A Decade Into IB: Teetering on the Edge of Cataclysm?
Not trolling, but I am speculating and generally interested in everyone's thoughts. I wrote my honors thesis on the European debt crisis, so I wasn't working at the time but I see a number of eerily similar hallmarks to the conditions that led up to the GFC... and now the real world implications are significantly more tangible to me personally.
The last 18 months have been borderline mania across asset classes, ranging from private M&A transactions and residential real estate, to the equity markets, crypto, NFTs and even high-end collectibles (sports and trading cards, art, watches, etc.) - all seeing increases often measured in multiples rather than merely percentage points. Much of the elevation of assets has been driven by loose monetary policy / expansion of the Fed balance sheet, coupled with immense leverage... all the while inflation is rising to effectively tax the poor and while global economies face relentless supply chain issues. So, less than ideal fundamentals.
At some point, the inflows into these bubbly asset categories will begin to slow / reverse, likely coinciding with the continued Fed tapering which will hit leverage levels and asset prices / valuation multiples... when this happens there could be a cascade of devaluations and selling of asset hedges to offset losses / cover risk exposure along with a deleveraging which will flow into the economy and cause things to slow a bit. Many long-term macro players have written extensively about this (suggest checking out Dalio's new book on Principles for Dealing with the Changing World Order).
I'm not sure what the catalyst will be, but I feel like there are too many potential "gotchas" out there to trigger the next not so statistically insignificant "black swan" event - ranging from Fed rate hikes, to Russia's invasion of Ukraine, China's invasion of Taiwan, cyber / economic warfare between the US and China, China pegging the Yuan to gold while simultaneously dumping treasuries, commercial real estate bubble popping in China, social unrest in the US / Europe, etc.
I focus a lot on managing low probability tail risk, because even if that risk is theoretically unlikely, it is the type of risk that is most likely to significant impact your life. Are we in the setup stages for this generation's defining economic event? Something just doesn't feel right...
We must always remember two things, the Fed has an implicit put on markets (Bernanke, Yellen, etc), and the second is STONKS ONLY GO UP. “Bulls make money, bears make money - pigs get slaughtered.”
I agree that we have had a powerful safety net, but I wonder if the continued support without a natural "reset" has unintended consequences such as an unabating faith to continuously YOLO, under the assumption the Fed will always be there to catch you... what if one day, they aren't?
What about Volcker and the high teens rates to combat inflation during his reign? I don't think it is totally out of the question that the Fed has to raise rates in the event the bottom 50% are in social uproar when their 2019 dollars are fighting tooth and nail to purchase 2022 goods / services. There are ramifications to having an overly supportive Fed, such as the potential loss of the global reserve currency when there is a rising rival power (China) that is more disciplined with the debasement of their currency.
*Always
As long as liquidity stays flush, the stonks will keep going up, even if there is "real" economic carnage - just look at the Venezuela stock market: https://www.ceicdata.com/en/indicator/venezuela/equity-market-index So if you're just looking at your PA, the question is really how long the fed will be accommodative and it's caught between fighting inflation and dicking over the market/employment rate or turning on the brrrr and risking runaway inflation. Maybe there is also a positive, in-between Goldilocks scenario too, IDK. I do think mass deleveraging likely results in the fed going brrrr as it did in spring 2020 but again who knows.
BTW not saying there won't be rolling bubbles in certain sectors (tech + anything loss making with long duration) as people rotate into value. The real question is: given these potential downside catalysts, where are you putting your money? (FWIW, gold/silver, real estate, and maybe oil + crypto off the top of my head).
Seriously though if you have good ideas, please post because I'm trying to rotate as described above lol
Great comments (+SB), and I wish I was smart enough to run the monte-carlo simulations for the various scenarios. A goldilocks outcome would be nice to keep the machine going, I just don't have a lot of faith in the system for that to occur... so going to start planning for the worst and hope for the best. Would be curious to see the increase of the Venezuelan market relative to their "fed" balance sheet - so what real returns were after accounting for debasement of the currency that results through printing. So, if you print 30% of total dollars over... say 18 months and assets go up by ~30%, you aren't actually richer - assets have just adjusted for the quantum of dollars.
On the where to put your money front, I'm thinking similar areas to what you referenced, but I think the key will be in asset CLASS diversification while also having liquid assets that are defensive to deploy if things take a tumble (including some cash, though it is trash). So, having equities with international exposure, but also having hard defensive assets such as gold, potentially coupled with other hard assets such as real estate / collectibles and having some crypto for further noncorrelation... maybe even some consumer nondiscretionary and metals / commodity indexes.
Having a healthy amount of fixed rate debt under solid assets should also pay off, as the debt owed will be inflated away through debasement while the underlying scarce asset appreciates at a rate of at least inflation - so you profit on the spread.
If your risk appetite is a bit higher, you can also "hedge" with either put options on levered indexes (e.g., SPXL / TQQQ - 3x S&P / 3x tech) - which use leverage and are disproportionately affected in downturns. Those can be tough on timing and risky given the premium you pay for options coupled with the theta decay. A middle ground approach to puts on the levered indexes could be just to buy the 3x bear inverse versions.
I'm just spitballing though... clearly not financial advice haha
The Venezuelan example is an 'upwards crash' due to inflation. The real returns, especially in USD, are terrible.
SB for TQQQ. Would SB twice for put.
Nice read
Thanks! It's fun thinking about this stuff.
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You seem like a very pensive and considerate person. Thx for the valuable insights (+SB).
If Inflation and interest rates rising are already pricing in, do we still need to have a correction? I thought only surprises would cause a bubble to pop if there is one.
