The Blood Lust of the Vampire Squid

Inflict more losses... The blood lust of the vampire squid... Looking for government service... The speculative frenzy is alive and well... It's luck not skill, people... The mania is even bigger in the private markets...

Your net worth is about to have the life sucked out of it...

At least it will if former New York Federal Reserve President Bill Dudley gets his way.

Dudley said yesterday in a Bloomberg opinion piece that the Fed will have to "inflict more losses on stock and bond investors" to get inflation under control...

The short essay felt like a Shakespearean soliloquy. It was filled with unanswerable questions about the future of inflation, labor supply and economic activity, and even a little soul-searching on behalf of the investing masses.

Dudley said...

Equity prices influence how wealthy they feel, and how willing they are to spend rather than save.

Dudley's tone reminded me of William Shatner as Star Trek's Captain Kirk, narrating his own struggle to resist succumbing to some alien foe... "Must... inflict... more... losses..."

Members of the Federal Open Market Committee ("FOMC") are also playing hawkish notes with dramatic flair. For example, Fed Governor Lael Brainard said Tuesday in a speech for a Minneapolis Fed discussion that the Fed will reduce its balance sheet "at a rapid pace" as early as its May 3 to 4 meeting.

She also said...

I expect the balance sheet to shrink considerably more rapidly than in the previous recovery, with significantly larger caps and a much shorter period to phase in the maximum caps compared with 2017–19.

Shrinking the balance sheet rapidly means the Fed will actively sell U.S. Treasury securities and mortgage-backed securities... "Caps" means the limit to the amount of securities the Fed will sell. "Larger caps" means more aggressive selling.

The period Brainard cited includes the four months of September through December 2018, when the S&P 500 Index plunged 20%, as the Fed continued to shrink its balance sheet and raise interest rates.

Now I (Dan Ferris) am getting a little technical here, so try to stay with me...

As a former Goldman Sachs executive, Dudley will carry the mark of a vampire squid of Wall Street for eternity.

So we must ask, if Brainard's prescription is followed and the Fed sells securities more aggressively than it did from 2017 to 2019, will a repeat of the late-2018 episode satisfy Bill Dudley's vampire-squid blood lust for investor losses?... Or will we need an extended bear market to replenish his life force?

Maybe we should all just sell 20% of our stocks at once, to keep Bill from getting too thirsty.

You probably didn't anticipate us getting into undead marine-biology territory, but hey... I go where the story takes me.

And Brainard – less a vampire-squid banker than a mashed-potato-brained economist – isn't the only current Fed official with a flair for making hawkish comments... St. Louis Fed President James Bullard said in a speech in February that he became "dramatically" more hawkish as inflation hit 40-year highs.

Sounding like Humphrey Bogart in an old gangster movie, Bullard also said he wanted to see "100 basis points in the bag by July 1"... meaning a one-percentage-point increase to the fed-funds rate. Bullard was the only dissenter on last month's 0.25% interest-rate hike.

It's worth noting that many of the other, apparently more media shy, FOMC members favored a 0.5% hike but voted for the 0.25% hike because the Ukraine war created too much uncertainty... I guess these folks value a consensus more than expressing their true opinions.

I'd be a lousy FOMC member...

I'd actually believe I was there to contribute something... not just to sip my Starbucks and vote "aye" to whatever everybody else wants.

These people want us to believe they're genius economic leaders. But we don't need leadership from government appointees. We need service...

And these people are less interested in service than they are in a government job with benefits and getting their picture in the Wall Street Journal, which they can then parlay into... you guessed it... vampire-squid-sized money.

Anyway, squid or not, the Fed isn't raising interest rates very fast, and cheap credit is a primary feature of most massive financial bubbles... Rates are still near all-time lows in all of recorded history. So it's not crazy to expect that even modestly raising rates will let some more speculative steam out of stock prices.

It's anybody's guess if higher rates push stocks down 20%-ish like in 2018... or a lot more, like how Bill Dudley dreams each day.

It's also anybody's guess what happens when the world's biggest holder of Treasury securities and mortgage-backed securities starts selling $95 billion worth of them each month, as the Fed suggested it would do in the latest Fed meeting minutes, released yesterday...

Maybe there'll be plenty of new demand for all the new supply. Maybe not. But we will definitely find out.

No matter what the future brings, the bond market didn't like Bullard's comments back in February and the stock market didn't like Dudley and Brainard's recent comments... When Bullard spoke, the fed-funds futures markets instantly tacked on 100 basis points, which is a gigantic move.

