Shift Back From Digital To Physical World: From Bits To Atoms

Nuclear Bomb Explosion - Mushroom Cloud

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This article takes a look at how disruptions in the global macro environment are causing a rethinking of intrinsic valuation of more traditional companies, particularly with respect to increased volatility and stock prices.

Further, we explore some history, plus what is driving an underlying shift from the digital world to the physical world, including several investing implications.

The Real World

Something critical broke during the Great Financial Crisis. Rather than dig through all the details, here’s a quick summary, during the late stages:

By the summer of 2008, the carnage was spreading across the financial sector. IndyMac Bank became one of the largest banks ever to fail in the U.S., and the country’s two biggest home lenders, Fannie Mae and Freddie Mac, had been seized by the U.S. government.

Yet the collapse of the venerable Wall Street bank Lehman Brothers in September marked the largest bankruptcy in U.S. history and for many became a symbol of the devastation caused by the global financial crisis.

That same month, financial markets were in free fall, with the major U.S. indexes suffering some of their worst losses on record. The Fed, the Treasury Department, the White House, and Congress struggled to put forward a comprehensive plan to stop the bleeding and restore confidence in the economy.

The essential problem is that markets never normalized. Specifically, many companies that should have been allowed to fail in a free market were instead kept alive, and even bolstered. In particular, banks – especially big banks – were saved. Zombie companies; TBTF.

Money did not flow to Mom and Pop, but instead, it poured into Wall Street. While this financial manipulation was likely necessary to stave off a full blown depression, it nevertheless kickstarted a trend in populism, but also money printing and interest rate manipulation.

What’s more, none other than Ray Dalio’s Bridgewater captured an ignition of populism by providing a clear look back into the Great Financial Crisis:

Bridgewater

Developed World Populism Index (Bridgewater)

Populism has little to do with theory, ideas and concepts. It’s much more about the here-and-now, combined with real-world, hands-on concerns. Citizens suddenly move their bodies and feet, forming groups, mobs and protests. This is often a result of outsized impacts to everyday life, including food, energy, and simply “getting by” (i.e., employment, education, security).

My point is that you don’t have theoretical populism. And, a bit like pornography, you know it when you see it, because people are actually doing something in the world, not just talking.

In any event, this is our first indication that atoms started to gain importance, in contrast to bits, really starting with the Great Financial Crisis.

Of course, this shift from bits to atoms has been largely cloaked by the financialization of the economy. Good times can easily hide ever-growing cracks. Simply look to the markets:

Chart
Data by YCharts

From this 10-year view, it’s clear that the S&P 500 has done fine, but the NASDAQ has done especially well, given the asset-light and high ROI businesses that are included in that index, such as Amazon (AMZN), Microsoft (MSFT), Alphabet (GOOGL)(GOOG) and Apple (AAPL).

Digitalization has been done via financialization, by way of buybacks.

Chart
Data by YCharts

The real point is that after the Great Financial Crisis, financialization of the stock market was back in full swing. The partly explains why value stocks have done poorly compared to growth stocks, which enjoy outsized returns when financialization nudges companies to invest in bits, not atoms.

It has been working quite well, but those cracks in the real world are growing, and even causing huge stress at times.

Disintegration Profits

Obviously there are subtleties and nuances to all of this. But, it does help to use this framework to better understand why AAPL, for example, would want to reduce direct CapEx “at home” by pushing physical production to China. We’re told the value is in the intellectual property. Hint:

Designed by Apple in California, assembled in China.

Now, when you combine the growing populism with the press to go digital, it’s not hard to see increasing issues related to inequality. The core problem isn’t that the rich are getting richer. That’s a problem that’s as old as dirt.

The real break is that the richer are insanely rich compared to those in the middle and the bottom. Forget the idea that the ocean lifts all boats. Now it’s only that super luxury yachts on a single exclusive lake are rising up and up.

