FWIW # 53 - Portfolio Risks and Protections

There is confusion in all the investment markets. What is concerning for some observers is the drop in the price of crypto. In our opinion, the issues are twofold:

1. The private credit market is in difficulty, and some holders of private-credit bad loans are liquidating other assets, such as stocks and crypto.
2. The credit rating of Tether, the stablecoin, has been downgraded.

The rating downgrade is the one issue with the potential to seriously disrupt the overall investment markets. Tether has been the largest stablecoin in the world. While the view into the collateral behind the coin has always been opaque, the time is coming when complete transparency about the assets backing the coin will be necessary for US citizens to own it.

Bad Medicine

Even without the obvious effects of a high valuation of all assets, other issues are facing the markets. One is the future of the Federal Reserve. Anyone active in the markets in 2007–2008, when the Fed was initiating what has come to be called quantitative easing (QE, the buying of US Treasuries and mortgage-backed bonds), remembers hearing a few economists and investors warn about the difficulty of unwinding those efforts when the crisis was over. Not only did the Federal Reserve under Ben Bernanke, Janet Yellen, and Jerome Powell maintain the financial crisis activities, they added to the future challenges by expanding the program with QE2. When the pandemic hit, the balance sheet expansion by the Fed was breathtaking. Some say it was necessary to keep the country out of a depression, but that’s questionable in both the 2008 financial crisis and the 2020 pandemic. There’s no doubt the economy was under pressure and would have gone into a serious recession (it did anyway in both cases). However, the digital printing of money always leads to inflation higher than the base inflation target.

Think about when a person suffers a serious illness or injury caused by activities above and beyond what they should have done. They take painkillers to cope with the results, and in some cases, the drugs become addictive. It’s easier to take another pill than to face recovery efforts without the comfort of the medicine. No thought is given to either an accidental overdose or the increased difficulty of stopping the addiction. While it’s a crude analogy, that’s what Bernanke, Yellen, and Powell have done to the US economy.

More Money, Less Liquidity

When the 2022 inflation spike occurred, the Fed quickly raised interest rates, reduced the M2 money supply, and began shrinking its balance sheet. These activities brought down the inflation rate from its peak; however, the rate only gradually moderated and is still above the “target” of 2% a year. Why doesn’t it return to what the Fed professes is the right level for the economy?

In 2024 and continuing now, the Fed has grown M2 to a level higher than the amount at the peak of inflation. This was done rapidly from the low point in 2023, when the Fed was actively trying to stop inflation from continuing to spike (M2 expressed in billions, May 2022: $21,690.7, October 2023: $20,687.3, October 2025: $22,298.1). There shouldn’t be any confusion about why the investment markets, particularly the higher-risk, speculative markets, have been performing well and the inflation rate stopped going down. To be fair, some economists believe the link between money and inflation is not proven because the velocity of money has not been stable. That is a debate for another time. What is known is that when M2 and the Fed balance sheet grows faster than appropriate and businesses and consumers are not fighting for survival, inflation spikes. An important point to understand: The higher prices of goods and services resulting from inflation do not disappear when the inflation rate decelerates. Prices for the consumer continue rising as the previous price increases roll through the economy. Those increases are permanent until and unless competition forces them down. That’s why people are experiencing an affordability problem now even though the administration is announcing a lower inflation rate.

            Just as important, on December 1, the Fed stopped shrinking its balance sheet, which it had expanded through purchases of assets by digitally printing more money. Undisciplined money printing has always led to excessive inflation. In August 2007 the Fed balance sheet (in millions) was $862.775; in September 2019 it was $3,761.508; in June 2020 it was $7,094.69 (the pandemic hit in early 2020); in May 2022 it peaked at $8,914.28; and it is now $6,552.419. The Fed has signaled it will start increasing the balance sheet again.

More printing of money—why? The economy and the banking system have deployed all the current money. The short-term money markets are under stress because of a lack of liquidity. This is one of the dangers some economists and analysts warned about in 2008. If interest rates in the short-term markets exceed the Fed funds rate, perhaps that’s telling the Fed that rates are too low for the markets. If the spike in short-term rates is a real systemic threat, then the Fed should look in the mirror and realize the painkillers it has been feeding the economy are the problem. If the highest level of M2 in history and a swollen Fed balance sheet are not enough to handle an economy with 4% unemployment, then the potential trouble can’t be fixed by buying more bonds—it will just delay the inevitable. If a forensic survey could assess where the past excess printed money was deployed, there would be evidence of diversion to the investment markets and to zombie companies that should have been out of business. The Fed had a choice during the period 2007–2022, just as it has now: Be disciplined in running the monetary system, allowing the marketplace to choose those who survive and those who don’t, or turn monetary policy over to the politicians and their debtor-supporters and allow them to indiscriminately debase the currency to further their own political objectives. For the past 15 years the Fed has chosen the latter, and the citizens have paid and will continue to pay the price for its questionable decision-making. But the serious problem is still coming.

