Overview:
Last night, Robb Fahrion of Flying V (DKI’s marketing partner) added a new “Ask Gary” feature. Immediately, the DKI community submitted some great questions. Some of those I’m going to address in short videos. However, one question is both very insightful and complicated, and I thought a detailed written response was the best way to explain my thinking.
David (a different David this time) asks the following question:
What are your thoughts on our SPY and QQQ short positions? If the Trump administration does get government spending under control, drop Fed interest rates to near zero, and promote US manufacturing, the stock market could have a bright future. I agree with our bets on inflation hedges, such as gold and bitcoin. However, do you really believe the stock market will crash in the near term? Enough to carry a large short position?
Round of applause to David for the fantastic question. I’m going to address this in three parts. We’re going to go through the strategy, reasons, and cost of hedging. Then, we’ll explore the two different paths David lays out and what I think will happen with each. Finally, I’m going to address some of the assumptions in the question digging into my expected policy outcomes of last week’s election. Let’s dive in:
Hedging and Strategy:
My first buy-side job was doing risk arbitrage. An example of a common trade would involve buying the stock of a company being acquired and shorting the stock of the acquiror. When the deal closed, we would capture the spread between the two values. Frequently, the stock of the acquiror would rise meaning we lost money on the short position and made money on the long position. If the acquiror stock fell, we would make money on the short position and lose money on the long position. Much of this depended on the details of the deal, but in general, we didn’t care if the stocks rose or fell (within reason) because we were trying to capture the spread and our profits were likely to be the same as long as the deal closed.
It would have been easy to look at our position sheets and wonder why we were losing money in half our positions. However, the way we structured the portfolio, it would have been inaccurate to view each position individually. They were put in the portfolio in pairs.
David is correct that the short positions are losing money right now. However, the long positions have made more money than the shorts have lost. When we pair the shorts against the rest of the portfolio, what we have is a money-making portfolio with reduced market risk. That means we’re generating alpha; returns above the market return adjusted for exposure.
In this case, the hedge has cost us money and we would have been better off just owning the long positions. Insurance isn’t free. I’ve paid tens of thousands of dollars in homeowners’ insurance since buying my house. Financially, I’d have been better off without it. That’s the most profitable approach until you need the insurance. David’s question about the value of this insurance is a valid one. My key point is that we shouldn’t look at the hedge alone; but rather, as a piece of the whole portfolio.
In this case, my strategy has been to own inflation beneficiaries like gold and Bitcoin, energy positions that benefit from growing demand and a dollar that’s losing purchasing power, and high-growth individual equities. I’m only hedging against the high-growth individual equities and betting that our positions that have the potential to appreciate 5x or more will outperform the market indexes. That’s what we saw happen with stocks like Shockwave as well as HCA and Houghton Mifflin for our longer-tenured subscribers. I think it will happen with other stocks in the portfolio, it’s going to take some time to see the result of that.
The Two Paths:
My issue with the economy right now is that Congressional overspending is providing wasteful stimulus while crowding out the productive private economy and creating inflation. We’ve seen that increases in government spending have accounted for more than 100% of recent GDP gains meaning the private economy is shrinking. Concurrent with our “guns and butter” “bread and circuses” spending policies, Congress is pretending that there is no cost to this largesse. Everyone reading this knows there is a cost and we’re all paying for it through inflation. The private economy is experiencing stagflation (negative economic growth with inflation) and this is being obfuscated by government spending.
That, combined with a market at all-time highs and near the top of typical valuation ranges, makes me cautious about taking on too much market exposure. I don’t want to be out of the market, and don’t want to be exposed in the event of a market downturn while owning high-growth stocks. To me, the best answer is to buy insurance and hedge.
David outlines a second path where we cut spending and the Fed cuts rates to zero. Right now, Congress is overspending by about $3 trillion a year and will potentially be facing an additional $500 billion in interest expense next year. This ignores the cost of incurred but not recognized off-balance sheet liabilities like Medicare, Medicaid, Social Security, and pensions which would roughly double that deficit. The government needs to cut trillions of dollars of spending.
If we head in that direction, we’d be looking at an instant recession as without government stimulus, GDP turns negative. If that happens, and it forces the Fed, to cut the fed funds rate to zero, I think we’d be looking at a down market. The stock market loves lower interest rates. It hates the reasons that cause the Fed to lower interest rates.
This doesn’t mean that there’s no path to a higher market in the next year or two. President Trump’s policies were a benefit to the stock market in his first term and he watches market indexes as his own personal report card. If the S&P 500 can trade at 25x earnings, it can trade at 30x earnings. I’m saying that the real economy is experiencing stagflation right now and that while I would like to see the US government aggressively follow David’s path of spending cuts, I think that leads to a recession and market downturn that the Fed can’t fix by cutting rates.
Again, none of this is a guarantee that the market hedge will make money. It provides you my reasons for not being 100% long given the risks I see. You are all welcome to let me know your thoughts on this and what you’re doing. And of course, you can always disagree with me by hedging less or not at all.