I would agree with this, and I guess I was attempting to allude that there appear to by a myriad of potential "events" that could trigger a correction / Black Swan type of event... and the fact there are many potential events makes it seem like a Black Swan isn't necessarily always so much of a Black Swan (if you catch my drift).
We are in a secular bull market that will last longer than anyone thinks is possible. Whenever stocks continually make new highs for very long periods of time, you always have people coming out and calling tops because “it can’t possibly go any higher”, but secular bull markets have lasted for 20+ years before. As an analog, look to the 1980 - 2000 market (with the 87 crash being a blip), the gains are pretty remarkable. We were basically flat for 10 years from the late 90s to the GFC crash but a new secular bull started in 2009 (imo).
That doesn’t mean we go up in one straight, continuous vertical line. We will have corrections. But population demographics and many other factors point to a secular bull. It’s my personal opinion that this decade will pretty consistently trend higher and I’m putting my money where my mouth is by staying fully invested.
Appreciate you sharing your thoughts! +SB
In your view, was the COVID correction a "reset" for this current bull market? I suppose I was leaning more toward the reset being artificially supported by the FED so we never really had a true correction and deleveraging, and the current bull market is a continuation of the post GFC period.
Also, on the demographics point, I would be interested in your thoughts there. I've been doing some reading and it looks like the baby boomers are heading into retirement, and as you head into retirement, your spending is significantly reduced - believe it's the largest population ever heading into retirement. Population growth has been relatively low in the U.S., but I suppose there are demographic investment opportunities in China / SE Asia and India?
Yes, imo the COVID crash was this bull market's black swan reset which is quite comparable to the October '87 black swan crash. Both quick, violent, and memorable blips on the longer timeline.
The issue I have with trying to call tops or get overly cautious by trading in-and-out of long bull markets, and I've mentioned this on WSO before, is that by simply missing a handful of days over a period of 10 years can shift your investment returns CAGR from positive to negative. For example, missing just the 30 best trading days from the past 20 years, a total of 5000+ trading days, would take your annual compounded market returns from a +6% to actually losing money...that's missing 0.6% of all trading days (see below for further reading)..
https://www.fool.com/investing/2020/12/31/missing-just-a-few-of-the-bes…
https://www.cnbc.com/2021/03/24/this-chart-shows-why-investors-should-n…
I think that's going to require a pretty extraordinary increase in overall corporate profit margins (AND maybe not extraordinary but highly unusual top line growth). Look at the CAPE. Does that strike you as indicative of the beginning or middle of a bull market, or one that's nearing the end?
Are you able to tell the future? FYI bull markets don't end when corrections occur. The market can decline peak-to-trough 19.9% and still be a bull market. There can be plenty of late cycle pullbacks and valuation resets without a 20%+ decline.
I’m surprised how far I had to scroll down to see this correct take finally...on a damn finance forum of all places...
Is this Michael Burry’s throwaway account?
Don't even get me started on treasury yields...
I'm guessing I'm similar age to you OP (perhaps a bit younger) so I wasn't an active participant during the GFC. However, especially on the real estate side this feels pretty different given most of the buyers are strong credits that are just flush with cash (as opposed to weak credits that could get access to unsustainable leverage).
I've followed the 'Buffet indicator' (see here: https://www.currentmarketvaluation.com/models/buffett-indicator.php) which basically measures total market value vs. GDP and seems to paint a pretty interesting/accurate picture of when the market is 'overvalued'. Based on this the market is quite overvalued. By another metric, on a fwd P/E basis, the S&P trades at ~22x vs. ~19x right before the pandemic (~15% difference). Could we see a correction of that magnitude over time? Maybe
We're in a different era though (compared to past corrections) where rates are essentially 0% and that link has a good discussion on this which arguably could invalidate comparisons with the buffet indicator. I think the biggest threat (to a correction in asset values, not a recession necessarily) is inflation/interest rate rises. The market has had visceral reactions to small movements in rates (especially for negative earning companies) so if inflation data continually comes out high it could cause a panic and rush to safety for defensive/value assets.
That said, if you read a bunch of the global macro research for 2022 there is very little recession talk. I think there are some real positive catalysts that could supercharge growth (supply chain debottlenecking, endemic COVID, etc.) and we may see fwd multiples come down but earnings growth more than makeup the difference as multiples return to normalized levels.
I'm personally bullish on this happening and an investor in strong blue chip stocks with good earnings/defensibility. I don't think we'll see 2021 level growth in the S&P but I do think this will be another strong year for US stocks in general. We'll see!
Long Value / short Growth for 2022. Thats the trade - DM for your wiring instructions for my 2/20. Thx!
Thanks very much for sharing your thoughts. The Buffet indicator is indeed interesting.
There was also some research performed recently on the market response to a given dollar inflow / outflow. From my understanding, the key takeaway is that because of ETFs and mutual funds, each $1 change in a specific stock leads to a $5 change in the market. It's interesting to think about what scenarios could unfold if we saw a 20% decline... and how that sensitivity changes with percentage of total market cap inflows / outflows - essentially duration and convexity for the equity market as a whole.
M&A dealflow to private equity will roughly stay the same?
I don't think so this year. My thought is that the year will be strong but not as crazy as 2021.
2021 saw a lot of pull forward M&A given the tax change threat that never happened, as well as catch-up from the deals that went on hold in the early quarters of COVID.
I'm not an expert by any means but I feel like debt levels are nowhere near the levels seen in previous bubbles. Consumer, Corporate and Municipal debt levels are relatively modest compared to historicals. National debt is something I don't understand well but negative real yield means that debt is easily serviceable.
It seems like most market participants are aware that valuations are stretched and are being very careful about where they allocate their capital. Software multiples have actually compressed over the past year. The rise in crypto/NFTs and collectibles is explainable in part by the increase in interest from retail investors, many of whom are flush with cash from government stimulus + hot labor market.
