FWIW #58 High Tide

I’ve discussed several times the challenges unfolding in the private credit markets. Problems continue as more private credit funds gatekeep clients’ investments (that’s Wall Street speak for keeping money from leaving the funds). Those belonging to wealthy individuals rather than institutions are the ones under the most pressure.

            Causes of this serious decline in faith and trust in the sponsors of these partnerships aren’t fully known because of the secrecy surrounding the loans. The high-profile defaults shaking the industry appear to have no significant due diligence documentation. When an investment idea takes center stage and money flows freely toward it, sponsors of the investments become lax in putting the flow of money to work. Evidence is private equity funds, which have been major borrowers from private credit funds, are also feeling the impact of requests to withdraw money. For a while private equity sponsors have had difficulty selling businesses or, preferably, cashing out with an IPO. This challenge has been shown through “continuation funds”—new money raised from investors who buy a company currently owned by the sponsor at a price the private equity management determines is fair. If ever a situation was a conflict of interest, this is it. Is the business priced to give the current investors a profit, or is it priced to give the new investors a good deal? What would an unbiased third party pay? Complicated situation at best.

            In both private credit and equity, what is the true value of the businesses or loan? The price of publicly traded sponsors of private investment funds offer some evidence that the stated price of the securities does not reflect reality. This factor is critical in that many of these sponsors have also bought insurance companies, and the new subsidiaries have invested a meaningful amount of their capital in the loans or equity of private companies owned by their shareholder. Here again, the price set for selling investments to an affiliated insurance company is not determined by a public market.

            Our opinion of these issues is that they are slow-moving disasters if regulators or the market ever requires systematic valuation of these investments. Based on the market prices of publicly traded sponsors that own these loans and companies, serious mispricing is possible. The current blocked requests to withdraw money by sponsors are a matter to be watched. An implosion in these markets will impact the public investment markets.

            Other financial crises will likely happen in the future, but at greater speed. Last week the regulators approved perpetual futures contracts on commodities, cryptocurrencies, and still-to-come stock indices. The short name for these contracts is “perps,” which stands for their name or, as it seems to me, “perpetrators.” These contracts will trade 24 hours a day, seven days a week. I haven’t looked at an actual contract, but it has been reported that some will use leverage to the level of 40 times the equity. Without a doubt, until a sudden change in outlook occurs, these contracts are high-powered for making the stock market or commodities linked to a contract more volatile. The leverage is the challenge that will eventually cause a disruption in the public markets. What should be of concern to us ordinary investors is the 24/7 aspect, which will allow large global speculators to impact a market’s valuation long before ordinary investors, who must wait for the markets to open in this country, have the ability to react. Be mindful of what is taking place and review your portfolio to make sure you have sufficient liquidity to cushion its decline (it will go down) and to invest in good companies at attractive prices. A final word about future risks: Wall Street is moving toward “tokenized” stock shares on a blockchain. Allow others to play this game. Own the actual shares (in their street names) in your brokerage account.

            I read last week about a large “smart” investor deciding he was going to buy stock in the three AI IPOs because the stocks will rise since market index funds will be buying them six to 12 months after the IPOs, thus pushing their prices up. On the surface it makes sense based on the Greater Fool Theory, which states a speculator should buy a stock at any price because there is always a greater fool who will pay a higher price for it. In addition to the Greater Fool Theory, this speculative concept proves my point that stock index funds are a form of momentum speculation. Think of the fragility of the price of these indices if there is a downturn in economic activity. When SpaceX came public last Friday, the stock went up 11%. Only time will tell if the price continues to climb based upon hopeful future business other than the Starlink internet business.

            The stock market is close to all-time highs for three reasons: (1) the amount of money in the US and global monetary systems is excessive, (2) speculators and investors believe the inflation rate will stay elevated, and (3) tax cuts and less regulatory burden from the One Big Beautiful Bill are creating higher corporate earnings. As long as corporate profits are increasing, share prices will stay strong; however, the market is priced to perfection. For the third of fourth time, it is proposed the war with Iran is close to an end. If so, the spike of inflation will recede, but not disappear. Bond prices may stay under pressure while the demand for capital stays strong. Finally, the new Fed chair has stated he believes (rightly so) that the Fed balance sheet is too large. If the Fed begins to remove some excess liquidity from the monetary system, there will be downward pressure on stock and bond valuations unless they’re offset by substantial economic productivity increases.

            The global markets’ volatility is steadily becoming more challenging. This stems from the stock market’s high valuation, obvious indications interest rates would rise if left to the market rather than the Fed, and potential continued decline in cryptocurrencies as investment markets face liquidity issues from private investments and political turmoil. Last week saw a massive selloff followed by a just as breathtaking rise. The markets seem to be in a period I call high tide, which is when the upward momentum has reached a peak and the selling closely matches the remaining buying. At some point the selling will gradually overcome the buying. Instead of “Buy the dips,” we’ll hear “Sell the rallies.”

            I’ll say again: Know what you own and make sure you have plenty of liquidity.