How Investors Can Hedge Against Inflation

Morgan Housel is the best-selling writer of The Psychology of Cash.

He lately joined Motley Idiot co-founder and CEO Tom Gardner for a dialog about:

• Why money is a greater hedge towards inflation than many consider.
• Parallels between the 2022 inventory market and the dot-com bust of the early 2000s.
• What Tesla buyers can be taught from Starbucks‘ previous decline.

To catch full episodes of all The Motley Idiot’s free podcasts, take a look at our podcast center. To get began investing, take a look at our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Jan. 8, 2023.

Morgan Housel: Everybody thinks when there’s excessive inflation, you do not wish to personal money. Your money in your financial savings account, your checking account, is dropping worth to inflation, and also you wish to eliminate that. You need actual belongings, actual gold and whatnot. However at any time when inflation pops up and it is surprising, the whole lot will get demolished. Crypto will get demolished, bonds get demolished, shares get demolished, gold will get demolished — each single time. That is what occurred in 2022, occurred within the Nineteen Eighties, occurred within the Seventies — brief time period, the whole lot will get worn out. The smallest declines, so to talk, come from money.

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Chris Hill: I am Chris Hill, and that is best-selling writer Morgan Housel. He joined Motley Idiot co-founder and CEO Tom Gardner a number of days in the past at our member occasion, and we’re bringing you a part of that dialog. Tom and Morgan talk about how buyers can hedge towards inflation for the brief time period and the long run, and a few surprising parallels between Tesla and Starbucks.

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Tom Gardner: It has been such a painful time for progress buyers, however the long-term prospects nonetheless stay very shiny, for my part, for thus many of those corporations — actually not all of them. We’ll be speaking about that, however we wish to begin on the macro degree and discuss in regards to the major worries that buyers face. So Morgan, why do not you begin this off.

Morgan Housel: I believe one large fear that nearly everybody has proper now that isn’t … I am not saying it is flawed, however I believe there is a fairly simple pushback to it. I believe individuals are taking this fear to extremes that they should not, which is the concept that what has occurred within the final 12 months or so is by some means irregular, or by some means signifies that the market is damaged, or that there is a large basic flaw, or that you simply as an investor, essentially made a mistake, so to talk. In some instances, that may be the case. There may be issues that individuals regretted. However I believe if you happen to look traditionally, in my opinion, there’s nearly nothing that has occurred within the final 12 months that I might contemplate irregular or unprecedented or one thing that even I might not say is assured to occur over the course of your life as an investor.

There’s an awesome quote that I really like from a author named Kelly McGonigal, who says, “Every part feels unprecedented when you have not engaged with historical past.” Such a very good, good quote. I believe in occasions like these, within the final 12 months, is when being an newbie market historian is probably the most advantageous. Every part from the Nasdaq happening 30-some-odd % to loads of corporations happening 60%, 70% or extra, to corporations like FTX being uncovered as a fraud — if we will use that phrase now. I do not wish to low cost the ache and the anxiousness and the uncertainty that that may trigger. However none of that’s unprecedented, and all of that could be a assured characteristic of being a long-term investor.

I do suppose there’s a level to make right here that if you happen to have been to have a look at the final 5 years and ask the query,  “What’s the anomaly of the final 5 years?”, It is not the decline that we have had during the last 12 months. I believe the anomaly during the last 5 years is the increase that occurred in 2021 in the course of the largest financial upheaval of the final 100 years — which isn’t an exaggeration, popping out of COVID and all of the stimulus packages — that we acquired to a degree of valuations that for not all corporations and never because the market as an entire, however for loads of particular person names did not make a ton of sense given the place they have been as corporations, at the very least for that second of time. If I have been to have a look at the final 5 years, I believe that is the anomaly. It is not the final 12 months, that is what it’s.

However I believe if you happen to have been to look traditionally on the final 100 years as an investor, even the final 30 years, as an investor, the frequent characteristic — we speak about this a lot and drive this dwelling so actually because it is so vital. The frequent characteristic of all market historical past is volatility. When folks take into consideration volatility, it is not 5% or 10%, it is 20%, 30%, 40%, 50% volatility that tends to be extra frequent than folks suppose.