How to Protect Yourself

I have no idea who President Trump will select as the next Fed chair. I do know who it should be. It’s unlikely the right candidate will be picked for several reasons; the two most important are that it would shake up the Fed and that interest rates likely wouldn’t come down as much as the administration wants. If the Fed were put on the path to returning financial strength and steady growth in the economy, its balance sheet should likely be reduced and the growth of the M2 money supply should be steadily increased at a rate appropriate for reasonable economic growth. Neither of these actions is likely to take place under President Trump. The president is a borrower by nature, and he will press hard for lower interest rates no matter what else is happening. He also wants an accelerating economy during his term in office, no matter what that does to the economy long-term.

Reasonable people will say the president’s posture is good. What we are facing is what we faced as investors in 2007–2021: deliberate financial repression. Inflation and financial repression are the only tools available to the government for, in essence, defaulting on its massive debt. Make no mistake, the government will pay the par value of the bond to the bondholder at maturity. Through inflation, the dollars it pays to the bondholders will have much lower purchasing power than the dollars given to the government when the bonds were bought. That’s the effect of inflation. Those same bonds will not have paid enough interest to offset the depreciation of the dollar, which is financial repression.

With this outlook, what can you do to protect your assets and net worth?

1. Be discerning about new investments

The first step is to avoid the multiple new investment schemes being dreamed up on Wall Street to get control of and use of your assets. When there is active financial repression, Wall Street comes up with a number of ways to entice retail investors to pay higher fees for what appear to be higher returns. The most precious characteristic of any asset class is an open and public market for that asset. Liquidity is crucial to any investor or family that has capital. It ranges from a daily withdrawal money market fund to quoted market prices for publicly traded securities to the time and costs of selling real estate. In all these cases, there is an open market. Prices fluctuate daily (even if they aren’t readily apparent in real estate), and, when necessary, the assets can be liquidated quickly at close to the true market price. Staying with publicly traded assets allows flexibility if needed.

2. Know what you own

If you own KO, MSFT, and MRK, you have very high confidence that each of those companies will survive any recession that may happen. Why? Because over decades they have already shown the ability to adjust to a changing economy. Make no mistake—they may all drop in price when the market is under pressure, but their business model is sound. If you own a package of securities, even if these stocks are included, others in the package may not survive a recession. Further, the committee or individual responsible for the package may choose to sell some good-quality companies just because the stocks are lagging the overall market in a relatively short period or for other reasons. Knowing what you own gives you confidence to hold your portfolio for a longer time through the economic cycle.

3. Keep the cash flowing

Make sure your portfolio gives you an appropriate cash flow from dividends and interest yearly so you have money to reinvest in a compelling value at any time or cash flow in case of an emergency. Do not believe for even a minute that the stock market or any other asset class will always go up. Sometimes stock indices do not go up for long periods—decades, even. These are the times you will recognize the beauty of having serious and steady cash flow for investing in quality companies at fair prices.

4. Diversify

Recognize that no one knows the future, so you need to diversify into a broad group of securities. The investment markets have changed over the last 30 years. At one time speculators were either in the markets or out of the markets. Now, with the high-risk hedge funds and institutional money managers, money flows from one asset class to another or, within an asset class, from one sector to another. Make sure you’re represented by individual companies across the public investing spectrum that are part of the economy.

            Don’t keep all your assets in one volatile asset class, figuring you’ll ride out any volatility. The markets can nurture your fears and drive you out of your investments at the bottom of a cycle. Your allocation to an asset class should be meaningful but not such that your portfolio is decimated in a major decline of 75% or more.

5. Prioritize safety

Put a value on liquidity and safety. Require a larger, secure premium return for making investments that are clearly not safe and secure or readily valued in a public forum.

If I’m wrong, and the president does appoint a Fed chair who understands the mistakes that have gotten the country into the financial mess we’re in, the investment markets will go through a difficult, volatile period. If that happens, be aggressive and disciplined in building your portfolio because the other side of the volatility will be substantial and solid economic growth.

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