FIRST SHELBOURNE LLC
COMMACK, NEW YORK 11725

MEMORANDUM FOR FIRST SHELBOURNE CLIENTS

DATE:             JANUARY 1, 2025

FROM:           CHRISTOPHER WARGAS - PRESIDENT

SUBJECT:      2024 PRESIDENTS' LETTER

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To my fellow clients,

     As we close the books on 2024, I want to begin by expressing my gratitude to each of you. The trust you place in me to steward your hard-earned capital is a responsibility I don’t take lightly. This firm’s principle remains clear: stable growth is the cornerstone of long-term wealth creation. The words of John Maynard Keynes resonate strongly in this regard: “People would rather fail conventionally than succeed unconventionally.” In investing, as in life, the prudent, methodical path often proves the most rewarding over time. Speculative bets may grab headlines, but they rarely build enduring fortunes.

     In this letter, I will discuss the current economy, lessons we can learn from Japan’s stock bubble decades ago, and the allure of speculation. The current market environment offers a compelling case for caution. Market capitalization as a percentage of GDP, a metric Warren Buffett has described as a key valuation indicator, has reached unprecedented levels, standing near 203%. For perspective, this measure peaked at approximately 140% during the tech bubble of 2000 and at over 105% before the 2008 financial crisis. Historically, such extremes have been followed by significant market downturns. While no one can predict short-term movements with certainty, prudence demands that turbulence is prepared for.

     A similar story is told by the yield curve, which has been inverted for some time. History suggests that economic weakness often follows when the curve normalizes and uninverts. These are not signals to abandon equities outright but to exercise greater caution. Broad market exposure via index funds has its place in long-term portfolios, but today’s valuations also favor a selective stock-picking approach.

Lessons from Japan

     Investors would do well to study the experience of Japan. The Japanese Nikkei index, similar to our version of the S&P 500, experienced its historic peak during the Japanese asset price bubble of the late 1980s and reached its all-time high of 38,915 on December 29, 1989. By April 28, 2003, the Nikkei fell to a low of 7,603.76, representing a decline of approximately 80.5%. It finally broke even in December 2023, nearly 34 years later. If an investor were forced to take required distributions during this decline, similar to how RMDs work in 401k plans and IRAs, they would have run out of most of their money by 2000. At the height of Japan’s market boom, investors were thriving, retiring with great confidence. Yet, within a decade, many found themselves nearly broke. This all-too-common scenario is a powerful reminder of the importance of caution and one we are determined to avoid at all costs.

The Allure and Risk of Speculation

     In a rising market, the temptation to chase speculative gains can be overwhelming. Stories of rapid wealth accumulation in cryptocurrencies or meme stocks often lead to hasty decisions. Yet, as Mark Twain noted, “There are two times in a man's life when he should not speculate: when he can’t afford it, and when he can.” Our approach remains focused on avoiding permanent capital losses while pursuing steady, reliable returns.

     Let’s now talk about bonds. At the beginning of 2024, the U.S. bond market was valued at approximately $53 trillion. This includes Treasury bonds, corporate, municipal, and other debt instruments. The U.S. stock market, measured by the market capitalization of publicly traded companies, was around $40 trillion (this has since grown over the past year).

     The key takeaway here is that the bond market is vast, with different maturities that react differently to changes in interest rates. Most of the bonds I’ve invested in for you have shorter maturities, meaning they are set to mature in less than five years.

     Longer-term bonds, such as those maturing in 15 years or more, are currently offering inadequate returns for investors. This is due to the yield curve inversion, where short-term instruments like 3-month Treasuries yield more than long-term ones, like 30-year Treasuries (although this is now changing as the yield curve uninverts). In September, the yield on a 30-year Treasury bond was just 3.95%. Ask yourself: would you be willing to lend money to the U.S. government for 30 years at that rate? Such an investment barely outpaces inflation and will likely lose value after taxes.

     However, volatility and capital loss are the more insidious reasons for not buying such long-term bonds. Thirty-year bonds are highly sensitive to changes in interest rates and can experience significant volatility. For example, 30-year Treasuries have lost over 40% of their value since their peak in 2020 due to rising interest rates. Unfortunately, many uninformed investors have mistakenly viewed these long-term bonds as safe investments, only to see nearly half of their wealth erode as a result.

     In previous annual letters, I emphasized that 30-year bonds are best suited for pension funds that intend to hold them until maturity. Pension funds operate primarily to ensure their assets are sufficient to cover future liabilities, such as pension payments. This is achieved by carefully projecting future liabilities and investing assets in a way that aligns with those obligations.

     Buying a 30-year Treasury bond only makes sense if interest rates are locked in at 7%, 8%, or higher. Instead, focusing on the short end of the yield curve allows us to maintain the flexibility to reinvest at potentially higher rates or capitalize on stock market opportunities after a significant decline. This strategy's strength lies in the optionality it gives us to have capital available when others do not.

     As we move into 2025, we must always maintain a long-term outlook. As the American economist Paul Samuelson said, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” I believe all investors should take this advice. 

I wish all of you a happy and healthy new year. 

Respectfully,
/s/ Christopher Wargas
President, First Shelbourne