You make a really interesting point about catalysts though. Lots of possibilities on the horizon that could really shake things up.
National debt worries me quite a bit... at some point, don't foreign investors get hesitant to continue buying our bonds? One bad treasury auction could be another catalyst.
Agreed that consumer debt and perhaps public corporate debt is down, but I'm regularly seeing pretty staggering leverage levels of 6-7x EBITDA in the private M&A markets, and when I was an analyst a really solid credit was in the 4.5-5x range.
Additionally, margin debt has increased pretty substantially... I found this interesting: https://www.finra.org/investors/learn-to-invest/advanced-investing/marg…;
Does it not scare anyone that we have no idea how much leverage is in crypto?
Imagine not knowing how much debt Lehman was in… Lehman was $60 billion in market cap and crypto has market cap over $2T
Waiting for someone to come explain to me why the blockchain can solve greed. “It’s a technology of decentralized debt collateralization, which can make sure everyone is fucked over and not just you”
It absolutely does... what happens when an event triggers volatility to 2-3x while prices fall and folks start panic selling out of crypto and other assets and those that used leverage are in the red?
100% agree with this too. Do know a friend who became a paper millionaire though by buying Bitcoin super early and selling a good chunk of his stake for a 7 figure sum. Still think he has 7 figures worth in crypto. Straight up quit his job a bit before the pandemic and essentially lives a retired/passive investing lifestyle since.
Wish I would have caught the Doge wave and sold at the peak haha
I think the vast majority of crypto is retail (about 8% of all bitcoin - not sure about the other currencies). Not exactly systemic risk. Institutions are piling in though.
Do you in your heart of hearts believe that the majority of $2T market cap is retail?
Reposting what I said to you in your initial comment in the "Hedging a Recession" thread:
You really think the Fed is going to go Volcker style or even half of that? I doubt it. It'll be the same as 2018, when they reversed course after getting up to 2.5%. Maybe they get rates up to 1% before the markets start tanking, and then they will reverse course and ease again. We as a country have way too much debt for them to significantly raise rates. The government would default on its debt, the housing market and stock market would crash, and the economy would go into a depression. All it took was going to 5% in 2008 to set off the financial crisis. With reported CPI inflation of 6.8% and real inflation probably closer to 14-15%, there's no way they'll be able to get high enough to have positive real interest rates. Above all else, the Fed will always swoon in to protect the markets. They don't call it the Fed put for no reason. JPow is dovish asf. I do agree with your general sentiment though. Keep most of your money invested, but accumulate some dry powder as there should be a good correction to DCA into as they raise rates. 1% will not do anything to stop real inflation, but it certainly can drop the market.
The below is not financial advice, and I am not responsible if you lose all your money lol:
As for stock picks, I am pretty bullish on oil, so I'm in some small cap oil stocks that will probably generate the best returns in an oil bull market. Also in some uranium stocks as well that have done really well over the last year. Have one to two low cost ETFs for companies with good dividends and value. And then like a 10-20% total exposure among TQQQ and SOXL to play some risk with the 3x leverage. Will probably increase the size here when there's a market crash
Thanks for sharing your comments here (+SB).
I think the Fed is in a a bit of a quagmire, candidly. On one hand, if they don't raise rates and inflation continues to run hot, the bottom 50% of earners will slide even further down the inequality spectrum and will, in simple terms, raise hell (social unrest, UBI, etc.). On the other hand, if the Fed raises rates to combat inflation, we likely see a fairly substantial hit to the equity markets. From my perspective, it's a bit of a damned if you do / damned if you don't type of scenario. A third option could be keeping rates low and continuing to fuel the bubble while inflation runs and you offset inflation to those lower in socioeconomic status through a UBI construct... under which that is further printing and could lead to a dangerous self-perpetuating inflation spiral and further bubble fueling (a la Weimar Republic). That continued debasement can then lead to loss of global reserve currency status in lieu of something like the Yuan (recall the English, German and Dutch empires when they lost this global reserve currency status). Obviously this is just a bit of a thought experiment, but it's tough for me personally to see how we smoothly transition out of our current predicament.
I agree with the general strategy of staying invested though, because if not you are losing substantially to currency debasement. Love the idea of some leveraged ETF exposure, particularly off the bottom - which I also referenced above :)
I think your analysis is spot on, and I'm in 100% agreement with you. There's no good choice for the Fed. Either they play bad cop and curb inflation by jacking rates which results in an government debt crisis, stock market crash, and general economic implosion similar to the financial crisis. Or, they play good cop (or is this also bad cop lol) and keep the bubbles inflated while letting inflation run rampant. I personally think the Fed will pick the latter every single time.
The board of governors just care about getting reelected and pushing the problems to the next Fed chairman. I do believe that because of the Fed's decision to surrender to inflation, we will lose reserve currency status. At the latest, I see the US losing it by 2030. Reserve currency privileges aren't permanent. Countries lose them all the time, as you note. The longest tenure by a country has been 110 years (Spain). Most have been between 80 and 100 years. The last one to hold it was Britain from 1815-1920, a total of 105 years. We've held it for 102 years now. Losing it by 2025 would not be surprising to me.
The graph in this article shows the history of reserve currency status: https://www.pragcap.com/how-much-longer-will-the-dollar-remain-the-rese…
I don't think it's any surprise that it always shifted hands when the reserve currency was a fiat currency. Every fiat currency in existence has failed. The government abuses the privilege and prints too much until nobody wants that currency anymore. That's why we need real/commodity money. It is great to see people like you though who seem to have a good grasp of economics and the actual consequences of particular actions. Most of the economics taught in university is straight bs. Keep up the good work
How do you manage low probability tail risk? Like the general theory and application of it and not this specific potential instance. Any book recommendations?