Policy not Politics:
At DKI, we try to stay out of partisan politics. Given the increasing role of the government in our economic lives, we do make a point of evaluating expected policy impacts.
Spending Cuts and DOGE:
I’ve been clear for years regarding my distain for excessive government spending. Within the past few days, President Elect Trump has appointed Elon Musk and Vivek Ramaswamy to lead the Department of Government Efficiency (DOGE). I love the idea and have a lot of respect for the intentions and intellect of Musk and Ramaswamy. Unfortunately, I’m not sure they’ll be able to cut much.
First, DOGE isn’t an official government agency and only has the power to make recommendations, like any think tank. More importantly, even if President Trump likes those suggestions, it’s not clear that he’ll have the power to make the recommended cuts.
We’re going to need to check with attorneys and Constitutional scholars on this, but I don’t think that the President can just eliminate government agencies and cut wasteful spending. Much of that requires an act of Congress. Cutting spending authorized by Congress does require an act of Congress.
While the Republicans will have a majority in the Senate, they won’t have the 60 seats needed to overcome a filibuster. (If Republicans are smart, they’ll remember threats by Democrats to push through partisan legislation by eliminating the filibuster, and will realize that doing this to pass current legislation will be something they’ll regret the next time team blue wins control of Congress.) In addition, we just found out today that John Thune will be the Senate Majority Leader. He’s more of an establishment (read uniparty) politician who’s had an openly hostile relationship with President Trump in the past.
In the House, the Republicans will likely have a very small majority. In recent years, Democrats have been very disciplined in enforcing party-line votes. Republicans appear to have more open fractures and more difficulty getting everyone on the same page. (There are advantages to either approach, but this is the current landscape.) Controversial legislation may not pass even if team red holds both houses of Congress and the White House. Even with control of both houses, President Trump and DOGE do not have unlimited power to remake the government.
Musk has talked about cutting $2 trillion of spending. Worth noting, only $1.7 trillion of the budget is discretionary. To cut more would entail reducing military spending and social services, highly controversial issues that are unlikely to pass in a disunified Congress.
Even worse, everyone agrees the government spends money on stupid things, but EVERY person in Congress likes the wasteful spending in their own district. They all want to cut the bad spending in OTHER districts. This regularly leads to compromises where there’s little real spending discipline.
I’m in my 50s and can’t remember a single government agency or significant program that was ever eliminated. I’d love to be wrong about this, but I think it’s unlikely that DOGE and the President are able to make significant cuts. Complicating this is a misperception about President Trump. The media likes to present him as a dedicated conservative. In fact, when it comes to government finances, he was a big-spending liberal in his first term. (I’m talking about spending only and not commenting on social issues.)
Conclusion: I believe major spending cuts are unlikely. I hope I’m wrong.
Promoting US Manufacturing:
I hope David is right about this. While I love the theory behind free trade and comparative advantage, the impact of pursuing those policies for the past several decades has led to the hollowing out of the middle class. It’s also ensured we no longer have much manufacturing capacity which is a national security issue. We get our semiconductors from Taiwan and our pharmaceuticals from China. It’s easy to see how that can lead to multiple disasters in future conflict with the world’s second largest economy and a growing military power.
The US can barely produce ships. During WWII, we had massive industrial capacity that was repurposed to produce weapons, ships, tanks, and planes. During Covid, we got our PPE (protective equipment) from China. I think we need to start making things here again even if it means we pay a bit more.
Again, I’m skeptical of the outcome. The likely Trump method to achieve this will be a combination of tariffs and subsidies. During his first term, Chinese manufacturers sent product to Vietnam and other countries which then shipped to the US. That allowed the Chinese to avoid US tariffs. Some producers avoided US tariffs by sending product through Canada. Subsidies lead to poor use of capital and encourages rent-seeking behavior rather than the production efficiencies that encourage more investment.
I also think there’s a limit to what can be done in this arena with short-term partisan action. Many of these proposals will face opposition from Republican members of Congress and are unlikely to be embraced by Democrats. Even if the President can implement some of these ideas, he’ll only have four years in office. If you were a US-based manufacturer, would you start building factories knowing that control of the White House was likely to change parties in the next 4-8 years? Building manufacturing capacity is expensive and only makes sense if you intend to produce for many years. Doing that on temporary policy is dangerous. I expect that the US will be doing more of its own manufacturing four years from now, but am not sure it will be enough to remake the economy.
Can the Fed Go to Zero Again:
It’s a poorly-kept secret that Jerome Powell and the other Fed Governors are not fans of President Trump. In any close call on policy decisions, they’re unlikely to provide him much help. Powell has made it clear that he will not resign if asked, and likely replacement, Judy Shelton, isn’t an easy money advocate. Inflation isn’t under control and I think the Fed is going to have to slow its rate decreases. The only way they cut to zero again, is if we enter a bad recession. I don’t think that scenario leads to a higher stock market.
Conclusion:
Thanks to David for the challenging question and thanks to the other members of the DKI community who submitted questions. We’ll start doing videos to discuss some of those other issues later this week. Looking forward to more discussions with all of you.
IR@DeepKnowledgeInvesting.com if you have any questions.
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