How Did I Miss This?
I keep a quarterly big-picture investment journal to catalog my current thinking on the markets. It’s kind of a quarterly investment letter to myself. In reflecting on how and why I completely missed on markets YTD I recently went back and read them.
Here are some of the things I wrote, in chronological order:
April 6, 2021:
HIGH INFLATION IS THE BIGGEST RISK, BUT I DO NOT THINK IT WILL MATERIALIZE
The major risk I perceive for stocks at the moment is inflation. I can imagine a world where all the money being injected into the economy results in higher prices for not just financial assets but also consumer goods and services. Typically, to combat high inflation central banks will raise interest rates and in a rising interest rate environment, stocks and bonds will likely perform poorly. Asset classes that I expect to do better in an inflationary environment are hard assets like real estate, gold, oil, and perhaps bitcoin and other cryptocurrencies in today’s world.
While I think high inflation is a risk investors need to be aware of and prepared for, I do not think it will ultimately come to pass. I think the deflationary pressures from technological advances will be the dominating long-term influence on the inflation rate. For example, electric vehicles are a relatively new technology and the most expensive component in an EV is the battery. Battery technology is improving at a rapid rate and the cost to produce them is falling. This means that while we might expect price of a new Toyota Camry, about $20k, to continue rising a few percent a year, we can expect the cost of a new Tesla to continue to fall and eventually become cheaper than a Camry, and for a much higher quality vehicle. Likewise, just as Zillow is taking costs out of the home buying and selling process by eliminating the 6% agent fee, medical breakthroughs like a cure for cancer might substantially reduce healthcare costs, and ETFs replace investment advisors and mutual funds at a fraction of the cost. Though you might not notice it in everyday life, everywhere you look costs are being taken out of the system and I expect this to accelerate in the decade ahead and keep a lid on inflation.
Nevertheless, inflation poses a serious threat to the stock market which investors must be robust to.
July 12, 2021:
The US stock market had a strong Q2 up 8.1%. The strength was driven by a dampening of the inflation fears I mentioned last quarter. Despite my view that high inflation (sustained 4%+) will ultimately not materialize, I do still think inflation is the biggest risk to the stock market over the remainder of this year and so I’m evaluating if the recent drop in inflation expectations presents an opportunity to hedge against this risk cheaply. In particular I’m thinking about an allocation to PFIX.
I continue to be bullish stocks and predict we continue to move higher over the second half of 2021. Capital is abundant and my view is that stocks are not priced for that reality yet and should be higher. In the medium-term (2022-2024 time range), in addition to inflation, the Fed raising interest rates and US-China relations are risks that need to be monitored and could negatively impact stock market returns.
October 29, 2021:
As I’ve previously written, the #1 risk to the market at present in my view is inflation. Inflation is currently running at about 5% year over year. There is debate over whether this is temporary (owing to easy comps due to lower demand and prices in 2020 due to the effects of Covid) or permanent (owing to the unprecedented increase in the supply of money by the Fed and other global central banks). My view remains that it is temporary. Try as we might, we have been unable to generate sustained inflation above 2% for the last 30 years owing to demographics, technological deflation and global demand for US dollars – all long-term structural forces that are still at play. However, in the event the market becomes convinced inflation is permanent, out of control and/or the Fed begins to raise interest rates, I would expect stock prices to fall significantly, on the order of 20-40% from highs over some period of time.
The question becomes how to best position the portfolio for all possible outcomes, weighted by the probability of each outcome. In pondering this in relation to the question of inflation/hyperinflation over the quarter, my answer became clear. “Hard money” assets offer the best protection and BTC and ETH are arguably the two best available. And, unlike other inflation hedges, they also offer the possibility (I would argue, probability) of outperforming stocks in a non-inflationary environment as well.
January 21, 2022:
As I’ve previously written, the #1 risk to the market at present in my view is inflation. The good news is that in Q4 the Fed took significant steps in assuring the market that it was taking the inflation threat seriously and announced a plan to begin shrinking their balance sheet and raising interest rates to combat it. The bad news is that this has caused “risky” assets to sell off.