When Brainard and Dudley's comments hit the tape Tuesday and Wednesday, the big stock indexes fell... As of yesterday's close, the S&P 500 and Nasdaq are down 6.5% and 12%, respectively, since January 1.

So the Fed talking heads haven't put much of a dent in the bubble. We'll see if Dudley gets his way. For now, downside potential remains significant in a stock market where...

The speculative frenzy is alive and well...

Market bubbles feature enthusiastic buying of garbage stocks. Many of these have fallen... Cathie Wood's ARK Innovation Fund (ARKK) is down about 60% since its 2021 high. But the meme-stock bulls are as enthusiastic as ever. They post embarrassingly naïve, overconfident comments on Twitter like this recent one about AMC Entertainment (AMC)...

$AMC Doesn't matter how many shares you own, just hold to the top.

It's all there in a single one-line tweet... Enthusiasm for a garbage stock. The unquestioned assumption about the future. Total ignorance of the fact that he won't know the top when it arrives. Zero mention of risk... Zero awareness of downside... Just hold to the top... What could be easier?

The meme-stock crowd on social media likes to say "We're not leaving," meaning they will not sell their shares until they cause another short squeeze.

But when the speculative frenzy is over and animal spirits have been wrung out of every corner of the stock market, nobody on Twitter or anywhere else will be saying that AMC is "going to the moon" and telling us all to "hold it to the top"...

These folks seem lost in their own private world... detached from the one you and I live in. Marketing guru Seth Godin recently summed up this aspect of speculative bubbles in a short blog post...

The very nature of a bubble is that there's an inside and an outside, an expanding reality-distortion field that assures people inside the bubble that they're doing things that are rational and normal...

But when the bubble bursts (and speculative bubbles always do), be prepared for reality to disagree with your assertions.

The guy tweeting about holding to the top is unprepared for when reality speaks up and disagrees with his assertions.

It probably seems rational to hold AMC with diamond hands if you didn't know what the stock market was before you got your first stimulus check in 2020... After all, it worked the first time around, when the stock soared more than 3,000% in the first half of 2021.

It will only seem foolish in retrospect.

Folks in a bubble don't think they're in a bubble... And they believe their newfound wealth indicates their budding financial prowess. They won't be convinced that they were just lucky until they're wiped out.

With that mindset, it's no wonder, as a Wall Street Journal headline put it recently...

'The Riskiest Bets in the Stock Market Are the Most Popular'...

There's garbage. And then there's garbage with a capital "G."

The WSJ recently reported on a 25-year-old former Chick-fil-A employee now in the U.S. military, who put $15,000 into the ProShares UltraPro QQQ (TQQQ), an exchange-traded fund designed to triple the daily return of the Nasdaq-100 Index.

The young man said he was looking to hold the fund until his stake was worth $50,000... Kinda sounds like "just hold to the top," doesn't it?

The article was published online on Sunday, March 27. The Nasdaq-100 hit its most recent peak two days later and has fallen nearly 5% since then. The TQQQ Fund is down about 10%...

I hope that young fellow cut his losses early and walked away. If he didn't, it's likely reality will disagree with his assertions about holding until he's got $50,000... It will be closer to $5,000 at this rate.

Citing FactSet data, the WSJ reported that TQQQ is the most actively traded fund this year... Its assets have risen 58% to $18 billion over the past year. The fund's share price has fallen 35% this year.

Assets in leveraged stock funds remain near the highest levels of the past decade, according to Morningstar.

The WSJ gave another example, this time of a 29-year-old human-resources worker who put 13% of his portfolio into TQQQ... seemingly with the intention to hold it long term.

But the TQQQ and other leveraged funds were not intended to be held a long time. They only promise to generate triple-leveraged returns for a given index over a period of one day... The leveraged funds' structures often involve complex derivatives, which puts them at risk of total collapse.

Perhaps you remember the "Volmageddon" event of February 5, 2018, when the CBOE Volatility Index ("VIX") more than doubled in one day and the VelocityShares Daily Inverse VIX Short-Term Exchange-Traded Note (XIV) imploded...

In a series of tweets, journalist Charles Forelle showed how the fund was "born to die." No need to delve into the technicalities... It was a levered bet the VIX would fall. The VIX went up more than its delicate structure could stand, and it collapsed. End of story, and the end of any investor money trapped in the XIV fund that day.

It's fairly obvious that folks buying leveraged funds have little to no idea of the risks they're taking. Just like the folks who bought ARKK, the meme stocks, and all the other garbage that's still out there.

But maybe I'm making this too complicated...

To see the bubble in all its glory, just look at the biggest equity index in the world...