These aren’t issues that occur as soon as in a lifetime. The 30% pullback within the Nasdaq, or 20% within the S&P [500]— that is the type of factor that may occur each 5 to 10 years as an investor. In case you are an investor like Tom and I, who wish to be investing for the following 30, 40, 50 years, that is the type of factor that, it is not a chance, I do know with nearly certainty that this factor goes to occur to me as an investor, I hope, 5 or 10 extra occasions throughout my lifetime as an investor

None of that ought to diminish the uncertainty or the ache of watching your internet value shrivel during the last 12 months as nearly everybody has. Regardless of the way you make investments, everybody has a point of that. I believe while you view this stuff as an inevitability and never a sign that one thing is damaged or a sign that you simply made a mistake, per se, is vital. What’s equally vital is that in case you are the investor for whom a 30%, 40%, 50% or extra decline was unpalatable, you could not settle for it, and it prices you a degree of sleep that, in hindsight, trying again on the 12 months was not value it, that is an vital realization as properly.

I believe the error that individuals make when there’s an error and the place there’s a scar that individuals will remorse, it is going via a decline like this, realizing that it is an excessive amount of threat than you wished to take promoting. However then coming again three years later and doing it over again, and making that very same mistake time and again.

I believe in case you are the investor — not everyone is — however in case you are the investor for whom the takeaway during the last 12 months was, “That was an excessive amount of threat for me,” I believe that is completely tremendous and OK, and my plea to you’ll simply be to embrace that mentality with each arms. And consider an asset allocation that’s extra acceptable to your capability to sleep at night time and your threat urge for food going ahead.

Tom Gardner: I like that a lot. Thanks for all these ideas. They remind me of a few of Peter Lynch’s writings about how every time it appeared like all the elements have been new, however while you checked out them collectively over time, there have been at all times issues, and at all times occasions of confusion, and at all times intervals of market volatility. And Peter Lynch, I keep in mind sharing his private story that it appeared like each time he launched a brand new fund or acquired a brand new job, proper as he allotted all of the capital, the S&P fell 15% or 20%, and hastily it was a devastating starting for them. This market decline is most painful, most damaging for the newcomers to the markets over the previous couple of years. And naturally, that included quite a lot of folks, as a result of we have been at dwelling, and with extra time to look into the digital screens and discover alternatives to speculate, and that made the markets extra thrilling, extra unstable.

And new asset lessons have been launched, cryptocurrency arrived, and an entire new group of buyers got here into {the marketplace} due to the circumstances introduced on by COVID. Sadly, that group is probably the most burned. For these of us who’ve invested for 10 years, 15 years, 20 years, 25 years, 30, 35 years, it doesn’t suggest it is not painful. I’ve at all times preferred my brother David’s assertion that he by no means feels completely happy when the market is down. It is like, “be grasping when others are fearful and fearful when others are grasping,” however he says, I by no means really feel higher when the market’s down. It is not a very good time. It is not a enjoyable time as an investor, it is way more enjoyable to see your corporations being rewarded for the dangers they’re taking and to see your investments rise. However for these of us who’ve been via numerous cycles, we will look again and see among the echo or hear among the echo of the previous.

So I might say for this market setting, I believe it is clearly most much like 2000, 2001, 2002, the place there was an unbelievable increase in enthusiasm for brand spanking new applied sciences and for issues that truly have traction and are actual. Distant work. As a lot as any firm needs to suppose or any chief or any politician or whoever needs to suppose that you could mandate a return to the office, it is not going to occur. As a result of that is a day by day behavior fashioned round commutes, round taking youngsters to high school at a specific time. That day by day behavior does not come again collectively for everybody in a company.

There are some organizations which are very native of their orientation, and so they have an area workplace, and so they simply weren’t in it and now they’ll all return. However for any firm that’s extra nationwide or international, that has a number of places of work, it could’t actually put the whole lot again collectively the way in which it was earlier than COVID.