I personally have not read any books on managing tail risk. This is just something I spend a lot of time thinking about... given potential implications. Candidly, it's a bit illogical in the purely mathematical sense, but that's where my trusty noggin' likes to perseverate.
Edit: list of books below for reference
Wanted to drop the books I've read over the last few years in case anyone is interested - great dialogue among a group of inquisitive minds!
This is an interesting thread, but I disagree with many of the fundamental premises of the OP and several posters. I've been getting slammed at work recently but will respond when I have some more time this weekend.
Excellent! Looking forward to reading your thoughts when you have time.
I agree that there are many factors which superficially look similar to other pre-crash periods in market history (e.g. the GFC in 07-08 or Euro sovereign debt crisis in 11-12). However, there are a few fundamental differences that I feel should be pointed out so that explain how these parallels are truly superficial rather than fundamental.
Both of these crises were not simply the cause of “excess speculation,” they were permanent breakdowns in the functioning of the interbank funding markets and the global monetary system. What 2011-12 showed was that 07-08 was not simply a one-off event resulting from the overleveraged US homeowner, but that the entire monetary system was dysfunctional. Banks relied on the use of various short-term liabilities (interbank loans, commercial paper, repo, etc.) to fund larger balance sheets because funding was cheap and arbitrage opportunities were plenty.
This is a much longer and more nuanced topic (I’ve written more about in on WSO if you’re really interested), but this wasn’t just a problem of 1990 – 2007. It was a problem with how the monetary and banking system evolved after WWII stretching back to the mid-1950s and the development of the first international wholesale funding markets.
Basically, the problem is that this source of funding is inherently unstable – there is no backstop. The Federal Reserve can only credit banks (not dealers) with bank reserves. The problem is that bank reserves aren’t actually that useful, especially if you’re facing a lack of funding (i.e. bank liabilities). Bank reserves are used for final settlement for select transactions between commercial banks and various other financial institutions (the Fed, the US Treasury, GSEs, FHLBs, etc) – nobody else can use them. So, when the Fed conducts QE, they’re removing high-quality collateral (US Treasuries) which have their own collateral multiplier and lubricate the financial plumbing, and replacing it with bank reserves, which have very limited use. What they’re doing is less akin to “money printing” and more akin to changing the composition of money and money-like assets (replacing a more useful form of money with a less useful one).
Of course, because most people in financial markets don’t actually understand how QE works and what it actually does, people react by buying risk-assets because they’re conditioned to not “fight the Fed.”
All this being said, the banking system is practically ossified now compared to a decade ago – look at how the size of bank balance sheets, OTC derivative books, repo funding, FICC personnel, etc. have all fallen off a cliff since that time. Speculative behavior driven by psychological motivations is not the same as a vulnerability in the banking system and is far less dangerous.
That being said, the economy is in a pretty rough spot. We’ve been in something like a silent depression for the past decade or so, with growth rates significantly below 100-year averages since we no longer have a functional banking system. I’m of the camp that expects inflation levels to fall significantly over the course of this year but acknowledge that supply chain issues have hurt the US economy from both a growth and inflation point of view. Unfortunately, the Fed tapering asset purchases and hiking interest rates won’t be able to relieve the semiconductor shortage or open China’s ports.
Crypto and NFTs taking off might seem like a speculative bubble, but I’m of the camp that actually sees significant potential in this space and think they might be one of the most important inventions of the last century, if not longer. Remember how everyone thought Facebook, Apple, Amazon, and Google were grossly overvalued and in a bubble in 2014? Decentralized finance has seen an adoption rate faster than the internet and it’s still going. Almost every trader/investor that I respect has at least dipped their toes into crypto during the last 6-12 months. You’d be surprised at how many PMs at large platforms are heavily invested and/or pivoting their business model to this stuff. Our fund is opening up an entire business line dedicated strictly to crypto strategies, and we’ve seen incredible demand from clients. 2022 might be the year of institutional adoption and prices are reflecting that.
Obviously, there’s always going to be pockets of speculation – I’m not justifying a reality TV star selling NFTs of her fart jars, but the crypto space is a black hole of talent sucking in the smartest people from the IB/VC/HF and big tech world. Don’t have time to get too deep in the weeds here, but I think that crypto, and DeFi in particular, can essentially fix our broken monetary system. One of blockchain technology’s primary benefits is its total transparency, especially when compared with the traditional financial system with all the mess surrounding collateral rehypothecation obscuring ownership rights. The Bank for International settlements, the primary international banking regulator, doesn’t even know how to count the sum-total of all cross-border banking claims/liabilities, debt securities, and OTC derivatives because it’s all off-balance sheet and global dollar funding markets are so damn opaque. The idea that “we don’t know how much leverage is in crypto,” as an admonishment of the sector, is the view of someone who doesn’t know what they’re talking about.
Geopolitical risk is certainly the highest that it’s been in many years. The authoritarian bent of many governments have shocked citizens who thought they lived in liberal democracies. Russia is holding Europe hostage over natural gas, citizens are rebelling against totalitarian governments, and China and the US are locked in some type of new Cold War.
I respect Dalio’s works on macroeconomics, but his recent book is trash and blatant shilling at the behest of the CCP. I’m intimately familiar with China and the Chinese economy and many things that he says are demonstrably false and he knows it. What kind of “strict parent” “disappears” their own children after they claim to have been raped?
There are many reasons why the US dollar is dominant and why the Renminbi will not become the global reserve currency in our lifetime – the institutional dominance of the US dollar in international trade, OTC FX transactions (forwards and swaps), international debt securities (Eurobonds), cross-border bank claims/liabilities, etc. DeFi threatens this, but not in the way that most think – I actually expect that the US dollar will likely remain the global unit of account, but the existing payment rails and financial plumbing will almost certainly be replaced (i.e., the medium of exchange function).
