Orthodox Investor Part 3

Most of us are old enough to remember the dot com bust and the housing bust first-hand. Something interesting happened on both occasions. A lot of people who had gotten rich and could have cashed out near the top decided to push their luck and go for broke. Many of them would end up spending another decade or more working just to regain the wealth they had to begin with. Somewhere there’s a Tesla employee who bought 500 shares of TSLA a decade ago at $20 a share, thinking he’d keep it for at least 20-30 years because it’s meant to be a long-term play. Seeing the price go to over $2000 a share last Friday should cause him to think “You know what? I just won the lottery. I’m gonna cash out. Gimme my million dollars now, and since that’s more than I would have earned working for the rest of my life, I’m not gonna work anymore.” For every such example, there are probably 100 others who also accumulated a million dollars, but did so by putting their wages in a savings account, through home price appreciation, inheritance, etc. When they look at the median wage of $60,000 and assuming that a frugal person can save about $30,000 of that per year, they have to be thinking to themselves, “Wow, that million dollars corresponds to a lifetime of savings. Who cares about working to make more, how do I lock in what I already have?” If you spend any serious time trying to find an answer, you realize that you can’t. Your wealth is determined by the percentage of the total that you own. If you own stocks, the most relevant question is what fraction of the $35 trillion US stock market capitalization do you own? If you own US dollars the relevant question is what percentage of M2 money supply do you own? Since M2 has increased by about 20% year-over-year, cash holders are now 20% poorer than they were a year ago (mathematically a 20% increase in supply makes you more like 17% poorer, but these things can’t be measured that accurately anyway). Given that the entire financial system is effectively a casino, every millionaire is necessarily a speculator, it’s just a matter of coming to that recognition. Most portfolio managers take comfort in backtesting their allocation models 50 years or 100 years or more. While the next few years are likely to be similar to the last 100 years, the two pillars of the investment industry, equities and real estate, rest on a shaky foundation. They are outdated rent extraction schemes forced upon a working class that over 100 years ago had no choice, but to work because the alternative meant either starvation or a lower standard of living. Today, many people would enjoy a higher quality of life if they stopped working, they just don’t realize it, yet, so in that sense, people cannot be relied upon to remain indentured servants for long. The risk that rent extraction is significantly reduced due to an ideological shift in the general population is not priced into either equities or real estate at the moment. At the same time, demographics and low debt levels were tailwinds over most of the last 100 years and are turning into headwinds. As a result, there is no investment that has compelling fundamental merit on its own. Every single investment asset can be thought of as nothing more than a competing currency. TSLA is arguably just another currency. You click and you own it. Same with bitcoin, same with gold ETFs, junk bond ETFs or REITs. All that matters is being able to frontrun the next fad or the next Fed rescue. Half the population is less skilled than average and likely to lose when they play this game. More likely, 20% of the speculators will gain at the expense of the remaining 80% based on the frequently cited 80/20 rule. The system works well for a few at the top, but it’s clearly not in the interest of the majority. The stability of the financial system hinges entirely on the willingness of this majority to eat the cost of money printing by working for a smaller and smaller share of the wealth pie. It’s made possible by the misunderstanding of the purpose of work. You don’t work in order to provide for your family. The necessities we need for life are largely automated through technology today. Most of us could quit work and we wouldn’t be any worse off (and neither would society as a whole). In reality, the economic system is more like a poker game. The objective is to make out like a bandit, and you do that at the expense of the suckers at the table. If you’re not getting rich really fast, well, then you’re the sucker who is helping the rich stay rich or get richer.

Negative real interest rates are a blatant market signal telling investors that too much money has been created, so negative investment returns should be expected. Better use up that money now while it still has purchasing power because in the future it will buy less. The first logical response to this is denial. Investors pile into all investment classes, creating the illusion that returns that beat inflation are possible. The big three (stocks, bonds, and real estate) become too big to fail and the central banks will provide unlimited support to thwart deflation. But this means that all too-big-to-fail assets can be thought of as money. Hertz will be allowed to go bankrupt, but the overall stock market capitalization will not be allowed to go down. For all intents and purposes, you can construct a portfolio and whatever the liquidation value of that portfolio, you can bank of having that amount of money, as long as you diversify enough and focus on the too-big-to-fail assets. This creates a funny situation where we could all be millionaires, as long as we don’t try to spend that money because then the reality would be exposed that the money isn’t worth what we think it is. The average net worth in the US is currently close to a million dollars (there’s a report that indicates it is close to $700,000 as of 2016, up from $550,000 in 2013 so it should be close to $1,000,000 today, see https://www.federalreserve.gov/publications/files/scf17.pdf). But it’s so concentrated among the rich that we have a situation where the money isn’t being spent. It’s just a bunch of rich people thinking they are getting richer and richer. There’s no theoretical limit to how rich an extremely rich person can get. Jeff Bezos could be worth a quadrillion dollars and there would be no noticeable change as long as he doesn’t try to liquidate or spend that money. This lack of consequence leads the average person to believe that they should focus on themselves, be appreciative of how much they have themselves and not concern themselves with the wealth of billionaires. But the amount of wealth that billionaires have is extremely important to anyone who saves any amount of money because if there is ever a financial reset and everyone loses 99% of their wealth, the billionaires will still be wealthy while the millionaires will be broke. The richer the billionaires the more meaningless each dollar in savings becomes. If you’re young and not yet a millionaire, you had better go for broke and try to make a killing because if you lose most of it, they’ll still give you food and shelter for free, as we are already starting to do today for the hapless unemployed. If you play it safe and accumulate a few hundred thousand, the risk is great that it won’t be enough to mean anything. Anyone trying to save money today for retirement needs to realize that there’s so much money being created today, you need lots and lots of Benjamins for it to make a difference. Anything under a million dollars is below average. You might as well have nothing. That figure is likely to go up every year. If you’re not saving $100,000 a year, you’re likely falling behind.