This isn’t a condemnation of the wealthy or elite. Instead, it’s facing the reality that without ownership in the stock market, real estate, or other appreciating assets, average folks are being left behind. But, for that to happen, it’s necessary to have extra, non-essential amounts of discretionary funds available to allocate. That’s become more difficult since the Great Financial Crisis, without closer access to the Federal Reserve’s money printer.

While blue collar manufacturing jobs were shipped out of the U.S., we were told that white collar jobs were safe. In large part, the rise in populism has naturally taken root in the middle of America, while wealth accumulated via financialization, as previously outlined, very much started to concentrate, moving to the coasts.

The Powell Pivot

A weakness was revealed in 2018 when the game started to change, hurting more of those in the middle and upper middle:

The last time the Fed was shrinking its massive trove of bond holdings and raising short-term rates in tandem, the S&P 500 tumbled nearly 20% in three months at the end of 2018. It didn’t recover until after Powell sharply pivoted in January 2019 by saying the Fed would be “patient” in its policies to withdraw some of the stimulus it had injected into markets.

This is rather easy to see:

Chart
Data by YCharts

Although this is nothing like we experienced during the pandemic in 2020, it was still quite distressing for investors at the time, getting plenty of press. The point being that more “bits” were injected into the markets.

Of course, nothing real and tangible was added to the economy, only more money. It wasn’t physical. And, again, growth stocks continued to do well versus value stocks. That trend was maintained, although investors were rightfully rattled as the board twisted and some of the pieces fell off.

Pandemic Twist

The bits versus atoms “seesaw” moved because of the pandemic. Suddenly, the real world mattered again. It takes just a minute to remember what happened to cruise lines like Carnival (CCL) and manufacturers like Boeing (BA). Plus, everyone was suddenly interested in food supplies, masks, hand sanitizer and more. The shift was sudden and real.

At the exact same time, financialization and the emphasis on bits did not go away. In 2020, we saw massive stimulus packages and support. Literally, trillions were pumped into the economy. Plus, several digital work-from-home companies such as Zoom (ZM), Peloton (PTON) and DocuSign (DOCU) enjoyed incredible stock price increases:

Chart
Data by YCharts

There was simultaneously crushing pressure on bits and atoms, hurting those companies not directly involved in what was happening in the real world, whether via online or offline channels.

In many ways, this forced everyone to rethink the physical world, from transportation, to education, to work, to health. Some common and normally abundant items suddenly became scarce, such as toilet paper. Plus, physical supply chains stretching around the globe suddenly broken, exposing multiple weaknesses in a tightly integrated world. Normally esoteric supply chain topics such as “cold chains” gained traction in the media. Again, the point is that eventually the real world matters, even if you try to ignore it.

China and Russia

Many investors were not fully aware of this ongoing shift from bits to atoms around the world. First, consider this small sampling of what China has been working on since the Great Financial Crisis. Let’s go back a little bit more.

Records state that since 2000, China claims to have mined around 6,500 tonnes of gold, and over half of China’s mining operations are owned by the Chinese government. And what’s really interesting is that China does not sell the gold it mines. Exporting domestically mined gold is not allowed in China.

However, to emphasize, it really wasn’t until after the Great Financial Crisis that we saw China get really aggressive about adding gold reserves.

Chinese Gold Holdings

Chinese Gold Holdings (Trading Economics & World Gold Council)

Commodities and real-world raw materials are in great demand in China, for many reasons:

The China-led commodities boom had a tangible impact on many economies. First, during and after the global financial crisis of 2008–09, Chinese demand supported growth in economies that supply commodities, including Australia, Brazil, Chile and Canada. The surge in Chinese demand during this period reflected the government’s macroeconomic stimulus, which underpinned rapid growth in residential construction and infrastructure investment and related manufacturing production, giving rise to strong imports of iron ore, coal and base metals.

An additional role that resilient commodity demand from China played in the late 2000s was to mitigate and reverse falls in commodity prices stemming from the unanticipated negative shock to growth in the advanced economies during the crisis…

The key point is that the Chinese saw the writing on the wall. Commodity security was essential to their prosperity, and perhaps even national security. The Great Financial Crisis wasn’t just a wake up call in the U.S. because it also provided the Chinese with clarity. While bits are desirable, atoms are essential.

