Portfolio Update: The Real Risk Beneath the Markets
This is what we need to look at and pay attention to. It's not inflation.
I have been under the impression that the markets bottomed on May 12th when ARK’s innovation ETF, ARKK, made a full round trip to COVID crash lows. To me, this represented the true froth and bubble that existed beneath the markets despite main stream media narrative. What’s unique is that it wasn’t only “tech stocks”. The bubble existed in nearly all stocks excluded from the major index’s.
In this weekend’s newsletter, I want to emphasize and bring attention to the real risk that exists in today’s financial system and broader economy. Inflation is not necessarily the biggest risk, not trying to downplay this, but in my opinion, deflation is.
We are going to talk about what is going on today, with the context of economic history, to shift our attention to an area we MUST be cautious of as it develops. Also, of course, like every week, I will provide an update to my long term growth stock focused portfolio.
As a quick update, this week is a very important one from both an earnings and economic perspective. I have seen a few authors discussing what is going on this week, so I wont go too much into detail. To give a spark note style:
CPI (consumer price index) on Wednesday is probably the most watched economic event going on this week
PPI (producer price index) on Thursday can be thought of as a ‘leading data point to CPI’
Mortgage applications on Tuesday will give us a pulse on what’s going on in the housing market. We should expect weakness here because mortgage rates rose so rapidly
University of Michigan sentiment, which hit an all time low last month, may head lower
Notable bank earnings (below) from JP Morgan, Morgan Stanley, BlackRock and Citigroup
The bank earnings will certainly give us additional insight into the economy and outlook for the financial markets. These will be worth, at least, reading through to see what sort of economic indicators they are watching.
Alright, now, let’s talk risks and history
The Stock Market and Economic Cycles
I often discuss market cycles, as every investor should at least be aware of what they are and use them to their advantage. However, I have never really distinguished too much between the two types of cycles within the economy:
Cyclical - lasting a short period of time, typically a temporary bump in an ongoing secular trend
Secular - lasting for a much longer, typically years, secular forces are significantly stronger and typically deep rooted in structural trends
Within the economy today, for the past 100+ years, there has been no stronger, more forceful, cycle than the credit cycle. Typically the credit cycle works both in secular and structural trends. Cyclically, it behaves much like the image below.
We go through periods of credit growth and contraction. The last “true” contraction and default of the credit cycle we witnessed was in 1929. The market declined nearly 90% and unemployment reached 25%.
2008 - 2009 was the closest we got to a repeat of the secular bear market, economic contraction and collapse in the credit markets. Fortunately, the Federal Reserve (through aggressive monetary policy) stopped the contraction before it cascaded to become the next Great Depression. During this period, the stock market declined 57% from peak to trough and unemployment peaked at 10%. I am convinced we would have met the Great Depression’s unemployment rate and possibly then some if not for the intervention of the Federal Reserve.
When looking at both events, they were surprisingly similar from how they formed to how they ended. The qualities they have that are similar:
Both were a result of an inflated asset bubble
Both were driven by a rapid expansion of credit (money creation & loans)
Both had poor lending practices
Both had rampant speculation (a “narrative”)
Both ended when the government spent money, expanded credit and the Federal Reserve funded it
In the 1920’s the bubble existed in the stock market. Investors/Speculators began to believe that the market could only go up. As a result, investors would take margin out on their homes and invest it in the stock market. At the time, the world believed American business would never collapse, therefore the stock market would always go up. Narratives are dangerous and so is herd investing.
In the 2000’s, the bubble existed in the housing market. Investors and flippers would speculate and took over leveraged bets. In addition, unqualified home owners were receiving loans that they would never pay off with crafty incentives and HELOC’s that superseded the value of the home. The thought process behind this was that “the housing market would never crash”.
Perhaps the most interesting and important comparison is that “good times” created the “bad times”. In other words, the boom led to the bust. Easy lending standards created the bubble that was popped when the assets declined.
Does this sound familiar yet?
Today is Not Different, It Just Rhymes
The asset bubble is not necessarily in the stock market this time, or even the housing market.
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