FWIW # 52 - Reputation Building Guessing Game

The reputation building guessing game has started. Everyone who has a platform or has hundreds of thousands or millions of fans on social media following their every word is now predicting when the stock market is going to crash. These Seers of the Future want to establish their reputation as someone with divine insight into the financial markets since the belief will make them rich.

It has worked in the past, even when some pundits predicted ten market crashes that never happened. Why? Because market participants, both professional and novice, find the investment markets too complex to understand.

That fact is interesting because the bedrock of investing is so simple. The secret is to buy a business that has a decent balance sheet and a product or service that can be sold for more than it costs to provide. The complexity comes when speculators try to predict cash flows and expenses. No one can predict the future. That’s why, when a company is obviously in its growth phase, it attracts speculators who pounce, driving the stock price higher. The price momentum sucks in more speculators who want to get a piece of the hoped-for future riches. One hundred times the hoped-for future revenue in five years is a fair value? Hard to understand.

This momentum speculation works best when there appears to be no other alternative to the company’s products or services. What many speculators don’t understand is there are other opportunities that also have high potential gains with much less risk. Remember “The Ugly Duckling,” the story from your childhood? There are a lot of ugly ducklings out there that will one day turn into beautiful swans—and I don’t mean black ones. With stock market indices making new all-time highs, it’s easy to say a crash is coming in six months to two years, as one exalted CEO has predicted. Let’s look at some of the signals the markets are giving, indicating some issues are truly out of kilter:

1. Billionaire private equity CEOs are buying London apartments for outlandish prices to go along with their other trophy properties in the global ultra-rich’s favored locales.
2. The financial services industry and their political puppets in Washington are making it easy for retail investors to sink their retirement and liquid assets into illiquid private equity and private fixed-income markets. “If the leaders of the private market companies can become billionaires, why can’t everyone get a piece of the pie?” seems to be the mantra.
3. Momentum investing is the current craze, and the biggest momentum speculations are index funds. Pick an index, put your money in it, and don’t worry—in the future, you’ll be very rich. The stock market always goes up over the long term. Right?
4. To reinforce the certainty of #3, the federal government is going to give every child born in 2025 through 2028 a $1,000 account that parents can add to, which will be invested in an S&P 500 index fund. The theory is that the parents will add to the fund, the fund will grow through compounding, and inequality will be wiped out in the future.
5. Gold is above $4,000 an ounce, while the ten-year US Treasury note is yielding less than 4%. That’s illogical. One or both investments are being distorted.

Let’s review some basics. Supply of a stock (index) and the demand for that stock (index) are what moves the price. Less supply and more demand lead to higher prices. Conversely, less demand and more supply lead to lower prices. With a significant amount of capital and shares  tied up in index mutual funds and ETFs, any activity outside those funds is now causing more volatility in individual share prices. It’s neither good nor bad, just a factor that has to be part of the buy/sell decision. For those of us who invest only in individual companies, if a stock is approaching or in a buy zone, the increased volatility offers an opportunity to find an attractive entry point.

But that’s not the point here. The Masters of the Universe in the private equity and private debt markets are being handed a gift of trillions of dollars in retail retirement accounts. Diverting money from the public markets to the private markets will impact the price level of the public markets. Perhaps the next four years, when the federal government is giving each newborn $1,000 of the S&P 500, will offset some of the money being diverted to the private markets. The amount of money in and out of retirement accounts that will follow the siren song of the private markets advocates can’t be known. Two aspects of the new policies for individuals participating in the private investment arena are known: (1) There will be news shouted across all media about early huge gains for individuals who jumped in first, and (2) the eventual Congressional hearings and Department of Labor investigations will expose the cost of private plane usage and other egregious expenses charged to retirement account investors participating in these deals.

Just as likely will be what happens when individual investors realize how long five to ten years is for holding an investment. Presently, institutional investors (mostly professionals speculating with someone else’s retirement money) are discovering that getting out sooner than the stated holding period means a significant discount from the current value, which is generally less than the expected target value at the end of the investment period. Who are the speculators willing to let investors out early at a substantial discount? They’re some of the same professionals in the private markets looking to take advantage of investors who can’t stay the full-time commitment. All investments, even publicly traded ones, should be held for ten years or longer, but many speculators are too impatient when the investment does not continually go higher.

My point is that the capital for these illiquid investments is coming from public markets, even index funds, which will make the public markets more volatile and susceptible to panic selling.

