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...
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.
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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.
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 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.
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
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.