Of course, in hindsight one might have predicted the short-term pain from such a switch in monetary policy. Indeed, the last time the Fed embarked on a tightening cycle the market sold off near 20%. It turned out to be a magnificent buying opportunity (as crashes usually are) as, after some short-term pain, the market resumed its steady ascent.
Today’s drop is nowhere near as large yet as we experienced at the end of 2018, and it is anybody’s guess how far we might have to go. Instead of engaging in a game of trying to time the market, in times like this I try to remind myself that cheaper stocks (and crypto) are a good thing for investors, not a bad thing, provided I don’t sell low. Lower prices today mean higher future returns.
Rule #1: don’t sell low
Rule #2: see Rule #1
Time will tell if this is just a blip like 2018 or the start of something more sinister, like a prolonged bear market the likes of which we haven’t experienced since 2007-2009. I’m betting on the former and predict price levels will likely recover in short order.
I think this is a case of the market taking its medicine with respect to the inflation bug, and suffering some necessary short-term discomfort in order to be more healthy in the long run. Indeed, with the Fed seemingly committed to fighting inflation, I believe the biggest overall risk to the stock market has been reduced, not heightened.
May 5, 2022:
It has been a rough start to 2022 for financial markets.
Through April, the S&P 500 was down 13.8%, it’s worst YTD performance through the end of April since World War II. Not even during Covid in 2020 was the market down YTD through April as much as it is 2022!
Two main things have taken place in 2022 to shake confidence in markets and dramatically heighten uncertainty: Russia’s invasion of Ukraine and the US/Europe’s subsequent reaction with economic sanctions, and inflation as measured by the CPI continuing to surge higher. I will cover both briefly below.
But, and with a healthy dose of humility, I will start by saying that in my opinion the events of 2022 have only served to increase the probability bitcoin’s success over the long-term. While steep drawdowns are never fun in the moment, they are the price of superior long-term returns.
As I write this today on May 5, 2022, the market is down 5% and threatening to make new YTD lows.
Some stocks have become exceedingly cheap. For example, PayPal is below its March 2020 covid lows despite tremendous growth in revenues and profits over the last two years, and a structurally better business due to the rise in online shopping that covid necessitated. There are many stories similar to PayPal in the market today.
Nuclear war notwithstanding, I firmly believe we will look back in hindsight at the current period as an extraordinary opportunity to buy BTC, ETH and market-leading growth stocks such as PayPal.
WTF Happened?
Number one, and I believe the biggest driver of the negative price performance YTD, is that CPI inflation has continued to surge in 2022 and last month was 8.5%, the highest level in the US since 1981. In response, the expectation for the Fed to hike interest rates has increased and sent markets into a tailspin.
We’ve covered inflation before. I confidently believe that today’s inflation is caused by temporary pressures on the supply chain, will abate, and is not structural. If this turns out to be true, I expect markets to come roaring back in the second half of 2022.
Here’s how I could be wrong.
1) Russia’s invasion of Ukraine triggers massive and rapid deglobalization, and the increase in the cost of goods is structural due to it costing more to make things in the US than China (for example), and due to higher prices in commodities such as oil because we have taken Russian oil off the market (reduced supply).
2) The unprecedented amount of global stimulus to fight covid was too much, and has lead to an overheating economy and runaway inflation (this seems very unlikely given that US just reported negative GDP growth in Q1, suggesting we are more likely in a recession than an overheating economy).
Number two, Russia’s invasion of Ukraine has, in addition to stoking fears of “WWIII” further complicated supply chains that were already in chaos and has increased inflation even more due to the second order effect of massive amounts of oil, gas and wheat being taken off the market due to sanctions and war.
These two risks persist, as well as the ever-present risks lurking under the surface that are only revealed after it’s too late. Nonetheless, I firmly believe 1) these risks will abate over the 2nd half of the year and 2) asset prices fully reflect these risks and absent a dramatic escalation of the war, some are plain bargains.