This stuff are actual. These modifications are actual and they’re creating the necessity for brand spanking new digital options to collaborative work communication. If we predict we have now Slack and Zoom, and there is nonetheless so many issues that must be found to assist organizations, households, mates, to assist folks join. And people issues will likely be digital, and they are going to be cloud-native, and they’re going to have a number of machine studying, and there will likely be better and better effectivity that may come from it. However, after all, once we have been all at dwelling trying on the markets, that was a time of nice enthusiasm. Valuations ran very excessive, traditionally. So is it unprecedented? Properly, no. The patterns are there from 20 years in the past. Then it may be helpful to have a look at what occurred after 2002, 2003, as a result of everybody felt fairly shipwrecked at that cut-off date. I would say most likely Berkshire Hathaway did not, and I do not suppose Berkshire Hathaway buyers really feel shipwrecked now. And S&P index fund buyers do not feel as shipwrecked.

It is not such an outlier that the S&P is down 15% to twenty%. It is painful. Relies upon who you’re as an investor, however if you happen to’ve been round a very long time. You are extra shipwrecked as a Nasdaq investor. However remembering in 2000 and 2001, the Nasdaq was down greater than 70%. So right here we’re, we have been down by 35%, I believe, 40% could also be on the max, 35% on the max?

However let us take a look at the sample of what occurred after. And what occurred after is that it turned out that the Web was for actual. You already know, Pets.com however, and a bunch of IPOs that ought to by no means have come public. And a bunch of SPACs in the present day and a bunch of cryptocurrencies, a bunch of issues that may vanish in the event that they have not already. And doubtless a number of extra frauds that may emerge and turn into extra evident. However then, you will notice taking maintain the true R&D spend that did matter, and what these elements have been. As a result of these corporations are all being tossed to the facet as properly proper now, just about indiscriminately, most progress corporations proper now. I imply, you might have a portfolio of Amazon and Netflix on the core. And you might really feel unbelievable for the final 15 years and you are feeling completely terrible for the final 12 months. It relies upon while you acquired in, however nonetheless, everybody takes this expertise on in numerous methods. It is available in completely different occasions, completely different quantities of capital, completely different expectations. And so now, I believe I actually simply wish to affirm your fundamental level, Morgan, that this is not that distinctive. And I say that, as painful because it has been for all of us as buyers. What we will see prior to now are among the little alerts, the proof, the clues as to what might come subsequent.

There are not any ensures within the market, however we do know the market does undergo cycles. And I must say that I believe there’s some fantastic know-how, cloud-native corporations which have some actually nice progress prospects over the following 10 years. I discussed Snowflake for example. This may be a horrible and unlucky time to be promoting the perfect of those corporations. It is painful to have the worst of them as a result of it is exhausting to keep away from them for progress buyers. However I believe the actually high-quality progress tales are very well-positioned proper now for pleasing returns over the following decade.

What about inflation, Morgan? How nervous are you about inflation?

Morgan Housel: Zero.

Tom Gardner: Zero?

Morgan Housel: Let me put it this manner. Personally, zero. For the broader economic system, perhaps a 4 or 5 out of 10.

Tom Gardner: Are you nervous about deflation, long run?

Morgan Housel: Long run? No. Positively not long run, as a result of the Fed has all of the instruments to stop deflation, and it isn’t scared to make use of them. They pull out the bazookas, the howitzers, and so they print trillions of {dollars}. Deflation, I believe will nearly by no means be a threat throughout our lifetime supplied we do not have a whole nut working the Fed, placing that apart.

Inflation is de facto fascinating. For my part, I believe that was the largest financial story of 2022. It wasn’t the market, it was inflation, which is, after all, at of 40-year excessive once we completed the 12 months — 8% or 9% annual inflation, it was one thing like that. Inflation from an investing perspective is de facto fascinating. Everybody needs to reply the query: Hey, we have now inflation, how ought to I make investments? What ought to I put my cash in to take care of my buying energy?” It is a very widespread query proper now, an excellent query.

The solutions, I believe, are fairly counterintuitive. I will provide the punchline of how I believe, broadly, folks ought to put money into inflation. Properly, I ought to say this isn’t recommendation, as a result of everyone seems to be completely different. However this is what I believe tends to work in an inflationary setting.

Let’s separate short-term inflation, which is the inflation over the following 12 or 24 months, with long-term inflation, of how do you shield your capital for the following 10 or 20 years? The largest, the best antidote towards short-term inflation over the following 12 or 24 months is the precise reverse of what everybody thinks. What works within the brief time period is money. That is what works. Everybody thinks when there’s excessive inflation, you do not wish to personal money.

