This blog aims to give an overview of expert opinions in combination with my own ideas on specific topics. It focusses on different issues such as the threats of the current macro-economic situation, the risks involved of overly positive sentiment and the asymmetric risk profiles of long-only portfolios. Furthermore, it shares thoughts concerning the digital assets markets. This builds to my analysis of a potentially strong downward momentum coming and threats and opportunities involved.
(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)
- Introduction
Over the past decades, many stock manias have been present, starting in 2000 with the Dotcom bubble, followed by the 2007 housing bubble. Never earlier have so many manias occurred in a relatively short period. Throughout history, many other bubbles have existed. A few famous examples are the Dutch Tulip Bubble in the 1630s, the South Sea Bubble in 1720, and Japan’s Real Estate and Stock market Bubble in the 1980s. Bubbles have always existed and will continue to happen. It is a product of human emotions. At the moment of writing, it seems like we are in an “everything bubble.” This bubble is not limited to the stock market but also seen in; Real Estate, Precious Metals, Cryptocurrencies, Collectibles, Bonds and Debt. Since March 2009, the S&P increased by 600% (nominally). During the same period, Bitcoin grew from cents to 46000$ per coin. The total cryptocurrency market is now a $2.3 trillion ‘Asset Class’ (in parentheses as cryptocurrency is still not seen as a full-fledged asset class). Bond prices are also trading at all-time highs while interest rates have never been lower. Never has sentiment been better than today and has the optimism been so high. Most sentiment indicators are at all-time highs and exceed levels seen in 1929, 2000 and 2007. It is a market of extremes! A perfect cocktail for a significant correction. Many will not be prepared for this and might see severe losses, while people that take timely action could see one of the most incredible buying opportunities of all time ahead of them.
2. Macroeconomic forces
This blog will base most of its analysis on the macro view. There is a simple explanation for this. Most fundamental rules do not count in this market. Mania drives inefficiency.
Since 2009, central banks have continuously pumped enormous amounts of money into the economy and artificially pumped the market ever since. The FED injected a stunning $8.7 trillion in stimulus into the economy since the pandemic’s start — this is around 35% of the US GDP. Over the past 12 months, 40% of US dollars in existence were printed and injected into the economy! In total, $25 trillion has been injected into the economy since 2008. Looking at these numbers, it is not surprising that the markets went up so much.
On 16 March 2020, the world realized that the COVID-19 pandemic was real, correlations of risky assets were close to 1, even Gold collapsed. A correlation near 1 occurs when all risk assets fall together, investors liquidate their positions to pay of loans and rush into global reserve currencies such as the Dollar. Only when things started recovering the systematic risks of the market did become more idiosyncratic again. I believe that 2022 might see similar trading days as violent as the 2020 Corona crash. The primary catalyst for this will be the FED reducing their balance sheet growth to 0% or negative and upcoming interest rate hikes. The system itself is already broken, but now the FED might give the final push.
Central banks: A case for inflation and deflation
Over the past months, a growing fear of rising inflation has been present in the media. Among experts, there is a debate going on concerning this topic. Hedge fund managers such as Ray Dalio (Bridgewater), Bill Ackman (Pershing Square Capital Management), Jack Dorsey (Square) and Chamath Palihapitiya (Social Capital) believe that inflation will be persistent for a longer time. On the other hand, others such as Cathie Wood (Ark Invest), Robert Prechter (Elliot Wave International) argue that deflation is possible. It is striking to see that most of these experts belief that a correction is coming. The reason for this is that the market is out of balance and needs a reset.
First of all, let’s do a quick recap of the concept of inflation/deflation and how central banks aim to use interest rates to control the economy. According to Webster, Inflation is an increase in the volume of money and credit relative to available goods,” and “Deflation is a contraction in the volume of money and credit relative to available goods.” So let me explain this a bit more. Economic growth comes partially from credit. For example, you go to a bank and lend $10.000, which gives you the ability to spend this money. When you spend this money on assets, goods, or services, someone else is earning this money. If the number of assets, goods, or services doesn’t increase enough or stays flat, prices go up — Inflation. Central banks aim to set inflation around 2% annually to stimulate economic growth, a tricky business. Current levels, however, are roughly 7%. So, inflation cannot be too high but should not be too low. Balance is key.
Central banks use interest rates to control inflation. Increasing interest rates means that people can borrow less money as the cost of borrowing increases with higher interest rates. Because of that, people will spend less on assets, goods and services, so less will be earned, resulting in a contracting economy. If central banks raise interest rates too fast, this can lead to a recession and a death spiral can follow; companies make fewer profits in recessions, so they want to cut costs. A way to deal with that is firing people; those people stop spending as they have no income, meaning that prices will drop further, which implies that companies will make less profit. In the case of recessions, central banks typically lower interest rates again to stop the spiral, but nowadays, interest rates are already low, central banks have nothing to spare anymore.
