FWIW # 44 Is This It?

Is this it? Last week and early this week, volatility caused a crumbling of the foundation for stock prices. Will it continue? No one knows. What is the cause? A combination of factors. Financial crises don’t just happen. The root cause of all financial crises is a liquidity issue. Well, what causes a liquidity issue? Many events that don’t seem to be correlated. Let’s look at some of them.

Think about the world today. Iran has resisted entreaties to be disciplined and measured in their response to Israel’s killing of the head of Hamas when he was in Iran. In a world where perception is as important as reality, the Israeli strike clearly indicated Iran’s defenses are weak. Iran has the potential to respond with massive force, using all their proxies to deliver a coordinated blow to Irael from every direction and starting WWIII in the Middle East. On the other side of the world, China could move against Taiwan while the US is distracted by the Middle East, and the political situation in Washington is in flux. Anyone can say what they want, but the current president is impaired. Thinking a committee of unelected officials can make military decisions is wrong. The fact is, if the Chinese move against Taiwan while the US is focused on Iran and Israel, the takeover of Taiwan will be accomplished before the US can respond effectively.

US F-16 jets have started to arrive in Ukraine. So have additional US munitions that have the potential to reach deep into Russia. Does anyone truly believe the Russians are going to allow the US and NATO to supply Ukraine with weapons and not extract a price from the US? It’s not a stretch to think the 1 million “got-aways” that have crossed the US southern border in the last three years contain cells of Russia-allied terrorists. Scary, isn’t it? Just the fear of one or more of these scenarios happening is enough to trigger a selloff in the global markets.

Stock market indices were grossly overvalued by a handful of stocks that were reaching hysteria-level overvaluation. Markets were overvalued due to anticipation—of a brave new world of generative artificial intelligence (GenAI), of a soft economic landing allowing economic excesses to continue without requiring anyone to pay for them, of continued but slower inflationary price increases, of lower interest rates, and of speculative ways to make quick and easy money through nontraditional alternative assets. Anticipation works when speculators take a current environment and extend it into the future in either a lineal way or an accelerating way. If some event occurs that could negatively alter the future, thus changing the anticipation of the future, the bubble bursts.

The latest craze in the investment markets is speculating in private credit. Private credit, just like private equity, is illiquid. In a rush to liquidity, which is the basis for a financial crisis, speculators who have illiquid private investments sell liquid public investments because they can’t sell their illiquid investments at a reasonable price. On Wall Street, the mantra is “Sell what you can, not what you can’t.”

As crazy as it sounds, the news that Warren Buffett sold $76 billion of stocks in the second quarter was eye-opening and bubble-bursting. The fact that he now has over $275 billion in short-term US Treasuries adds to the impact of his selling. Why would the “smartest investor in history” (as the media and some on Wall Street call him) be willing to hold that much cash? Is it because he sees an economic problem that will let him take advantage of other people’s poor liquidity management? Is it because he thinks after the election the incoming administration will raise corporate taxes? (He’s a stalwart Democrat.) Is it because of his age? Only he knows what caused his move to liquidity, but the signal to the markets could be part of the trigger for the selloff. Since the global selloff began in Japan, could it have been triggered by Buffett’s sale of his Japanese holdings?

The unwinding of what is called the “carry trade,” borrowing money in one currency in order to investing in assets another currency, has been cited by some Wall Street people as a partial reason for the steep drop Monday.

All these potential bubble-bursting events together could trigger the actual financial implosion caused by liquidity drying up. Look at Bitcoin, which was worth almost $70,000 a week ago and on Monday hit $51,000 before rebounding somewhat. How many of the speculators holding Bitcoin used leverage to maintain their position? It’s the same for stocks. Large speculators use leverage as a matter of course to boost their returns. When they sense potential trouble, they liquidate to reduce their borrowings. Market volatility leads to margin calls (lenders calling for more collateral), which leads to accelerated selling of securities. The current market volatility implies the market’s liquidity is low. Since global markets and all asset classes (stocks and alternative assets) are interlinked, selling in one asset type leads to selling in another, driving all asset prices to decline.

Initially, bonds are different. The proceeds from assets sold are usually parked in short-term US Treasuries. That’s one reason the yield on Treasuries has dropped so quickly. The other reason is major market participants believe the Fed will step in and provide enough liquidity to stop the stock market from collapsing. This belief is based on the last 30 years of Fed action. The Fed has become the primary opioid for speculators, relieving them of the pain of their stupidity.

The US stock market hysteria has been so high for so long, a selloff of the indices of 10%–20% will not make the indices attractive to serious investors. Investors are looking at the companies they want to own for the next 10 years at a price that makes sense. They’re not worrying about the price of a high-flying tech stock involved in GenAI or other future developments. Investors are determining where they can improve the economic power of their portfolios. Economic power in a portfolio is a total return concept: steady dividend returns each year and potential returns from profits based on operations performing as well as they have in the past. Sure, if the economy goes into a recession, the operational earnings will be lower; however, when the economy recovers, operations will recover. When a speculator uses some wild guess of future earnings for selecting stocks, which is illogical to do since no one—I repeat, no one—knows the future, there is no foundation for their assumed growth.

How long and how far this decline in stock prices will go can’t be known. The way the decline ends can’t be known. In the past, some declines ended with a sharp rebound, as we saw Tuesday. At other times, they ended with prices settling at a lower level and taking a long time to repair stock market sentiment.

What to do? You should consider determining what stocks you need to improve your portfolio’s economic power and pick a price for the shares that is close to their lowest price during the last 10 years. Another method is to look at your 19 Rules spreadsheet, see how the company was impacted by the 2020 pandemic selloff, and use that as a buying point guide. What you should not do is assume a stock is an attractive value just because its current price is a certain percentage below its highest price.

Most importantly, if you have a portfolio of individual companies representing the 12 US economic sectors and paying you dividends, think about improving your future, not panicking about events you can’t control.

So, is this it, the change in market direction? No one knows. But it does make sense to be prepared for the opportunities it would bring.