Right now, the trick of giving people positive real returns in stocks and real estate (even though bonds offer no return) is working. But if bonds are trading at a negative real yield, and stocks and real estate are backstopped to the point where they are almost as safe, it’s just a matter of time before the market prices stocks and real estate at a negative real yield as well. There has to come a point where this realization kicks in, yet in a market where everyone believes that the trend is your friend, valuations are likely to continue to fluctuate between extreme overvaluation and extreme undervaluation. Valuation, however, becomes an increasingly unimportant metric, as there are too many uncertainties. On the one hand, there is safety in size, but the fact that the market cap of equities and real estate is so huge relative to all other investment options means that there is more room for it to get worse. The favorable tax treatment means it’s more likely to get less favorable in the future given the increasingly popular calls to do something about wealth inequality. A society driven by rampant consumerism could turn into a society driven by slightly less rampant consumerism. If unprofitable businesses are propped up, does it really matter much what the valuations are? Can’t we think of everything as just another cryptocurrency or precious metal, where the value is whatever you want it to be? At the end of the day, you’re trying to gauge at what levels should stocks trade relative to real estate, relative to cryptos, relative to precious metals, relative to bonds, relative to competing fiat currencies. If there is some way to gauge what is cheap and what is expensive, you can implement a strategy of buying low and selling high. As for myself, I don’t attempt to predict short-term trends. In 2008, when I saw my co-worker get all excited about the iPhone, I thought he was joking (he wasn’t). But he was an engineer, and I know nerds like toys to play with, but I also thought I knew that there wasn’t a snowball’s chance in hell that the smartphone would be adopted by the average person. I was wrong and Apple is now a 2 trillion dollar company. I was one of the last to catch on to the trend, and I still don’t understand why people buy smartphones. Nonetheless, from a very high level, I see an inevitable trend toward more and more distrust. Most financial assets are hard to understand, and the average person takes a leap of faith to invest in them. Is the stock you’re investing in really very profitable or is it engaging in creative accounting? Are cryptocurrencies really a cheap and efficient way to transact, or does the distributive nature and the never-ending growth of the blockchain make it wasteful and unmanageable? These questions are impossible to answer for the average person and that makes them faith-based investments. The habit of believing and trusting is so strong, the average precious metals investor chooses to rely on faith in others to judge the authenticity of his investment. It only requires a basic understanding of physics to test metals. With a few cheap tools and using concepts of mass, density, specific gravity, magnetism, and ultrasonic testing one can quickly determine the authenticity of metals with near 100% certainty. There is a very finite number of elements in the universe, and investing in pure metals is orders of magnitude simpler and straightforward than anything else. If this doesn’t trump all else in the end, I don’t think any better decision would have been possible anyway. You can come up with an infinite number of other investments, but they are all complicated, involve counterparty risk, or cannot be held in your hand. When trust in equities and real estate disappears as the Ponzi nature of our economy is exposed, the logical alternative is obvious.

Since the S&P 500 made its 666 low in March 2009, the financial markets have moved in this predictable back and forth pattern of risk on and risk off. Every time the Euro peaks, it also coincides with peak positioning by non-commercials in the weekly COT report, high treasury yields, a high silver price, and a strong stock market. As we move from peak to trough, everything that was previously strong performs poorly or tepidly at best.

In the summary below, EUR is the Euro/Dollar exchange rate, Ag is the price of 1oz of silver (argentum), TYX is the 30 year US treasury yield, and SPX is the S&P 500 index.

RISK ON 03/08 $1.60 EUR $21 Ag 4.4% TYX 1350 SPX (COT positioning did not correlate with EUR/USD between 2006 and 2008)

RISK OFF 03/09 $1.24 EUR $12.50 Ag 3.6% TYX 750 SPX

RISK ON 10/09 $1.50 EUR $16.50 Ag 4.2% TYX 1050 SPX

RISK OFF 06/10 $1.19 EUR $17 Ag 3.85% TYX 1000 SPX

RISK ON 04/11 $1.49 EUR $49 Ag 4.5% TYX 1363 SPX

RISK OFF 07/12 $1.20 EUR $26.5 Ag 2.4% TYX 1360 SPX

RISK ON 03/14 $1.40 EUR $22 Ag 3.7% TYX 1862 SPX

RISK OFF 03/15 $1.05 EUR $15 Ag 2.5% TYX 2075 SPX

RISK ON 02/18 $1.25 EUR $17 Ag 3.2% TYX 2750 SPX

RISK OFF 03/20 $1.05 EUR $12 Ag 1.3% TYX 2200 SPX

RISK ON 08/20 $1.19 EUR $30 Ag 1.5% TYX 3375 SPX

This pattern will break at some point, but right now it’s looking like market participants are making the exact same mistake that they’ve been making at every other peak or trough over the last decade: they overextrapolate the current trend based on compelling “stories”.