China can’t dump Treasuries without blowing up their entire economy – they don’t even denominate their own trade in RMB (70-80% of their trade is US dollar denominated) and the idea that they could peg the Yuan to gold is laughable at best. Luke Gromen, if that’s who you’re getting this view from, is an unsophisticated charlatan who doesn’t understand the full complexities and nuances of the global financial system.
Great post. It's intriguing to see so many mentions of DeFi, but so few of Bitcoin. It therefore seems like you are quite dismissive of Bitcoin. If this is true, why?
Thanks for this - great read! Appreciate the thoughtfulness and detail of your point of view - fascinating to say the least.
great post, now I'm curious
how're you invested personally?
couple things here, you may be experiencing some cognitive bias due to your experience writing about a debt crisis, many factors are different today particularly when you look at the quality of bank capital, consumer balance sheets and debt ratios, and so on. now, this does not mean we're immune from some tail risk, it just means that the next crisis will most certainly look different from the GFC.
now the idea about mania in various speculative parts of the market leading to contagion risk in the other markets, no argument there, if there's ass-covering you could see a tech bubble unwind type environment where the most speculative stuff falls first, then the next highest quality, and so on until it snowballs in a 2002 like environment where no one is spared but the carnage in the quality/value world is far less, even if still double digit declines
in the tech bubble unwind, 2000-9/11 wasn't as bad as covid, just was drawn out, and then it cascaded downward in 2002 before finally settling towards year end if my memory serves me right. people will say all sorts of things about what caused this or that movement, but the point is there was a massive devaluation of the broader markets, multiples crashed, there was forced selling, and then geopolitical events like 9/11 certainly didn't help matters. now, while I was still in school, I've studied that period deeply and my business partners happened to have navigated it quite well.
the question you're not asking explicitly I believe is the following - given all of the factors today, there is some tail risk that's not being properly discounted, so what ought investors do to protect themselves and their portfolios, under the assumption that the losses at the index level could be 40-60%.
in terms of tail risk hedging, read some of mark spitznagel's stuff, including his most recent book safe haven. essentially what he posits is that tail risk insurance shouldn't detract from performance like bonds do and should be cheap. while he never divulges his strategy, many people suppose his portfolio is something like 95% SPY futures and 5% deep OTM puts, so that when black swans like covid come, the 5% performance drag is more than eaten up (and deep OTM puts are cheaper than other forms of hedging when things are on fire), he proved this with his covid performance, have seen reports that he did 3,600% in Q1 2020. so, if you have $100mm you could just invest it with universa and consider your tail risks protected, but if you're like the other 99.99% of the population, what should you do?
now, I disagree with spitznagel's greediness for returns, I just focus on the CAGR I need to meet my personal and my clients' financial goals, so while that's in the teens %-wise for an all equity portfolio, and I'll never be ed thorp, jim simons, or spitz making 20%+ CAGR, I'm ok with that because I only assume 4-6% CAGR over time. here's how I think about it. black swans are inevitable, and we've already discovered that unless you want to run a put option portfolio in addition to your core strategy, it's unattainable, not scalable (to an entire clientele if you're like me), and blood pressure increasing for the vast majority of individuals, so not practical in my opinion. now, is a black swan really all that bad? think about that, let's say you bought SPY in March 2000, you'd pay about $97 for that, today it's at $467, or a 7.4% return without dividends reinvested (would likely be in the 8-10% range with div) over 22y. so were the 2 black swans the end of your financial success? not if you held, and DEFINITELY not if you bought more or reinvested dividends.
which brings me to my next point, survival. I do not hedge, I do not use margin, I do not buy leveraged investments (apart from some of the companies I own having small amounts of debt on their balance sheet, but not like firsthand leverage where I'm buying $200 of stock with $100), and I have a long time horizon, so there's no forced selling for me. what downside does a black swan have for me over the long term? assuming survival, I really don't think it poses a threat to my long term goal of eventual financial independence. so how does one focus on survival? avoid the things which bankrupt people - leverage/margin, concentrated bets (lack of diversification), buying junk companies that never recover, avoiding extremely highly valued stocks that may survive but never get back to prior levels (see CSCO 2000-today and MSFT through 2015), and keep some cash on the side to pick up bargains (in my case this is relatively minimal as I'm still earning a good income so by definition I can buy into markets every month). these tactics have never caused an investor to go bankrupt, only miss out on a lipper award, but in my observation (having seen wealth get created firsthand), it's almost always the tortoise who has the last laugh, not the hare.
so I ask you this, do you want to hedge against the possibility of a black swan event because a HSD % CAGR is unacceptable to you? do you want to hedge because you fear you do not have the patience to ride out declines? do you want to hedge because you have FOMO and you want to try to get the timing right on getting out of the market so you can get back in when things get really cheap? let's unpack each of those because while none of them are literally incorrect and most are understandable, I think a broader view is helpful
CAGR jealousy - I've got news for you, if your financial wellbeing depends upon you getting >10% a year instead of 6% a year, it's not the market that has a problem, it's you. adjust your expectations, and plan for stagflation in terms of return assumptions. arrange your life in such a way that if you get inflation +2-3% for the rest of your life, you'll be OK. you have no control over what returns the market gives you, and unless you're quite literally the next spitz, simons, thorp, etc., you won't ever get there.
patience to ride out declines - not using margin can help with this as you won't be forced into any selling, but also you can hold cash on the sides for emergencies as well as opportunistic buying. sure a portfolio that's 70% stock and 30% cash isn't optimal but if it helps you from hitting the sell button, you should do it, so maybe just carry a bit more cash?