Clearly, the inflation story didn’t take me by surprise. I consistently highlighted it as the #1 risk to markets and predicted that stocks would be down 20-40% if high inflation persisted. Yet, I never sold long-duration assets, nor bought puts, to protect myself from such an outcome. Why?
Was I just feeding myself a steady diet of copium and hopium?
HOW DID I MISS THIS!?!?
The truth is, I thought better days were around the corner every step of the way.
Hopium!
I was firmly on team transitory, and still am.
Copium!
I was all bulled up on the ETH merge and thought that so much money had been put into the system that crypto had potentially much higher to go in this cycle. I thought that the May-June 2021 drawdown in crypto was the reset needed to propel us another leg higher. I thought $100k bitcoin was inevitable.
In November 2021, it seemed like I might be right as crypto was making all-time highs, with bitcoin reaching $69k, despite the growth-tech end of the stock market getting wrecked since February 2021 and SaaS multiples having already come way down. It seemed to me at the time like crypto had decoupled from the ARKK complex. The inflation hedge narrative was picking up steam just as inflation was picking up steam, and price was confirming it.
I thought families were going to be getting together at Thanksgiving for the first time since the onset of the pandemic, and Nephew Kyle was gonna tell Uncle Bill about all his NFTs, and we were going to see a repeat of 2017’s December blowoff top.
I was haunted by my perception that my biggest investing mistake time after time in my career was taking gains on BTC and ETH too early. I had put in the time and done the work to better understand the assets and have long-term conviction, regardless of price action.
BTC up 100% and ARKK flat from July 12, 2021 to November 9, 2021! CPI at 5%! BTC is an inflation hedge!
I thought that Covid was going to rip through winter and team up with the transitory narrative to give the most dovish Fed we’d ever seen an excuse to keep their foot on the accelerator. I believed (believe) that deep down, the political pressure and motivation to just keep on printing would be the overwhelming driving force of Fed policy.
Turn’s out legacy and embarrassment are pretty big motivators as well.
Here are the reasons I thought stocks, and in particular crypto, still had a long way to go up as recently as November 2021:
I thought easy monetary policy (interest rates at 0 and QE) was going to continue until late 2022 or 2023 because the Fed was focused on Omicron and saying more stimulus was needed to fight the ongoing pandemic, and 2022 was an election year so the political pressure to not take away the punch bowl would be intense.
I thought elevated inflation prints were due to transitory effects of short supply stemming from pandemic closures that would be rectified as economies re-opened, and would not prove to be a structural, long-term issue to contend with.
If inflation did get out of hand, I thought crypto would be relatively insulated as a hard money asset and a growing narratives around 1) being an inflation hedge and 2) central bank incompetence.
I thought more fuel was about to be dumped on the monetary fire in the form of fiscal stimulus, with another $3 trillion Build-Back-Better bill making its way through a democrat-controlled congress and seemingly inevitable.
I thought the Ethereum merge, perpetually 3 months away, offered a market structure supply/demand anomaly that would potentially offer generational returns.
Today, we can conclude that 1, 3 and 4 above were definitely wrong.
Many would say 2 has also proved definitely wrong although I would contend the jury is still out – inflation has only been above 2% for not even 18 months now and is beginning to roll over. Coooooooppppiiiuuummmmmm.
Regardless, inflation rose to higher levels that I expected at the time and, as I reminded myself repeatedly, was and is the greatest risk to asset prices.
5 is still ahead of us – the merge has been pushed out several times and now is expected to be completed in September of this year. Even if my thesis ultimately proves correct, I was definitely wrong on the timing.
So, what were the warning signs, and why did I not react to them?
Warning Signs I was Wrong
The first warning sign was elevated inflation. Again, this risk was not ignored, and I wrote about it in every quarterly letter as the primary risk to markets. This of course makes it incredibly frustrating that I did not react properly to it. However, the exact path of inflation is difficult to predict, and I’ve consistently thought that the balance of probabilities was that it had likely peaked and would begin to come back down toward 2%.