First of all, the current peak Euro is remarkable because we’ve seeing new record COT positioning every week for over a month now. The 10 year and 30 year yields didn’t go higher in this cycle (they remained flat), so this could be an indication that they need to rise before we get to the final peak. It looks like we are close enough to the peak that we can attempt a prediction of where the next trough will be:

Time Frame: 3 months to 2 years

EUR $0.85-$1.20 It would be highly inconsistent for the Euro to get stronger from here based on futures market positioning

Ag $10-$35 This is a tough one to predict. There are few people who invest in silver so it doesn’t take many dollars to drive the market higher or lower. Also, investors tend to buy and sell at the worst possible time, exaggerating the oversupply and undersupply of the metal. Nonetheless, a dramatic increase in the silver price would be highly inconsistent with recent history.

TYX 0-1.5% The zero bound limits the downside. Yields are already deeply negative in real terms, but history says an increase in yields from here contradicts the pattern we’ve seen over the last decade. A spike higher followed by a drop would fit the pattern, however.

SPX 1500-3700 The lesson that the last 11 years teaches us is that the S&P will dip below current levels in the future creating better entry points. In addition, upside is limited at this point. We need to hit the next trough before the market goes more than 10% higher.

I’m not making the prediction because I’m particularly confident in my ability to predict the future on a short-term basis, but it’s a good test to see how my perception of the markets compares to reality. Within another year or two, I can review how and why I was wrong.



  1. steve h Said:

    Any chance of posting an updated outlook? Your comment on ZH about 10-11 months ago really changed my perspective, and lately I’ve been searching and finding – every media market in the US (both large metros and tiny ones) is running local news stories about labor shortages – even South Dakota, where Noem singularly turned down federal UI money. It all seems to tie into your thesis and Hugh Hendrys system-implosion thesis “when enough ppl say I’ll fight you to the death, then you’ll have inflation…”, and makes me wonder if it carries any legit indication that the whole system could blow sooner than later.

    • It’s funny I was just thinking about the labor situation. I go to stores and there is enough staff everywhere, even though employees are forced to wear uncomfortable face coverings and they would be paid more (due to the $300 weekly bonus) sitting at home and watching Netflix. I’m in Nevada. What do you see? Do you see long queues because stores can’t hire enough cashiers, stockers, truck drivers, etc to keep things running? To me, it’s clear that people continue to cling to the belief in work. The breaking point is not even close. Since May 2nd, Nevada is requiring PUA recipients to look for work. It looks to me like the bennies will become harder to come by and inflation will prove to be temporary.

      I reread my post from August and I agree with the predictions I made there. Most importantly, I believe TYX will see a trough between 0 and 1.5%. We’re at 2.28% now. This is an opportunity that’s too good to pass up and I’m in the middle of writing up a presentation of what I call The Angry Trade. I will post in this blog, so that there is a permanent public record of it.

      • steve h Said:

        man, i could write pages of my observations, and will share just a few below. as for your ‘angry trade’ – very interesting, though I’m not dealing with that kinda leverage, especially since i think stop-loss-annihilating yield pingpong moves are more likely than not in the next year or two. The 10 year could go up to 2.5 and test everyone’s bluff, then crater back to 0.9 in the blink of an eye. than back to 1.8, then back to 0.6. every leveraged speculator gets wiped out in this scenario.

        I am in a very liberal metro-Boston community, while regularly making trips to a property i own in collier county fl… in collier, people act like there’s no pandemic,that it’s a joke. places are plenty staffed, nobody is wearing a mask except old snowbirds/tourists. you stick out like a sore thumb with a mask. the area is absolutely booming. if i time traveled from 2 years ago, i would literally notice zero difference.

        as for metro-boston, there are help wanted signs in most dunkin donuts/restaurants/retail stores. however, i wouldn’t say the stores are empty. some of the ‘hot’ restaurants are under-staffed and lines out the door when we’ve tried to go, some that are more old school are mostly empty monday thru thursday. however, the pandemic is pervasive with white/chinese/indian families largely still wearing masks outdoors, signs of the lingering pandemic are omnipresent. when i’m feeling cynical, the metro-boston folks seem like coward pussies, the florida locals (rednecks?) seem like the reasonable ones…tho in normal times, the florida folks are too right wing reactionary for me, the metro-boston folks a little too woke for me etc…

        anyway, i could go on for several paragraphs more, maybe can contribute more observations and logical conclusions at a later time.

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