FOMO/market timing - good fucking luck bro. even Buffett has mistimed things. he backed up the truck in Q4 2008 only to watch markets fall yet another 30%. being early is indistinguishable from being wrong, but I'd rather be early and then get proven right eventually than never have the chutzpah to ever get back in. plenty of prognosticators that are intellectually brilliant like hussman, gary shilling, etc., were calling for things to get worse all through the 2009 bounceback, and you know what their predictions have gotten them? career killing returns but a following among doomsayers. fuck that.
so what's someone to do when everything looks expensive, there's any number of geopolitical events that could throw shit off the rails, and the economy is due for a slowdown (I mean, we are already at full employment and starting down the barrel of the highest inflation in a generation)? rather than pontificate anymore, I'll just tell you what I do (like Taleb says, don't tell me what you think, tell me what's in your portfolio).
I invest in the same basket of 30-40 high quality large cap names that I do for my clients, this makes up about 50-70% of my allocation of my stock portfolio. the remaining chunk is held with managers of mid cap, small cap, international, and emerging markets as that's not my day to day. the focus is on survival, and as I've said before, I have a GARP/div growth/value bias. my stocks look more like the Dow than the S&P, to give you an idea (bc of FINRA, I won't divulge specific names). I also don't rely on a high return assumption for my own long term goals, and you shouldn't either. I look at it like this - if I get good returns like what's happened the past 10y, great, but I can't count on that, so either I'll be right on the money, I'll be pleasantly surprised, or the world will come to an end in which case your stock portfolio won't matter and we'll all be beholden to the doomsday preppers.
and since I didn't really go deep on this other than an allusion to the tech bubble, I don't really worry about NFT/crypto/speculative contagion throwing me off course financially. if we get that, I'll view it as a buying opportunity, but since I don't own it and market corrections can come from anywhere, it doesn't keep me up at night
happy to discuss any of the above if someone wants
This is a load of crap frankly. You must have chill and enjoyable job. Most people here want to be free before they are gray in the head and it won’t come from doing the above unfortunately. Get serious the world has changed.
let's dissect this, you think my points are a load of crap because
I have a chill and enjoyable job - yes I do, but what does this have to do with the math behind investment returns and survivability of black swan events
most people want to be free before they're grey in the head - fair, then I'd suggest looking at the FIRE movement, most of those folks rely on similarly precarious investment return assumptions, aggressive savings %, and forgoing of experiences to get, so where is that wrong? because my experience with returns doesn't match with someone hating their job and wanting to break free? that sounds like a problem with the job one has, not with investment returns, so I'm not sure how this means I'm incorrect
get serious the world has changed - I don't know what you mean by this, so if you could elaborate we could have a better discussion
if your entire plan to break free of a shit job depends upon getting 20%+ CAGR, I wish you well and I hope you get there, I just think this is far too risky of a strategy as it has a binary payoff - either you make it big or you go completely bust and need to stay in said shit job for longer just to recoup losses
Thanks so much for the insightful and well-constructed thoughts - all terrific points and mathematically supported. I'll also check out some of the readings.Perhaps I get too caught up in thinking about how to capitalize on market volatility. Over the long run, it will all work out well by diversifying and selecting strong companies.Thanks again. +SB
happy to help, and I'm glad you feel it helped. often times perspective via history or pulling a thread down to tactical action is what psyches me out of a bearish tailspin, so if you ever go here again, just keep asking "so what?" until you get to an action. it can be what I suggest here (buy and hold) or it can be SELL EVERYTHING, hard to say, but if you stay in the hypothetical, you'll stay frustrated
I'm not going to lie....when I initially opened this post, I scrolled and scrolled hoping to find your take. Always appreciate the insight!
I'm flattered bro, nice to see you around the forums again!
One of the bigger risks is demographics.
1. Aging populations typically struggle to produce genuine GDP growth to outpace inflation. Most governments will attempt to (i) lower interest rates to promote commerce, and (ii) increase immigration. Given we are at low interest rates (and negative rates get confusing quickly), immigration will likely become a bigger talking point. Unfortunately, this often leads to social / civil unrest (eg. Us vs. Them attitudes). I wouldn't be surprised to see armed conflicts (national or international) within the next 10 years. But, with advances in technology, its tough to say what a 21st century war looks like.
2. What happens when baby boomers retire and see their nest eggs eaten away by inflation?
Love this - some points in here that remind me of Raoul Pal.
Disclaimer I dislike energy firms. I am invested in technology.
When I saw on this forum that people essentially were creating their own 2021 crypto/tqqq/bonds all weather funds/strategies I was in shock how basically no one here has grown up in anything but a bull market. Next the fact everyone says “labour market” is red hot and jump jobs asap if anything goes wrong, lateral today is just wild to any of us who graduated before 2012.
Difference between 2022 and the previous “fed fake outs” is that this inflation is going to be real this time. This is one time the boomers/the_safe cagr dudes should be listened to. Not to follow their strategy but to understand the vast majority of large money managers who have basically been long TQQQ (tiger/d1/rtc) are going to run for the hills this year to cover their own arse. Does this mean the retail investor cant blame them out and continue this bull market in 2023 no, but it sure as heck is going cause people a whole lot of pain.
Why is the inflation real? We have a real energy crisis, a real labour crisis, a real wfh awakening, so on. Its real not due part cuz of “world is going to shit”, its real in terms of the young folks on here who yell at us boomers about their NFT wiz retired friend. The generational change is going to bring inflation. Someone calling out crypto leverage is silly in my mind, tons of that market cap is backed by people trying to fuel new innovations into this world, cause the government/1% have not done it for this generation of kids. The leverage countries have on their fed balance sheets is way worse than anything these poor kids who want clean air/higher wages/a home with a yard have.