Meanwhile, Russia has also been making the transition in their own way. Already rich in natural resources, the Russian approach been by backing away from the U.S. dollar, and debt.

CNN reported in 2018:

Between March and May, Russia’s holdings of US Treasury bonds plummeted by $81 billion, representing 84% of its total US debt holdings.

The sudden debt dump may have contributed to a short-term spike in Treasury rates that spooked the market. 10-year Treasury yields topped 3% in April for the first time since 2014.

It also sparked a guessing game about Moscow’s motivations. Maybe Russia just wanted to diversify its portfolio, as the central bank stated. Or perhaps Russia was seeking revenge for Washington’s crippling sanctions on aluminum maker Rusal.

Meanwhile, that cash needed to go somewhere; enter gold. Again, this news was being clearly provided back in 2018:

Padhraic Garvey, the global head of debt and rates strategy at ING, said that for Russia it was like “moving from a safe asset to an ultra-safe asset.”

Russia has been buying large amounts of gold as it continues to sell US Treasury bonds, recently overtaking China in Gold reserves with $80.5 billion worth, according to Russia’s central bank.

Shifting from digital assets to physical assets is obvious, per the above. But, there’s more. If you consider that Russia and China are rivals to the U.S. then this might provide a bit of a surprise:

China and Russia’s combined military spending exceeds that of the United States when adjusted for purchasing power, which has allowed China to shorten capability gaps in its quest to become the top superpower by midcentury, the top U.S. military officer said Thursday.

“Combined, the Russian and Chinese budgets exceed our budgets if all the cards are put on the table,” Joint Chiefs Chairman General Mark Milley told the Senate Armed Services Committee. He called China’s increased spending trend “disturbing.”

The U.S. doesn’t dramatically outspend Russia and China, as many think:

Let’s be clear. Because the Chinese and Russians manipulate their defense budgets, measuring their actual spending is very difficult. Both Beijing and Moscow lie about just about everything—the coronavirus, genocide, poisoning political opponents—so it should be no surprise they intentionally hide significant parts of their defense spending. For instance, the Chinese don’t report any research and development spending in their defense budget, and significant portions of their space program and basing costs are omitted.

Although a huge amount of military spending is on non-physical, digital goods, the vast majority of this investment is in hardware, infrastructure and the like. In other words, planes, bombs, tanks, satellites, and much more.

All of this is to say that in China and Russia, vast amounts of money have been pouring into the real world, not simply services and entertainment, for example. The flow is from bits to atoms; paper money to hard money, and commodities. Most warfare is real-world and kinetic. Atomic, if not nuclear.

Quick Aside About Bitcoin

Many investors dislike Bitcoin (BTC-USD) because of the view that it’s fake money, based on nothing. In other words, on the surface, BTC appears to be “soft” digital money.

But, BTC is extremely inelastic, with only 21 million ever possible. There is exactly zero elasticity, with zero inflation. Right now, it could be rationally argued that BTC is the world’s hardest money.

For further clarity:

Elasticity is a measure of how much supply or demand changes in response to price swings. Let’s say gold goes to $4,000 an ounce as a result of fiat currency printing, for example.

If that happens, the rate of gold miner production will expand. It won’t expand by a huge amount relative to the above-ground gold supply, but the supply of gold will still go up, at least a little bit, in response to upward price pressures.

But Bitcoin’s elasticity is zero because the rate of Bitcoin creation will never expand, no matter what the price does.

Even if Bitcoin shoots up to $50,000 or $100,000 per coin, the rate of creation for new coins will stay the same, and not budge one bit, because the whole structure is algorithmic and pre-determined.

This is critically important when we add a crucial element. Namely, that to mine BTC, it’s necessary to consume tremendous amounts of energy. That energy is produced in the real world, with true consequences. It’s “proof of work” and network security, all rolled into one.

