I’m writing this from Bangkok, Thailand where for the first time in all my travels, I’ve gotten sick. Other than the occasional case of travelers’ diarrhea, my friends have laughed and marveled at the fact that I would be out in crowds, on packed subway trains, in sold-out soccer stadiums, and Peruvian salsa clubs and somehow, always stay healthy. Not this time. I’ll be fine, but have spent the past four days in bed.

 

This of course makes me think about portfolio management. We can take all the recommended precautions, and sometimes, weird things happen. I’m old enough to remember that in October of 1987, the market fell 23% in a day…for no reason. President Reagan wisely chose to do nothing and the market recovered. I managed through the Long-Term Capital Management blowup in the ‘90s that blew out arbitrage spreads, and made money shorting the tech implosion of the early 2000s.

 

I haven’t always gotten these events exactly right, but I’ve survived them all with capital intact. Losses were temporary. The most frequent question I’ve received in the past few months has been about the large market hedge I have in my own portfolio. Let’s talk about what’s behind that. I’d also like to relay some commentary from one of the best portfolio managers I know.

 

Despite a down past week, the market indexes are still near all-time highs and showing some concerning signs. It’s not just that the P/E ratio of the S&P 500 and the NASDAQ are insanely high; but also, that market breadth is terrible. That’s just a fancy way of saying that almost all the gains in the market have come from a few mega-cap tech stocks, while about 490 stocks in the S&P 500 have done nothing. In hindsight, instead of shorting the market indexes, I should have shorted the equal-weight index (mea culpa!).

 

You all know my views on inflation. Despite terrible decisions by the Fed, the real culprit is Congress which is overspending by trillions a year. This is a bipartisan problem. Congress has decided to fund its spending with inflation instead of taxes. That means that unless we have massive spending cuts, inflation will be an ongoing problem.

 

While I am strongly in favor of Elon and Vivek cutting $2 trillion of spending at the Department of Government Efficiency, I’ve previously stated that I don’t think it’s going to be possible. The White House can’t cut much Congressional spending, and every member of Congress likes the wasteful spending in their own district. I’ve spoken with John Mauldin about this, and he thinks that when faced with an actual emergency, Congress will pull together, do the right thing, and make enough cuts to right the ship. I respect John’s work, but I’ve never seen that kind of healthy long-term thinking out of Congress. I also think most of the people in Congress are financially illiterate and may not understand they are creating the problem.

 

There’s another risk as well. If you back out excess government spending, it’s clear that the productive private economy is already in a recession. We are propping up our GDP calculations with the world’s largest credit card, not actual production. The current White House did this intentionally because no one wants to run for re-election during a recession. President Trump likes to use GDP and the stock market as a scorecard. I’d like to think that he’d take the hit from a recession to get this problem under control, but I don’t expect that will happen. Again, overspending and addiction to debt is a bipartisan problem.

 

What I see is that we either get a recession or more inflation (or both). The fact that the Fed cut rates and the 10-year yield increased tells us that the bond vigilantes are watching carefully and that the Fed has lost control of the situation. I expect that at some point, we’ll see another round of inflation-causing QE.

 

We’ve spent the past two years noting the inverted yield curve where long-term rates were below short-term rates. This is usually an excellent indicator of a recession which I believe hasn’t happened solely due to government spending. In the past few weeks, the yield curve has un-inverted, but the way it happened is important. The yield curve can un-invert when the price of short-term Treasuries rises. This lowers the yield on short-term bonds and returns the curve to a more “normal” state.

 

That’s not what happened here. When the Fed cut, the bond market projected higher long-term inflation and the price of the 10-year fell leading to a rise in yields. In the first example, the bond market is generally projecting lower risk. What we’re seeing is a projection of higher risk.

 

Making all of this worse, Treasury Secretary, Yellen has made a terrible error. She should have extended the duration of the Treasury securities she issued when rates were much lower. Instead, she front-end loaded Treasury sales with short-term debt. That means we’re going to see a lot more refinancing at higher rates when Federal interest expense is above $1 trillion a year and rising.

 

Last week, I spoke with one of the best stock analysts and portfolio managers I know. He recently cut a bunch of positions he likes a lot because he’s very worried about market risk. This is a valid response. My response has been to remain heavily invested and heavily hedged. Either strategy is fine. You just need to be aware of what you’re doing and why.

 

I hope this helps you better understand my thinking on this issue, but these are complicated topics, and you are welcome to email me questions at IR@DeepKnowledgeInvesting.com or use the “Ask Gary” tab on the home page.

 

For those of you who were wondering, I did make the tax-related trade I mentioned earlier in the week. So far, the put options I bought have done their job in replacing the short market exposure I covered. They’ve made about the same amount of money this week that remaining short the indexes would have produced.

 

Next week, we’ll be releasing the second edition of our Bitcoin white paper addressing the claim by Nassim Taleb that Bitcoin is worth zero. We’re going to make it available to subscribers early. The official release will be on Twitter/X where I hope you’ll like, repost, and help draw attention to this work. Every now and then, we do a flagship piece, and I think this highlights DKI’s analytical capabilities. I’m particularly proud of the fact that Intern, Alex Petrou, contributed a technical chapter which improves on my original. Intern, Andrew Brown, not only produced all the images with incredible speed, he also anticipated what I’d want and started producing charts I hadn’t requested, but ended up using. I’m proud of both of them.

 

IR@DeepKnowledgeInvesting.com if you have any questions.

 

 

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