So I guess my bottomline is, 2022 is a macro hedge fund volatility game show year coming up. Just like the past 5 years they sat out as TQQQ soared does not mean you need to chase energy/sell tech, or buy the dips this year. You can be cautious by just understanding this is a very tough year for the index as a whole to go up, and sure you can buy puts here or there but understand you are now “trading” not “investing”. So just prepare to take some pain this year if you fully invested but beleive in the theory long-run we will back, but just know the big guys helping you to push things to a new level may not be there with you this year. Or you can wait for small pullbacks, or heck wait for rates to go high enuff to actually make one care about owning some bonds again. Lastly, covid while painful was a “deflationary event” this coming is real inflationary.
PS, everyone who says “cash is trash”. Is a boomer or global macro guy. If someone knows a young a PM who says I would love to see it. Cause cash was trash before the covid drop too right.
Interesting thoughts. Why does inflation have to be antithetical to a bull market in technology stocks though?
Some stats:
In 1980, 1981 and 1982 the average annual CPI increase was 13.5%, 10.3%, and 6.1% respectively. The average 10 year yields were 11.4%, 13.9%, and 13%. Throughout the 80s the average annual increase in CPI was 5.5%. There was a short bear market from 81-82, but the Nasdaq and S&P returned 207% and 234% that decade.
I don't think anyone who's serious thinks we're going back to 13% CPI increases and 15% on the 10 year, and it sure looks like the stock market doesn't think so either which is why we're spitting distance from all time highs on the indexes despite continued inflationary pressures.
Of course, there's going to be some continued repositioning this year from technology into more defensive/inflationary sectors like energy, utilities, REITs, etc., but I would be surprised to see a bloodbath in the Nasdaq 100.
On a longer macroeconomic timeline (i.e. zooming out beyond 2021 and looking back into history), I think we are in a deflationary spiral due to technology and the efficiencies of the modern world, and I can't think of a single thing that would alter this trend, outside of the absolute drainage of raw materials/commodities from this earth, like oil or other finite resources (water). I also think the longer term deflationary pressures are part of the reason the FED has been so accommodative for so long, with 0% FED funds rate and other accommodative policies -- it's just really hard to get sustained 2%+ CPI caused by real economic growth without letting the economy run hot due to a 0% fed funds rate.
Generally, growth stocks with earnings far in the future become less valuable with high inflation. Inflation makes dollars in the future less valuable. This also supposes that interest rates rise as the inflation premiums increase, resulting in a higher discount rate and lower stock price. However, if the Fed refuses to fight inflation like it is right now, then it's bullish for all stocks. By artificially suppressing interest rates, the Fed makes the high growth tech stocks look far more valuable since the discount rate is lower. There are a few explanations for the period you noted in the 1980s.
The main one being that after we went off the gold standard, the dollar depreciated significantly. The dollar was originally defined as approximately 1/20 oz of gold (exact conversion is 1/20.67 since $20.67 equaled one oz of gold). We later devalued the dollar such that $35 was equivalent to an oz of gold. In 1980, which by then we were off the gold standard for almost 10 years, gold reached a high of $850 dollars. That's almost a 24-25 times fold reduction in the value of the dollar. Oil went from $3 to $40 a barrel. So instead of the NASDAQ becoming more valuable, the dollar was just becoming less valuable, so everything priced in dollars went up. Priced in real money like gold, stocks actually fell in the 1980s.
A more extreme example is the Venezuela stock market. Venezuela had an upward crash. It's currency depreciated so much that even though stocks still rose, the cost of basic needs like food and housing rose much more. There was a decline initially as you note when interest rates were jacked by Volcker up to 20%. However, as they were eased lower towards the mid 1980s to relatively easy levels of 6-7% (easy for the US then but would be tight now sadly) the bull run was reignited until the 1987 crash. There is also a lag effect. Once the inflation takes place, jacking up interest rates won't immediately stop all inflation. In fact, while Volcker was able to bring down inflation, we never actually had any deflation. Prices were still rising, just not as rapidly. The increase in nominal earnings got priced into these tech stocks, which still supported their increase in price.
I also disagree with your premise that this decade will be a period of deflation. I expect this decade to be even worse than the 1970s. The CPI readings you used for the 1980s are far more honest and accurate with their methodology than the CPI used today. The Boskin commission rigged the CPI in the 1990s to understate inflation (can go into more detail why today's CPI is unreliable if you like). It is not an apples to apples comparison to use today's CPI and look at it against CPI in the 1980s. Despite the CPI stating we have only 6.8% inflation y/y, using real rents instead of the fake owners equivalent rent method brings that up to 11.1% y/y. After also considering the hedonic quality adjustment and substitution effects that were introduced in the CPI, the real inflation rate for this past year is more accurately somewhere between 13-15%. That means this past year is already worse than any year in the 1970s or 1980s in terms of inflation. Volcker was able to bring down inflation rates of 10-12% by getting interest rates ahead of the curve and going to 20%.
Could you imagine what would happen if the Fed got us to 2% interest rates, let alone 20? We saw what happened in 2018. The economy started tanking and stock market went into bear market, especially the NASDAQ. That was with only 2.5% interest rates. We have far more debt than we did in 2018. Remember 5% rates is all it took to set off the financial crisis in 2008. I'm not even sure the stock market could tolerate 1% interest rates without a significant correction. The Fed will choose to continue propping up the bubbles instead of fighting inflation. 1-2% rates may prick stocks, but it will not stop real inflation in the economy which is running somewhere in the mid to high double digits. The Fed needs to get to double digit interest rates to even have a chance of fighting actual inflation. But it won't. Because then the government would have to default on its debt and cut spending, the housing and stock market would implode, and the economy would go into a depression.