Past FWIWs have highlighted the large M2 money supply, the inflated size of the Fed balance sheet, and the excessive liquidity both of these factors bring to the investment markets. Looking at these factors, it’s easy to see the M2 has surpassed the pandemic high amount and the Fed is signaling they are stopping the shrinking of its balance sheet. These factors keep excess liquidity in the markets. Excess liquidity makes it hard to have a market crash without an overleveraged mistake. With the Fed and the administration signaling lower interest rates, the obvious direction of fixed-income assets is toward a higher price and a lower yield. The conundrum of $4,000 gold and 4% ten-year Treasury notes is real. We are certain about the distortion of the Treasury yields. For years, the Fed and political officials have worried about the Treasury’s fixed-income securities market. They have good reasons.

If a speculator wants to participate in buying and selling Treasuries, they can do so with extremely high leverage. To own $1 million in par value treasuries takes only $100,000. That’s right—the leverage can be up to 90%. Aggressive traders can go to another lender, borrow the $100,000, perhaps by pledging other securities or just using a line of credit, and therefore use solely borrowed money to control $1 million of Treasuries. Extrapolate these numbers. Controlling $1 billion in US Treasuries takes $100 million, which is easy for some Wall Street trading houses or hedge funds to borrow. Not only that, but the monetary and political authorities who control the interest rate are telling speculators that rates are going lower, so they should load up for what are close to no-risk capital gains. The only potential risk is that some event not only keeps interest rates from going down but causes them to rise unexpectedly. With the leverage in the Treasury market and the herd mentality that has most large bond speculators following each other, the bloodbath in both the Treasury and stock markets could be significant. The deliberate interest rate distortion by monetary authorities in the Treasury market is evident.

Now, look at gold. We all know that the use of financial sanctions against US enemies, namely Russia, Iran, Venezuela, and North Korea, has led many central banks to add gold to their reserves instead of more dollars. The citizens of India and China have historically made gold an important part of their net worth, and they’re now enjoying enhanced prosperity and buying gold in large quantities.

These are known factors. What is moving the gold market to new heights are flows of retail speculators’ capital into ETFs and mutual fund ownership of gold or gold shares. Some of these funds use futures contracts to add leverage to their promise of returns. Introducing leverage into a market that is usually non-leveraged has helped drive gold demand higher.

Note the word leverage. Leverage has always been the Achilles’ heel of investment markets, not because it’s inherently bad but because it’s addictive. When the investment using borrowed money goes in the right direction, the returns on the equity involved are enhanced. If 50% leverage works great, why not 100% or 200% leverage? That’s what the really rich speculators use, right? Yes, but when leveraged speculations go bad, which usually happens when investment prices are stretched, as they are now, the equity is wiped out faster than the blink of an eye, requiring more equity deposits. Those deposits usually need to be made the day the lender demands them; otherwise, leveraged assets are sold, turning a potential temporary loss into a permanent one.

Overleveraging in any market has implications for all markets. Why? Because one of the rules on Wall Street is speculators in trouble sell what they can, not what they should. If a speculator has placed a portion of their assets in illiquid or highly leveraged investments and must raise more liquidity fast, what are they going to do? They’ll sell their publicly traded investments. The market was crunched a couple of weeks ago. The media blamed it on President Trump’s threat to increase China tariffs. A few days earlier, the First Brands bankruptcy surprised the markets, and major private debt lenders suffered large losses. The selling the day the market dropped looked more like large speculators had to liquidate in a hurry. The market’s recovery over the few days                                                                                                                                            after the sell-off implied the pressure on prices was from a one-off event. My point: When a serious stock market sell-off happens, the trigger will likely come from an overleveraged or illiquid situation, not from the public markets themselves.

Another factor is the likelihood the trigger event will be some action or lack of action that no one thought about. In this geopolitical world, where several situations are highly complex, the chances of a miscalculation are significant. The real issue, however, is not whether or when a market crash will happen but how an investor should handle it. Do not think for a minute that the tech stocks won’t dive 60%–80% in a market crash. Look at the favorite stocks of past bull markets. What should an investor do? They should look at their portfolio as a whole. What is the mix of stocks and fixed-income securities? Is the portfolio 90% stocks? If the stocks went down 60%, would the investor be able to be disciplined and maintain the portfolio? Would they have new funds from portfolio income and selling fixed-income assets in the portfolio (see 19 Rules For Getting Rich for details) to invest in stocks while they’re down? Does the investor know now what stocks they want to add to the portfolio if the volatility to the downside increases? What will be the consequences to the portfolio if the market declines and stays flat to down for a decade, as it did in the first decade of this century? If most of the portfolio is in growth stocks that don’t pay a dividend, will stocks have to be sold at depressed prices to maintain a lifestyle? Examining your portfolio to prepare for a potential market crash makes a lot more sense than worrying about when there will be a crash.