Your money in your financial savings account, your checking account, is dropping worth to inflation, so that you wish to eliminate that. You need actual belongings, actual gold, and whatnot. However at any time when inflation pops up and it is surprising, the whole lot will get demolished. Crypto will get demolished, bonds get demolished, shares get demolished, gold will get demolished — each single time. That is what occurred in 2022, occurred within the Nineteen Eighties, occurred within the Seventies. Quick time period, the whole lot will get worn out. The smallest decline, so to talk, comes from money. Take a look at 2022. We had 9% inflation, and perhaps your financial savings account yields 3%, so that you misplaced 6% to inflation in your money — adverse 6% actual return is what we name that. For those who look throughout all completely different belongings, dropping 6% in 2022 was nice. That is the perfect that you might’ve probably achieved — higher than crypto, higher than gold, not by slightly, however by an order of magnitude.

Money tends to be the way you protect your wealth in short-term inflation. Longer-term inflation, if we’re speaking about greater than a 12 months or two, there, the decision is fairly clear as properly, traditionally. There’s mainly two methods to guard your belongings from inflation over the long run. One is — let’s put shares and actual property into the identical bucket as a result of that is simply proudly owning fairness in actual belongings. What that tends to do is, in the long run, not solely sustain with inflation, however tends to exceed it. The long-term inflation price, traditionally, in america — over the long run, the final hundred years — on common, is 2.5% to three%. Shares after inflation have returned about 6.5%. So not solely are you sustaining it, you are exceeding it over the long run.

That features the Seventies, the Nineteen Eighties, contains the final 12 months, and so forth. Gold over the long run tends to maintain up with inflation, however nothing else. And within the brief time period, it’s a very poor inflation hedge. There’s loads of intervals, even 10- and 20-year intervals, when inflation was reasonable to excessive, and gold declined. That is what occurred from the mid-Nineteen Eighties via in regards to the early 2000s. So within the brief and even medium time period, gold tends to be a fairly poor inflation hedge. And even in the long run, it is an inflation hedge, however you are not going to exceed it, you are going to perhaps sustain with inflation. In order I view this for my very own cash and I believe it is a good fundamental framework. How do you shield your self from inflation? Money and shares.

The money half is so counterintuitive to folks, and it is nearly like heretical to say that, that you really want money to battle inflation. However within the brief time period, I believe that is the perfect you are going to do. It is not that you’re going to beat inflation, it is simply that it’ll decline the least relative to different belongings, notably one thing like gold or crypto that you simply suppose goes to be the perfect. And in the long run, it is simply shares. It is corporations that may increase their costs together with inflation. When airline ticket costs go up by 50%, Delta’s income simply went up by 50%. Which is able to finally switch to the nominal greenback quantity of their earnings over time, which is what drives inventory costs over time.

In order that’s how I take into consideration inflation, generally. I might say this. I’ve not modified something about my asset allocation or how I put money into years. When inflation was low in 2020 and when it was very excessive in 2022, I did not make a single change to my portfolio simply because, A) I simply do not suppose it is a very sensible strategy to be fidgeting with the knobs in your portfolio based mostly on what inflation was final month, however, B) it is that I settle for that there is going to be intervals of excessive inflation. My portfolio will not be at all times going to maintain up with it within the brief time period, however over the long term, I’ve sufficient money for the brief time period, and I’ve shares that I plan on proudly owning for the following 30, 40, 50 years that I am very assured won’t solely sustain with however exceed inflation throughout that interval.

Tom Gardner: I actually simply wished to suppose slightly bit about what corporations find yourself succeeding via intervals like this, however not simply intervals like this — simply succeeding.

So if we take a look at Starbucks and go all the way in which again to their IPO in 1992, you see there, the opening value or shut value of their early days, they’re someplace round 34 cents, there it’s, I believe one thing like 34 cents. So right here we’re, and it is $100 a share. We are able to look down right here because the IPO and see it is up about 300 occasions in worth, which is a really pleasing return to recover from a 30-year interval. Which is what it has been right here for Starbucks. So 300-bagger in 30 years.