An excellent example of this was the pandemic’s start, a deflationary event that harmed the economy. People couldn’t work, and unemployment rose rapidly. Because of that, people spent less and a recession was luring. Because interest rates were already near zero, it was hard for central banks to lower interest rates more. So they started injecting money into the economy, a lot of it, an extra $5.1 trillion in less than two years.
Surprisingly, the central banks continuously failed to create inflation over the past decade. Inflation has only been growing steeply since the pandemics started in early 2020 and is currently exceeding levels not seen since the 70s. Before that, inflation was relatively low. A reason for this could be that deflation was already programmed for a long time and that the current high inflation levels are simply a product of the excessive central bank policy. There is a good chance that inflation might be short-lived and will fall dramatically as the central banks start tapering and rising interest rates. The FED announced three rate hikes for 2022 to raise interest rates back to 75BP by the end of the year and continue in 2023. The market is now actually pricing in four rate hikes in 2022 with a possible 50BP hike in March. Although stock prices are still trading near their all-time highs, this is still a bearish event for the market. After all, low-interest rates have been this bull market’s main driver. It is only natural to reverse the same effect when things start shifting. It might take some time for the market to realize this. Markets typically aim to squeeze out the last bit of returns before things start turning. It is not a surprise the FED is taking action now as the current levels of inflation start posing a severe threat to the US dollar and economy. Most investors nowadays believe the market will continue its glory in perpetuity and that central banks will continue injecting money into the economy no matter what. The reality is that central banks do not have much to spare anymore. Continuing their printing will drive up inflation and destroy the Dollar and economy. On the other hand, raising interest rates will deflate the artificially pumped markets and harm the economy. It is easy to conclude that the economy will suffer from both outcomes. A reset is needed and could start a series of events crashing the markets. At some point, the music will stop and the results could be catastrophic for people that are not paying attention.
Inflation versus deflation
It is difficult to tell if we will see inflation or deflation over the next decade. You will probably not hear about the scenario of deflation very often as more extended periods of deflation are infrequent. So I will try to discuss some expert views on it as there are multiple catalysts to see deflation in the future and it could be as dangerous as inflation. This does not mean I think that deflation will happen. It just highlights the massive imbalance that central banks have caused and the threats that can come from both inflation and deflation. Furthermore, to be successful in this market, it is essential to be open-minded to contrarian views.
The case for deflation: Global Debt, Bond market signals, Supply Chain constraints, temporary high energy prices, future productivity growth
Debt
Global debt is expanding rapidly. Currently, it is sitting at $222 trillion, of this astronomic amount roughly $29 trillion is US public debt. Generally speaking, a trend of credit expansion (like we see today) is composed of two critical components: The general willingness of market participants and the ability of borrowers to pay interest and principal. These components depend respectively upon; 1. the confidence of both borrowers and lenders (do both creditors and debtors believe that debtors will be able to pay), and 2. The evolution of production, which influences the ability of debtors to pay. This implies that credit will likely expand as long as the confidence in future production growth is here. However, as the confidence in production decreases, credit will also decrease. So this process might go on for a while more. However, at a certain point, the rising level of debt becomes too expensive to sustain (interest payments are becoming too expensive). According to Robert Prechter (2020), a high-debt situation becomes unsustainable when economic growth falls beneath the prevailing rate of interest on the money owed and creditors refuse to underwrite the interest payments with more credit.
As the trend changes and the economy starts contracting, defaults will rise. Increasing defaults or the fear of default will make creditors reduce their lending even more. A debt liquidation event is a deflationary crash and can be disastrous. Borrowers will liquidate their assets to pay their debts, resulting in a colossal sell pressure in stocks, bonds, real estate, commodities, etc. Historically credit expansion generally ends in busts. The current credit expansion driven by excessive central bank policy is the greatest ever. It might continue for a while longer, but it will likely end badly after all.
Bond market signals
The bond market did something strange. It rallied when the FED indicated that inflation would not be transitory. So the bond market is saying the opposite of the Federal Reserve (inflation is the bond market’s biggest enemy and should continue to perform well in case of deflation). It was also striking that the yield curve flattened as soon as money growth rates slowed. This typically signals that the bond market (smart money) is scared of a recession and inflation could go down.
Supply Chain constraints
Another reason why deflation might happen is that current supply chain issues will resolve. Over the last year, supply could not follow demand, and companies had issues producing goods and offering services — for example, a shortage of microchips. The deficiency causes an imbalance between demand and supply, increasing prices and thus inflation. Supply shortages generally lack demand. To deal with these production problems, they increase production with new factories, etc., it takes time for new production capacity to become available. When the new production capacity becomes available, most demand has been served already; supply will now be higher than demand and prices will decrease, causing deflationary pressure. Another great metric to see that supply chain problems are resolving is the Freightos Baltic Index (FBX): Global Container Freight Index. The price per container is going down, which is at itself deflationary.