Your idea of technology bringing deflationary pressures won't do anything to stop the running inflation train that is currently chugging along. I do agree that 10 year treasuries probably won't get up to 10+% in the near term. That's only because the Fed has essentially enacted yield curve control and suppressed rates artificially low. It can't work that way forever though. Eventually, investors will dump treasuries like hot potatoes and there's nothing the Fed will be able to do to suppress rates. I mean it probably will still print, but at that point we have a dollar crisis.
I'm also not a fan of this terminology of "running hot" when describing the economy. It's a term that Keynesians like to use. The economy isn't like an engine that can't be turned on or off. Real growth does not require inflation. Inflation is not a necessary evil to grow the economy. That's just a myth economics professors tell students in college. In fact, real growth should reduce prices. An economy that is growing produces a significant supply of goods and services, thereby reducing prices. That's how standards of living rise. The industrial revolution brought us a significant reduction in prices, and it vastly improved our lives. How do the Keynesians explain their boogeyman of "deflation" there? What we have right now is a bubble economy. The emphasis is on consuming and not producing. We worry about spending instead of saving, even if that means taking on a shit load of debt at low interest rates.
What's wrong with energy? Oil is definitely heading over a $100 a barrel, which means big gains in oil stocks. People don't have to pick one or the other. I have energy and tech. Inflation was always real. The government just wasn't reporting it accurately with the CPI ever since the changes it made in the 1990s. Plus, a lot of the inflation has stopped prices from falling, which would've improved our standard of living.
While COVID was initially deflationary for the market, it was an inflationary event for the economy. We shut down our factories and reduced supply. At the same time, we kept demand the same or even increased it by printing money and giving it to people to spend through stimulus checks. That is literally the worst thing to do and leads to the inflation fire we're seeing right now.
Prices fell 25% in the Great Depression. Yet, after the financial crisis, we never saw any deflation in the government's rigged CPI. Commodity prices tanked for sure, but the average price level was still up. The Fed will do nothing to fight the inflation because it can't feasibly do so without wrecking the economy, stock market, housing market. It would also bankrupt the US government and cause a debt crisis if it raised rates to the necessary levels.
They will get to 1% interest rates max before the air starts coming out of the stock market bubble, and the economy grinds to a halt. The Fed will then reverse and begin easing to support the markets again, just like it did in 2018-2019. Just buy the dip and DCA and shit will go back up again.
Also, when people say "cash is trash", they mean not being invested in anything and holding 100% cash. That's entirely different from always being 100% invested in the market at all times without any extra funds. It's okay to accumulate some dry powder to prepare for dips and corrections. You're better off being mostly invested and then DCA with cash you have sitting on the sidelines when shit hits the fan than just sitting around with more than 50% cash while it loses value to double digit inflation.
Overall, I agree with most of your points though and believe this decade will be far worse than the 1970s for inflation.
I agree with everything you said just wanted to be optimistic for a bit longer, a slow demand led energy crisis is one thing. A supply shock pushing to a recession is a lot harder. You were correct we got the latter.
You think China would actually invade Taiwan? I recently had the opportunity to speak to a former ambassador about Ukraine and he seemed a little spooked, so I think that's definitely possible. It's an interesting topic. I think China has a much more to lose but also much more to gain (TSMC) with an invasion than Russia does.
I think Putin may feel like he's backed into a corner. He clearly doesn't want a one of his last buffer zones with the West to 'fall' to NATO. I think he views that as a threat to their security.
I also wonder if NATO would invade Kaliningrad considering it's Russia's only port that's in a good strategic location. It's surrounded by two EU member nations, Poland and Lithuania; I dunno, maybe just some airstrikes? The idea of a major conventional war between two major sovereign nations certainly feels like an unthinkable occurrence for people of our generation, but I suppose everything is impossible until it happens. I feel bad for the Russian people. An invasion of Ukraine doesn't do much to help the Russian people, but the ensuing economic fallout would be devastating for them.
Just circling back here in light of the unfortunate and tragic events in Ukraine.
my opinion hasn't changed, one must separate how they feel as a compassionate human from how they behave as an investor. we could have more to drop, or maybe enough risk is being priced in. what I know is this - high quality names are down 10-40% from their highs so I'm continuing to go shopping. returns during WW1 were 75%, WW2 was 115%. war is not a reason to deviate from one's investment strategy
Agreed - I'm BTFD and using the pullback to buy things "on sale."
So, I heard this week the feds are raising rates.
Also, Poland almost got hit too.
I wish I was half wrong…I now also am invested in energy. While I think a company like snowflake/twlo/appn should crush it now, the energy crisis and macro fund video game of 2022 went into hyperdrive. This vol is next level and just more pain ahead. So you really cant play offense for time being. Even energy firms are at risk due to change in government policy no easy stuff out there.
I repeat again cash is not always trash, especially in crazy vol environments.
The point is not to detract from the more complete investment / markets guidance above (not trolling or seeking monkey sh8t). As someone who is a junior in investment banking only being a senior analyst about to make associate, what are the chances of job cuts pre-summer? Talking from the perspective of lower Tier BB that hired a lot last year.
[THE PsYcHoLoGy] tagging you and bumping this as things have taken a turn for the worse. approaching the door of bear market territory in S&P 500 and the worst bond market since 1842. glad to answer any questions anyone has, but my thoughts and advice have not changed. high quality should survive, people who loaded up in zero/low earnings tech are getting their asses handed to them as they should, a lot of damage has already been done so this could be a buying opp, and finally, remember that the logical endgame for the fed is a recession (to tame inflation, which is FAR WORSE than a recession), so buckle up and remember the principles of diversification, quality, live below means, and patience, I'll see you on the other side.
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