Now, a few issues to consider. Throughout Starbucks has been steadily elevating costs. I do not know what a Starbucks venti latte price again within the early Nineties, however I can let you know it is quite a bit lower than it does now, and so they simply saved inching their costs up over time as a result of they’ve a model and a novel providing within the market, largely as a result of they’re such a well-recognized identify, and so they’re ubiquitous. The previous joke on Starbucks was that Starbucks was fascinated about opening up a Starbucks inside the boys’s room of current Starbucks areas.

Now another issues to recollect about Starbucks which is that its excessive earlier than the meltdown was one thing like $18.70 there you see in October 2006, and the low in 2006, two years later, was round $4.30. So a drop from $19 to $4 — that is about an 80% drop, 75% to 80% drop within the worth of Starbucks over these years. Keep in mind, it is a interval earlier than this, the place Howard Schultz — I believe it was a mutual resolution — however type of stepped other than Starbucks as a result of the sensation was that Howard had too many different pursuits. He wished to amass and create on-line communities. He wished to make motion pictures; Akeelah and the Bee. And {the marketplace} was saying persist with the espresso, it is a espresso enterprise. That was a part of the story.

There’s much more dynamics that I do know nothing about with Starbucks throughout that interval, however Howard’s gone, the inventory falls 80%. Howard comes again and builds the enterprise up. And I am really going to say a controversial firm and inventory proper now that I believe might undergo an analogous journey, and that’s Tesla. I believe that {the marketplace} is getting simply actually disenchanted within the founding father of Tesla. I would not say that uniformly throughout all folks, as a result of clearly, there are sturdy emotions about Tesla and about Elon Musk, and it is type of a lightning rod. These corporations like Starbucks, Apple, you may look again in historical past — all of them had their “lightning rod” intervals, the place everybody was speaking about them and everybody was saying, “That is horrible, that is going to fail.” And you realize what? Typically the final market was proper and so they did fail.

So I do not imply to say that, “Oh, it is a sample, it is apparent and it is automated.” However to me, Tesla has a novel providing, and so they have a founder/CEO, who’s displaying a number of curiosity in different issues. For me, really, I do not thoughts his curiosity in different enterprise. When it simply begins getting so in every single place, it is an excessive amount of, it is changing into a distraction, and I would not be stunned if some change in management got here or some assertion or clarification on what’s occurring there. It is a little little bit of a interval that I believe Tesla goes via the place there are a number of questions on management, and the inventory is down from $400 a share to $100 a share, so a 75% decline. Now that is really, sadly, not that distinctive on the market on the Nasdaq amongst a number of progress corporations, however for such a big firm, it’s a dramatic decline.

However I consider that Tesla, like Starbucks — there are only a few similarities between these two enterprise fashions, however highly effective client manufacturers with distinctive choices that I consider over the long-term have pricing energy — that when these corporations see their shares decline so dramatically … and it occurs to each nice progress firm. All of us want that we might personal, identify the good firm — Amazon, Apple, Microsoft, Tesla, Starbucks — we want we might personal them with out going via a 50% decline. However that is why Warren Buffett has mentioned if you cannot deal with a 50% decline within the worth of one among your investments, you shouldn’t put money into it, as a result of the possibilities are it’ll undergo that interval.

The exhausting factor is that every one of those corporations are going via that interval collectively. That’s the exhausting factor. The factor that is slightly bit simpler about is once they all undergo it collectively, you realize there are some environmental points which are affecting all of them — that there is not a number of discrete particular person analysis of corporations, and saying this one has fallen manner behind all the different companies on the market.

I do suppose the inflationary interval we’re going via, rising rates of interest, and the try and return to a 2% to three% price of inflation yearly is an enormous disruption within the market, hurts a number of growth-oriented corporations, corporations trying to reinvest of their enterprise. And that has damage the Nasdaq fairly a bit.

In order that a part of inflation I am unable to say is underrated, however I do agree with you that I believe in a long-term manner, I am way more involved in regards to the potential spilling over of the battle in Ukraine than I am about inflation.

Now, this stuff are all linked collectively, so to drag one out .. however I believe that that is a way more regarding problem than the problem of bringing inflation again in line.

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Morgan, we will shut with one piece of funding recommendation that you simply provide to the world, realizing that there are such a lot of completely different folks in so many various conditions that may hear this recommendation. And for some, it is going to be so spot on, and for others, it is going to be simply off the bull’s-eye. However what is the piece of recommendation that you could give that’s more likely to get near the bull’s-eye for as many individuals as potential?