The S&P 500 Index is less than 7% below its all-time, most-expensive closing price ever... It hit 4,796 on January 3, 2022. The index traded at more than three times sales then, its highest level in recorded history ‒ making it more expensive than it was at the 1929 and 2000 peaks... You know what happened next.

The risk in paying high valuations is not hard to understand. Valuation of any security is the value placed today on $1 of cash flow received in the future...

It's easy to understand with bonds. If you pay $100 to receive $10 per year, you're getting a 10% yield. It's up to you to decide if that's enough. If it is, you buy. If not, you pass.

It's the same with stocks, only you don't get interest payments... A stock is a piece of business, so a stockholder's claim is on the future excess cash flows that the business generates.

We don't know how much they'll be or even if they'll occur, which is why there's generally more risk in stocks than in bonds.

We tend to see the wealth generated by securities as the price you pay to buy it at any given moment. But that's wrong... The real wealth is in the cash flows. The share price is a current reflection of the market's assessment about the size and certainty of those future cash flows.

The more you pay for those future cash flows, the lower your return will be... That's simple, irrefutable arithmetic.

So when you pay more than has ever been paid before, it's only reasonable to expect a lower return than has ever been made. That can be true for a single stock or an entire index full of them.

If this sounds oversimplified to you, it's because it is. But I can afford to oversimplify, because I only have to be approximately correct and Bill Dudley's blood lust for investor losses only has to be partially sated for it to wreak havoc – if only temporarily – on your net worth.

The hard part about paying too much for stocks is that it can seem OK for a while. When prices keep rising, it tends to make folks think that valuations and even business fundamentals like profitability and financial strength don't matter.

But over the long term, valuations and fundamentals become an inviolable law of nature, like the force of gravity... They are ultimately all that matters ‒ and investors who bet that way will survive as others wind up in Bill Dudley's pancreas.

But by focusing on the stock market, maybe Bill has his sights set too low. He's settling for rats and mice when he could be drinking the blood of grade-A prime beef. Because, you see...

The private-market bubble might be even bigger...

That's the conclusion surmised by the writer who posts on Twitter and Substack under the name Doomberg.

In a recent piece titled "Crouching Tiger, Hidden Problems," Doomberg showed how private investors can execute transactions that create no real wealth but that assign exorbitant valuations to private companies with questionable business prospects...

In one example, SoftBank (SFTBY) founder Masayoshi Son guaranteed a $2 billion loan to the founder of India-based co-working firm OYO, a private company backed by SoftBank... OYO's founder then used the loan to repurchase $2 billion worth of shares from two venture-capital firms. The transaction assigned the company a $10 billion valuation.

Masayoshi Son then marked his own stake in the company based on that $10 billion valuation... OYO doesn't make money, and Doomberg says he doesn't understand how it ever will.

And remember, the folks putting up the $2 billion aren't naïve Robinhood Markets (HOOD) app users. A consortium of banks including Mizuho Financial lent OYO's founder that $2 billion... If they don't know better, who does?

In a bubble, it's very hard to find an investment so bad that nobody wants a piece of it. And it's hard for most people to fathom the opposite condition, but it'll arrive sooner than you think. It always does.

I have no trouble believing this behavior is widespread throughout the world of private investments. When the market whose task is to assign value is as illiquid as that, it can be directly manipulated to assign the rosiest valuations... at least in the short term.

Over the long term, most of those private-market manipulators' businesses will fail to produce the real wealth – the excess cash flows – and the investors who backed them will go bust.

Just like with AMC's investment in Hycroft Mining (HYMC), SoftBank's backing of the loan used to repurchase OYO shares is not about improving the business so that it might generate real, sustainable, long-term wealth.

As Doomberg put it, it's all about "painting the tape"... meaning creating a false market signal about a business that's distressed and unlikely ever to generate real wealth.

Stories like AMC/Hycroft and SoftBank/OYO suggest a world where money is like a desperate, attractive young woman, willing to accept any suitor who comes along.

Conditions suggest plenty of folks are engaging in this nonsense...

The "Vampire Squid Financial Conditions Index" measures the relative ease or difficulty of obtaining financing for new or existing ventures.

When the index is high, money is tight. When it's low, conditions are loose, and money flows easily... Today, though it's risen a bit lately, it's still near recent all-time lows.

Given that the chart is in a consistent downtrend most of the time since the early 1980s, it's fairly obvious that financial conditions have generally loosened as interest rates have fallen.

That makes sense. When lending money yields so little return that it's hardly worth doing, investors tend to seek higher returns by taking more risk.

