.

It is easy to look around at asset prices in December 2021 and say things are crazy.

Let’s see if they are. If so, what do we do?

Stock Market

Let’s use Nike as an example.

Nike made $5.7 billion in 2021.

At the time of this writing, Nike’s stock price is $168.

The company has 1.582 billion shares. You multiply those two numbers and you get $265 billion.

The company has $25 billion in debt, but it also has a similar amount of cash and short-term assets, so for convenience we’ll say these cancel out.

This effectively means that Nike is worth $265 billion today.

Let’s say you and I wanted to buy Nike.

As we get a little more serious about this, we would start asking each other: What are we getting for $265 billion?

Well, hopefully we say $5.7 billion a year.

Next, we would probably think it is cool to tell people we own Nike. Sounds better than owning Reebok.

But, then you say, “Wait, $5.7 billion a year?”

Me: Yeah

You: They made $2.6 billion in 2020 and $4 billion in 2019, so it seems a little inconsistent.

Me: What’s your point?

You: How long will it take us to get our $265 billion back?

Me: If they make $5.7 billion a year, we will get all of it back in 47 years.

You: Huh? That seems like a very long time.

Me: They will probably increase the price of shoes and sell more of them between now and then. So, it will likely take less time than that. Plus, remember we will still own Nike after that!

*Quick note: An accounting profit is different than cash flow. For simplicity, we are using them interchangeably.

Never Take Your Eye Off The Lemonade Stand

You: My friend’s kid has a lemonade stand that makes $1,000 every year.

Me: Nice! Regardless of the zeroes behind the numbers, you should compare every investment you ever make to a modest lemonade stand.

You: Are you saying that paying that much for Nike would be like paying $47,000 for that lemonade stand?

Me: Yes, but is that lemonade stand going to be there in 47 years?

You: Sheesh. Probably not. A lot can happen to Nike in 47 years, though. Sears was bussin’ 47 years ago.

Me: People have loved Nike for 40 years. You think they are going to stop anytime soon? Are we ready to get the investors?

You: Wait. Even if the business is safe, that doesn’t mean our money is going to be safe if we pay too much for it!

Me: You make a good point. How much should we pay for businesses?

You: We only looked at Nike. What about something completely different, like Chipotle?

Me: There is good news and bad news. The good news is we only need about $47 billion if we want to buy Chipotle (instead of the $265 billion to buy Nike).

You: What is the bad news?

Me: They are having a great year this year.

You: And why is that bad news?

Me: If they keep up the good work, it will take 69 years to get our original investment back.

You: You cannot be serious.

Me: Well, they are on pace to make about $700 million this year. If we have to pay $47 billion for it and they keep making $700 million, it will take 69 years to get all of the $47 billion back.

You: They have been crushing it with their app and delivery, but are our investors going to want to pay that much? What else can we do with this money?

Me: The safest thing out there is risk-free bonds.

You: Do I even want to ask?

Me: 30-year rates are 1.83% today.

You: Translate.

Me: For every $1,000 we invest, we would get $18 a year for 30 years, then we would get our $1,000 back.

You: That is if we lend to the US government right?

Me: Yes

You: Compare that to buying Nike and Chipotle stock.

Me: If we invest $265 into Nike and it makes $5.7 a year, that’s 2.15% ($5.7 / $265).

You: Okay, so for every $1,000 we invest in Nike, our share is $21.50 of the profits a year??

Me: It is not guaranteed and their profits are inconsistent. It would have been $9.8 last year.

You: What about Chipotle?

Me: For every $1,000 we invest in Chipotle, we would get about $14.60.

You: You can’t even get a burrito with extra guac for that!

Me: Remember, it’s different than the risk-free bonds, because although the cash flow is consistent with the bonds, it does not grow. It is the same low return each year for 30 years.

If Chipotle gets more customers, reduces costs, and/or raises the prices of burritos, it could go up! But, I suppose it could also go down…

You: So, we know these companies are safe, but the equity is priced almost like it is as safe as government debt!?

Me: Basically.

You: Can we lend money to Nike and Chipotle?

Me: Yes, they issue bonds, too. The rates are a little better than the government’s, in the mid 2-3% range for 30 years.

You: Must be nice for Nike & Chipotle!

Me: Tell me about it.

You: It sounds like there is basically one main difference between buying the debt and the stock of these massive companies today. If we buy the debt (lend money to them), we are locked into super low cash flows for a very long time. If we buy the stock, our cash flows are tiny and riskier, but at least they could go up!

Me: That’s it.

You: What about all these tech companies that don’t make any money?

Me: If you understand when they are going to start making money and how much they are going to make, then you may be able to make a lot of money.

You: These days it seems like it is less about the actual or likely cash flows. It seems more like it is beliefs all the way down. As you’ve said before, the narrative is more important than the truth.

Me: It is hard to argue that.

You: Realistically, I am not going to forecast cash flows. I am probably just going to ride the wave.

Me: That works until it doesn’t. How would you feel if a year’s worth of your savings permanently disappeared because you were “riding the wave” and then the stock dropped and stayed there?

You: I’m going to throw up.

Me: Let’s take a break.

You: Hold on. What about these cryptocurrencies, like Bitcoin?


Me: How much time do we have?

You: Ehhh, I’m interested in how it connects to this, but I’m going to zone out if you tell me the technical details.

Me: You are in luck, because I don’t know anything about SHA-256 cryptographic hashes.

You: Please don’t say any of those words again. I’m really just trying to make money.

Me: Okay. So, we know that all assets are “expensive.”

You: Yeah, that’s why we’re here.

Me: There are basically two types of assets: Those that generate cash flow and those that do not.