Morgan Housel: I might say, if you happen to’re fascinated about investing and economics and the place issues may be going subsequent, spend much less of your time studying financial forecasts, and spend extra of your time studying historical past. That recommendation most likely applies to much more than economics. Spend extra time studying historical past and fewer time studying forecasts. I believe you will have a greater view and a greater grasp of the long run, sarcastically, if you happen to try this.

Tom Gardner: I really like that. For me, I will say Shelby Davis Sr. was an investor for, actually, the second half of his life. I believe he actually started investing in his early 40s, and I consider he died in his mid-80s. So he had a few 40-year interval. Now, he did have low-interest margin entry at his brokerage agency and he did use that. For these of you who already know the place I am going, I do not recommend that that is an achievable return by everybody. He was working the levers, however here’s a little bit about Shelby Davis Sr.’s journey.

He began investing in his 40s, he had $50,000. His philosophy was to at all times be shopping for corporations that you simply consider in for the long run. Clearly, to simply accept a few of these corporations went down all the way in which all the way down to zero. I consider he had an organization value a few million {dollars} in his portfolio that went to zero.

Began with $50,000. Couple of million. We’re speaking Nineteen Forties to Nineteen Eighties is the time interval, that 40-year time interval.

So beginning at $50,000, makes his manner ahead, and one among his ideas is, I am by no means going to promote. I will take the dividends. Some corporations are acquired, I will get money that manner. However I am not going to promote, and that is going to trigger me to work exhausting to try to determine what to purchase. I am just about not going to promote. One of the best time to speculate is correct now, and the perfect time to promote isn’t. That is Shelby Davis’ barbell ideas there to his funding type.

Within the Seventies, inflationary interval, for the inventory market, the Dow Jones Industrials fell 45%, 1973-74. Shelby Davis Sr.’s portfolio was down 75%. Market was down 45%, he was down 75%. All informed, from the primary funding he made within the Nineteen Forties to the tip of his life, he turned $50,000 into $900 million via the ability of compounding, via at all times investing. Now once more, utilized margin, low-interest margin. We actually do not try this at The Motley Idiot, and most of the people haven’t got entry to 1% margin prices.

I have never achieved the work, however if you happen to have been to take away all of using margin, and begin at $50,000, I will say he at the very least had $75 million. Let’s simply say that. Does anyone want greater than $75 million? The important thing for all of us, regardless of our state of affairs, is to stretch out our time horizon and to consider making a multi-generational wealth, the place your youngsters and their youngsters — even when they don’t seem to be fascinated about investing, they do not must be keen about it in case you are. Everyone knows that.

I’ve at all times beloved the Warren Buffett thought of succession and who ought to be the following CEO. I believe he mentioned one thing like, ought to John Elway’s son be the following quarterback of the Denver Broncos? I do not suppose that is a sensible strategy to do succession planning. However all of us can be taught to make use of index funds, save, put cash away, and let it compound over lengthy intervals of time, and permit for the actually troublesome years.

And I do not imply to reduce what’s occurred within the final 12 months. Definitely, my portfolios that I handle at The Motley Idiot and my private portfolio are down considerably. The IPO portfolio I handle is down 60%. Many of the portfolios I handle are someplace down 35% and 30% to 50%. Despite the fact that we’re deploying money and regardless that nonetheless taking a look at a few of these corporations are simply seeing them, it is a painful, painful factor to undergo.

However we began with Morgan asserting that it is not unprecedented. And I assume I will shut with my settlement that it is not unprecedented, as painful as it’s. If it is not unprecedented there have to be patterns, and there have to be data that we will discover to assist us make sensible selections and keep within the sport of investing for the remainder of our lives. Morgan, thanks a lot for spending this time with us, and sit up for extra of those conversations collectively in 2023.

Morgan Housel: Thanks, Tom. It has been enjoyable.

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Chris Hill: As at all times, folks on this system could have pursuits within the shares they speak about, and the Motley Idiot could have formal suggestions for or towards, so do not buy or promote shares based mostly solely on what you hear. I am Chris Hill. Thanks for listening. We’ll see you tomorrow.