In other words, real-world, physical atoms much be rearranged to make BTC possible, in every way. Although BTC has a digital structure, and enjoys a code-based architecture, the manifestation of value is entirely physical. You don’t have BTC without burning dinosaur bones.

I am bullish on BTC.

Who Will Benefit

This is no condemnation of digital companies. In fact, I very much believe that most of the giants will survive, and even thrive. I’m talking about juggernauts including Microsoft (MSFT), Amazon (AMZN), Apple (AAPL), Meta (FB) and several others. They will survive, and likely thrive.

It’s not like the shift from bits to atoms will cause great harm to these companies, which often have their hooks into the physical world (e.g., infrastructure, data centers, employees, more). Plus, they already enjoy incredible and substantial advantages; network effects, monopolies, regulation barriers, and far more.

Instead, there are likely a few shifts, opening up growing opportunities. For example, the more likely winners are:

  • precious metal miners
  • oil and gas companies
  • food and fertilizer companies
  • domestic transportation companies
  • domestic technology manufacturing

There is a long runway here. We’ve already seen these “atomic companies” take off. Here are some quick examples to chew on.

  • Newmont Corporation (NEM)
  • Exxon Mobil (XOM)
  • CF Industries (CF)

This likely foreshadows a growing shift of growth to value over the coming years. It will almost certainly be volatile, given the response required by the Federal Reserve and the U.S. Government to ongoing stressors and conflicts, including income inequality, the rise of populism and of course kinetic warfare.

That said, there could very well be “real world” value opportunities in plain sight, right at this moment. For example, tobacco products are quite physical, and hands on despite the press to electrify smoking via vaping, and such. In any case, Altria (MO), Philip Morris (PM) and British American Tobacco (BTI) are currently sitting at reasonable valuations. More on this below.

There are also almost always pockets of value in real estate too. For example, VICI Properties (VICI) is going through some adjustments, but it’s an “atomic” company because it is real estate but also because it involves a tremendous amount of human activity; in and out of gambling establishments. It’s also quite local, with a huge footprint in Las Vegas. This is just one example, but it should be enough to get investors looking at real estate opportunities with fresh eyes.

Perhaps the biggest risks in the market are those growth stocks which aren’t tethered to the real world in substantial ways. This could simply translate to an increase in volatility, but not necessarily a decline, or collapse. Smaller, weaker software companies could face even more violent sell offs. Unless the value propositions are clear, there could be severe pain.

In contrast, some companies such as Palantir (PLTR) could continue to struggle but nevertheless grind upwards due to the value proposition. PLTR, for example, provides increasingly important products and services to the U.S. government, and its allies. Furthermore, much of PLTR’s commercial value is tied to helping automotive companies, ecosystem companies, telecoms, and much more. PLTR isn’t exactly lost in the Metaverse.

Final Thoughts

Now is still a good time to go looking for mispriced companies. If nothing else, there are always some stocks which are beaten down. While the market itself continues to be expensive, there are interesting opportunities. I’ve already mentioned a few of my favorites. Here’s some added clarity:

  • PM under $90
  • BTI under $40
  • VICI under $30

I might also add 3M (MMM) below $150, Verizon (VZ) below $52 and Cummins (CMI) below $200 to the mix. Regarding income and stability, I am rather fond of dirty-and-gritty dividend paying stalwarts.

We should all be mindful that any kind of shift of the pendulum from bits to atoms will not be smooth, or complete. In other words, there is not any kind of all-or-nothing scenario here. There is far too much interaction between the digital world and the physical world.

At the same time, we should be aware that there appears to be more pressure to accumulate valuable atoms. It’s also true that nonphysical tools – stocks, real estate ownership, and even BTC – are acquired and held via digital tools and services.

Put another way, I continue to hold a diversified portfolio, including cash, BTC, real estate and more. And, I continue to hold a select number of highly desirable growth stocks, with almost no physical footprint.

Again, we must never put on blinders, ignoring opportunities. Indeed, we must always remain vigilant. Thanks for reading.

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