The next warning sign was when Joe Manchin killed the Build-Back-Better bill in December 2021. At the time, inflation had continued to increase, and I thought that passing the bill would have stoked inflation fears and been negative for markets, so the bill getting terminated was actually a net positive for stocks. It’s hard to say if this take was correct or incorrect but given the inflation hysteria we’ve witnessed since I believe it was probably correct, and a passing of the bill might have resulted in an even swifter or deeper drawdown.
At the same time (December 2021), the Fed began jawboning the market on inflation. They brought forward their estimates of rate hikes and QT. In retrospect, this was the time to sell or purchase insurance. If I’ve learned one thing over my career, it’s don’t fight the Fed. Maybe it is really that simple. Surely, one day that trade will break, too.
But, frankly, I never even considered selling crypto in December 2021 because 1) I already had a massive tax bill coming due and was extremely averse to adding to it by taking more gains before year-end 2) I thought the hard-asset inflation-hedge narrative was correct 3) I was, and am, extremely convicted in the long-term potential of the asset class and last but not least 4) ETH merge just around the corner, bro.
And, as mentioned, in growth stock land valuations had already come in a fair bit. ARKK and SaaS had peaked in February 2021 and by December 2021 I thought plenty of long-term value was offered by the stocks I owned.
Instead, I took solace in the view that whatever happened over the next 5 months, I firmly believed that in 5 years the assets I owned would generate good to great returns.
February 2022: Russia Invades Ukraine
Then before the Fed was even able to get off one rate hike, all hell was breaking loose.
When it happened, I thought it would be over in a matter of weeks. Again, wrong.
Although clearly the invasion and subsequent sanctions on Russia would disrupt global energy supply and exacerbate already high inflationary pressures (as I wrote at the time in my journal), stocks had already immediately sold off in reaction to the war and my dominant thought posture became “well, I’m not going to let the fear reflex take over after a 15% drop caused by a geopolitical event that I think is going to come to a rapid conclusion.”
The war had begun, and the risks associated with war more acutely priced in.
I even reasoned that the US sanctions regime and the freezing of Russian Central Bank US dollar assets would prove a catalyst for bitcoin adoption by global central banks, as the value proposition of a global, decentralized, non-sovereign, censorship-resistant monetary asset had never been made more abundantly clear on the geopolitical stage.
Since then, the war has raged on and the consequential soaring price of energy has pushed inflation even higher and tightened financial conditions. The Fed has become terrified they’re going to be remembered as the Fed that let the inflation genie get out of the bottle and is seemingly willing to hike interest rates aggressively into a recession to avoid that legacy. And, collapsing asset prices have triggered several forced liquidations in the crypto ecosystem, which have pushed prices to even more depressed levels.
So, I missed it. Now what?
It seems likely to me now that the Fed is hell bent on hiking rates until either 1) inflation is tamed 2) something breaks, or 3) they simply can’t any more due to US debt load and the inability to service the debt at substantially high interest rates. I don’t think a falling stock market is going to give them any pause. It will take something like credit or treasury markets freezing up to get them to stop absent the other two conditions.
My base case is that something indeed breaks and/or inflation begins to come in and allows the Fed to not keep hiking into a recession. In the former, we probably have a leg lower to go; in the latter, the lows are likely in.
Either way, we will get a pause, likely followed by a pivot. This is when you want to get f**king long risk assets again.
Don’t fight the Fed.
The money spigot will turn back on, and the whole cycle will begin anew.
Ironically, this is the raison d’etre for Bitcoin in the first place. To free us from the tyranny of a group of 7 Economics PhDs deciding interest rates, monetary policy, and global financial conditions while the rest of us have our employment prospects and savings whipped around by their whims. To free us from the financial repression of high inflation and low interest rates. To free us from the never-ending boom-bust cycle exacerbated by Keynesian central monetary authorities. To free us from the prospect of having the government surveil our every financial transaction with Central Bank Digital Currencies.
To have freedom, and to be free.