Temporary high energy prices
Another huge contributor to the recent high inflation is higher commodity and energy prices. It could be the case that this increase in energy prices was only temporary. Some of these commodities’ prices are already coming down, which is deflationary. Moreover, weakening China growth could accelerate this. Petrochemical demand from China is already lower than expected (40% of Global demand comes from China). On the other hand, a lack of new investments in the energy sector set supply low. There is a good chance that the imbalance between supply and demand might resolve itself.
Furthermore, Caty Wood (Ark Invest) made some compelling arguments for a more deflationary environment. She argues that there will be much innovation over the next decades, such as artificial intelligence, automation, machine learning, robots, etc.; this could lead to a huge boost in productivity growth. Because of this, the cost of everything will go down, creating deflationary pressure. More productivity growth -> More innovation -> More deflation etc.
3. Investing as a cult
Over the past years investing has become mainstream and the number of investors has increased dramatically. With interest rates at historic lows, people start to look for alternatives instead of putting their money in the bank. This trend has accelerated quickly with inflation fears — financial institutions anticipated on the increased demand. Investors can now open trading accounts with near-zero fees and trade a broad scala of new financial products, making it easier than ever before. Many new investors are now rushing into ETFs, inflating broad indexes.
Most of these new investors have been on the right side of the trade lately as markets continued to rally higher. Most of these investors are familiar with the concept of markets that are trending upwards. They will likely keep their only long positions until they are, in some cases, liquidated or forced to sell. That is because a long-only strategy always worked for them, and yes, it worked for a long time. People’s brains are programmed to judge based on what “they want to happen” a market that will continue to go up forever is a collective bias that stops most of them from making rational decisions. Most of these new investors are now searching for higher-risk trades, such as crypto assets and penny stocks. Retail investors are buying more than ever, while the most intelligent people on earth are offloading huge proportions of their holdings. I would not want to make a bet with these Billionaires.
After that past years, Crypto became mainstream and is currently in a hype cycle. You see it everywhere. The amount of money available in this market is enormous. Crypto is now sponsoring large soccer teams or, for example, Formula 1. There are even commercials of Meme coins in the subway or whole trams covered in Meme coin marketing. To be clear, this does not mean that Crypto will not succeed. The digital asset market has been flourishing over the past years and many innovations and narratives have their hype cycles within the overall crypto hype cycle. Examples of innovations are Defi (Decentralized Finance), NFTs (non-fungible tokens) and Play2Earn/Metaverse tokens. I am a massive believer in these new initiatives and invested in them from the start. On the contrary, the market will likely grow over the following decades. However, the current investment climate is toxic and it will probably correct before continuing to rally higher.
Another far larger group of market participants consists of institutional investors. Most of these organizations are searching for yield to cover their future claims. Because interest rates are too low, balances of these organizations have been filled with high proportions of equity. Although this is mainly seen in the US, it is a massive threat for the market. Some American pension schemes discount their cashflows with a 7% annual return and cannot cover all their future claims. This means they expect a 7% average return on their investments. Future cash flows should be discounted with low-risk returns, not equity returns. A bizarre situation will probably end in a disaster. Imagine what would happen if a steep decline occurred. They would have to liquidate a portion of their equity holdings, accelerating the downward pressure resulting in a snowball effect. Most people will think governments and institutions will never let that happen. They are probably wrong. And when things start going the wrong way, these institutions will not take responsibility; they will tell you that your losses are caused by unforeseeable shocks in the market that was out of their reach.
4. Closing Remarks
The above information provides an overview of important topics that could form a threat to the market. In my opinion, the most critical threats are the uncertainty concerning the Central Banks’ future policies and the impacts this will have on inflation levels. Furthermore, many other risks come with over-positive sentiment and high levels of risky asset holdings in retail and institutional investors. Of course, it did not cover all threats, such as weakening China Growth, emergences of new COVID variants, second-order impacts supply chain constraints, geopolitical risks and cybersecurity risks. Nevertheless, this might create awareness for these topics and hopefully help people review their portfolios and risk preferences once again. Of course, this is just an opinion and not investment advice.
Many people will argue that nobody can predict the market. I partially agree with that. I believe that inefficiencies can remain for extended periods, and therefore, it becomes hard to ‘time the market.’ However, under(over)-valuations will deviate back to their fundamental values in the long run. So yes, there might be a scenario possible where this mania continues for many more years. If you ask me if that is likely, I would argue no. While asset prices are overvalued, asymmetric risk-return profiles arise. As a result, even if the market keeps on pumping, the probabilities of a decline are becoming more extensive. I cannot stress enough how vital these risk-return profiles are. There is, of course, the likelihood of an ongoing bull market, but the expected return from that is not justified by the risk of a potential downward move. After capitulation occurred, it is time to start buying again. With the increased use cases of crypto assets, more money from traditional markets flowing into Crypto and increased demand from millennials and institutional investors, it might be a great idea to accumulate Crypto when the dust settles.
The following 24 months will be crucial for the markets. My analysis is telling me that it is a good time to wait on the sideline and minimize exposure. For that reason I have been actively selling over the past months. So this is what I do. There is, of course a scenario possible where markets continue to run higher. Would I bet my money on it? Not today.