You: Right. If we own a lemonade stand and it’s making money, we can take cash out of the business every year and spend it on things we want.

Me: Exactly. And if we own something like a cryptocurrency, it does not generate cash for us every year simply by owning it. In order to make money, we have to sell it to someone who is willing to pay more for it than we did.

You: That makes sense. There are a lot of things to consider in how much to pay for things like the lemonade stand, Nike, and Chipotle because even though there is cash flow now, the future is uncertain.

Me: Of course, but the tether to reality is always cash flow.

If our lemonade stand makes $1,000 a year and that’s all we need, we can ignore what people are telling us it is worth. Whether they say it’s worth $10,000 or $100,000, it still makes $1,000 a year.

You: If someone offers us $10,000, that would be nice because we get 10 years of cash flow TODAY. But, we may think that the lemonade stand is a great asset and will be selling lemonade profitably well beyond that. So, we may keep it if someone offers us $10,000.

But, if someone offers us $100,000 of cash today for a lemonade stand that makes $1,000 a year, it would be very difficult to turn down that offer because it would take 100 years to make that if we waited.

Me: Exactly. And we would look at it the SAME WAY if we were looking to BUY the lemonade stand and didn’t already own one!

You: Yes, that makes sense. But, if we don’t own a lemonade stand and we want to own a lemonade stand, what do we do if they all cost more than $40,000?

Me: It is a hard question, because if we hold onto our cash for too long, it will lose its value by the rate of inflation. Doing nothing with cash makes people very uncomfortable. Most can’t resist the temptation to do something.

You: Suppose we pay $60,000 for a lemonade stand that makes $1,000 a year. Then, in a few years, we want to sell our lemonade stand and people are only willing to pay $40,000?

Me: It seems like few people are considering that possibility, today. More people are focused on missing out and do not want to see their friends get richer faster than them.

You: I heard someone call 10% “Boomer Returns.” Do I have this right though? If we bought this lemonade stand for $60,000 and people were only willing to buy it from us for $40,000, we would have to hold onto it for 20 years to break even?

Me: You got it.

You: Yikes. So, tying this back to cryptocurrency. Those do not generate cash flow. How would we determine how much each one is worth?

Me: This is where it starts to get slippery. Basically, what someone is willing to pay for it.

You: Um, that sounds like great news. It’s super popular.

Me: What is the right price to buy it and what is the right price to sell it?

You: I don’t know, but it doesn’t seem like it’s going anywhere.

Me: Great point, but is the right number $50,000, $500, or $500,000?

You: I get it. These are tricky to say what they should be worth because they don’t produce cash like a business does.

Me: Exactly.

You: You said people dislike holding cash. Isn’t that one of the big reasons people want cryptocurrency? They don’t want their cash to lose value due to the government printing more money.

Me: That is one of the most desirable things in the world, so I get it. However, all of them have proven to be more volatile than US dollars, so they are not reliably holding value over a short period of time. One of the questions is: Would people still be interested in them if they increased 2-3% per year?

You: Hmm. I hear you, and I am going to do my homework before I put any serious money into this. But, I have watched people make A LOT OF MONEY in it.

Me: As my boy Warren B says, “Forget greed…Envy makes the world go round.”

Real Estate

You: Last question for today: What about Real Estate? That’s been popping off, too.

Me: Above, we said 30-year risk-free rates are 1.83%. Well, 30-year home mortgages are priced off that rate.

You: I’m pretty sure I knew that. I definitely know mortgage rates are ridiculously low.

Me: For better or worse, everyone else noticed that, too.

You: Ah yeah, they knew they could take on more debt without the monthly payment changing much. Which means they can pay more.

Me: Yes

You: Earlier, you mentioned two types of assets. Ones that produce cash flow and ones that don’t. Residential real estate seems like it can be both.

Me: Excellent point. If you rent it out, it’s a cash flow generating asset. If you live in it, it doesn’t generate cash flow per se.

You: If you live in it, you’re not paying rent to someone else, though.

Me: So, maybe take what we would pay in rent and compare it to what we pay per month to own and maintain the house.

You: Got it. So, if we are renting out the real estate, it is a cash flow generating asset and we can compare it to everything above. If we are living in it, we probably don’t want to do, that right?

Me: Makes sense. We may want the expensive tile in the shower because we like it, not because of its financial return.

You: Yes, but here is a little secret: You can justify anything you want to do if you tell yourself it increases the value of the house. It is fun and reduces guilt.

Me: The most important reason to differentiate your house from all of these other investments is you can’t live in your other investments. I cannot live in financial assets like Nike stocks or government bonds.

You: Got it. We have covered a lot, but we haven’t talked about commercial real estate. What about office buildings and apartment complexes?

Me: You basically look at all of these cash flow generating assets the same!

You: Let me see if I can do this by myself. Suppose our lemonade stand was an apartment complex. If the apartment complex made $1,000 a year and it cost $20,000, we would take the $1,000, divide it by $20,000, and get 5.0%.

Me: Perfect. In commercial real estate, they call that 5.0% number a capitalization rate (“Cap Rate”).

You: What’s the point in doing that?

Me: So that you can compare it to other real estate and assets.

The Most Important Thing

You: Okay, so it sounds like the two most important things in any financial asset is figuring out how much cash the investment is going to make every year and how much you’re paying for those cash flows?

Me: I love you.

You: And we keep comparing everything to that risk-free rate?

Me: Always.

You: It sounds like there is really no place that is “safe” to put money right now.

Me: It is always hard.

You: You are not going to tell me exactly what to do are you?

See also:

Thanks to James Bunch, Sean Justice, and Ari Schaffel for reading drafts of this.