Longer-term, as we look out 5-10 years, I see two potential likely paths forward:
Deflationary forces (technology, debt, demographics) overwhelm inflationary ones (tight energy markets, deglobalization), inflation falls back to sub-2% levels, and the Fed resumes their pattern of stimulating to try and get inflation up to 2%. This is basically the world we have lived in for the last ~40 years (since the last time we had high inflation in the 1970s) and is bullish for asset prices. This is my base case and I believe it is a contrarian view at this point.
High inflation does persist, but the Fed is not able to hike rates beyond a certain point to combat it because doing so would make the debt service too large relative to the size of the U.S. economy (i.e., the U.S. would not be able to fulfill its financial obligations and would default on its debt). The national debt is technically reset by a period of sustained high inflation and low interest rates — financial repression like what was experienced in the aftermath of WWII in the 1940s. I believe this is the significantly more painful path forward and is a world more challenging for financial assets such as stocks and bonds. Hard assets such as gold, real estate, and bitcoin (I still believe) probably do relatively well. Some stocks, such as monopoly-like businesses with pricing power (FAAMG), businesses with high gross margins (SaaS), innovation stocks that can outgrow high inflation (ARKK), or businesses with significant debt but stable, predictable cash flows and pricing power (potentially cable) I think would do well relative to SPY. Low gross margin businesses such as retailers and banks I think would underperform due to being relatively less able to handle an increase in COGS and an inability to earn interest at higher rates than inflation.
So that is the world as I see it today.
Perhaps we are in a short, sharp recession and technological advances and human ingenuity will again lead us out and into another period of peace and economic growth. Or, perhaps we are on the cusp of a great global reset, necessitated by the heavy debt loads of governments and the inability to raise interest rates to combat high inflation.
Regardless of the macroeconomic outcome, I believe crypto networks will continue to be adopted and disrupt the traditional financial system, making it more open, accessible, fair, transparent, efficient, and resilient. I believe capital will continue to find its way into the space and crypto asset valuations will appreciate.
The accelerating advance of technology is not going to just stop because muhhhh inflation. I have the utmost confident in that.
As Mark Andreesen said, software is eating the world, and I believe we are in the process of witnessing crypto (software) eating the global financial system, in a race against the global financial system eating itself.
For years everyone exhausted the point how finance was the only sector to not be disrupted by technology. Now that that disruptive technology is upon us, many are in denial.
What Would It Seem Like, If It Did Seem Like?
I’ll leave you with paraphrased thoughts borrowed from a book I’m reading – Bitcoin is Venice by Allen Farrington and Sacha Meyers.
Ludwig Wittgenstein once asked a friend “Tell me, why do people say it is more natural to think that the sun rotates around the Earth then that the Earth is rotating?”
The friend said, “Well, obviously, because it just seems like the sun is going around the Earth.”
Wittgenstein replied, “Well, what would seem like if it did seem like the Earth was rotating?”
What would it seem like if it seemed like a global, digital, sound, open, programmable money was monetizing from absolute zero?
It would seem like a promise of superior certainty in the future, with an admission of increased uncertainty in the present.
It would seem like as much an exciting and dangerous narrative and experiment as a provable guarantee.
It would seem like widely disparate views, rapid change, and no consensus, with sentiment ebbing and flowing unpredictably as the merits of the promise of the future certainty from the challenger and the supposed failures of this promise from the incumbent were constantly being weighed and re-weighed by the market.
It would seem like superficially extreme uncertainty masking such a substantial improvement in the promise of protection from dilution that the nuisance of the uncertainty of the period of emergence could credibly claim to be outweighed.
If it did seem like a global, digital, sound, free, open-source, programmable money was monetizing from absolute zero, it would probably seem a lot like this.
Disclosure: the author owns BTC, ETH, PYPL, and stocks in some of the indexes, funds and sectors mentioned.
Disclaimer: nothing published in this newsletter is investment or financial advice. The author may be long or short any of the securities or assets discussed at any time before or after publishing.