And interest rates are still near all-time historical lows, despite the worst global bond sell-off in at least 32 years... So of course some investors are still into meme stocks and TQQQ.

Dudley said investors are sensitive to financial conditions. A significant tightening could make them fearful and bearish and more interested in avoiding downside and raising cash than trying to stay exposed to more upside.

So yes, the bubble is still here... The war in the Ukraine and the recent weakness in stock and bond markets probably prevents many people from seeing that. But it seems rather obvious to anyone who takes so much as a peak below the surface.

You probably already know what I'll say you should do about all of this...

The first thing I'd recommend is raising cash by selling any speculative garbage stocks you own... Sell meme stocks... Sell TQQQ or anything other levered fund you might own.

When asset prices fall – and they always do, eventually – there is no substitute for cash. It's one of the few assets you can trust to hold short-term value during market declines.

And when assets become attractively priced, you'll be glad you have the cash to take advantage of them.

That's not a prediction of lower asset prices. It's a recommendation to prepare for them...

Preparing means seeking out great businesses that will create massive wealth over the long-term. When you find them, buy them... at the right price.

You can prepare for the relentless long-term decline of the value of the U.S. dollar by owning gold, silver, bitcoin... maybe some land... or other assets you believe will maintain their value over time.

Cash, stocks, gold, silver, and bitcoin.

That's a core portfolio that'll prepare you for a fairly wide range of future scenarios.

I would also recommend not being so foolish as to base your investment decisions on certainty about the future. You have none. Nobody else has any, either.

In short, as I've said many times...

Prepare, don't predict.

And if you think your travels will take you anywhere near Bill Dudley, for goodness sake, wear a stainless-steel turtleneck.

New 52-week highs (as of 4/6/22): AbbVie (ABBV), Bristol-Myers Squibb (BMY), Brown & Brown (BRO), Costco Wholesale (COST), Dollar General (DG), Franco-Nevada (FNV), W.W. Grainger (GWW), Hershey (HSY), Johnson & Johnson (JNJ), Coca-Cola (KO), Altria (MO), Novo Nordisk (NVO), Sprott Physical Uranium Trust (U-UN.TO), Westlake Chemical Partners (WLKP), Walmart (WMT), and Utilities Select Sector SPDR Fund (XLU).

A great mailbag today. We have a variety of feedback on yesterday's Digest, which included talk about rising interest rates and the war in Ukraine... And our subscriber conversation about the oil market continues... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"I thought the discussion of Buffett's Law and the relationship between interest rates and the market to be extremely well stated and useful to the average investor. Thanks to Corey McLaughlin." – Paid-up subscriber Ken D.

Corey McLaughlin comment: Ken, you're welcome and thanks for the note.

We're always trying to share useful, easy-to-understand information, so when we hit the mark with even one person, it's good to hear it, so that we know whatever we did that day worked...

Same goes for when we're not being useful or perhaps too complicated in our explanations... Anyone has an open invitation to let us know when that happens too, so we can do less of it.

"Everyone seems to be focused on what rising interest rates mean to families and businesses.

"Somebody should take a minute and calculate how much more it will take to service the national debt, what government handouts and earmarks are going to cost when the Fed is done raising rates.

"This country has had the privilege of being the world reserve currency for so long the powers-that-be have forgotten that it is a privilege that can be taken away. When that happens, the inflation of today will be half or less of the inflation to come." – Paid-up subscriber Todd H.

"Russia seems to have pulled back their invasion to the Eastern border (where the majority of Russian speakers live), and along the Southeast toward the warm water ports of Crimea and Odessa. Mr. Putin will control that arc of land and control all shipping. If hostilities cease, how would a much smaller Ukraine (if it remains a sovereign country) export the commodities the globe wants to buy?

"It seems Russia is already pivoting toward China/Asia as trading partners... And we all know the Asian countries will buy all of the supply. This is a disaster for the Europeans and will most likely take down their economies first. It's great for the Chinese for the commodities and food that they can import to feed their giant population. And it's terrible for the future inflation prospects for America... driving a larger wedge between the haves and have-nots.

"China has been buying grain commodities from U.S. stockpiles... for deliveries this year and next year. Smart move to hoard the world's food/grain supply. How did we ever get into this situation? Political gamesmanship in the U.S. on both sides of the aisle. And gamesmanship on a global scale between NATO/West versus China/Russia. Time to personally get out of debt, own tangible items, stock some supplies... and pray!" – Paid-up subscriber Rob C.

"Regarding the comment about fertilizer shortages... 'We'll likely see farmers and companies like General Mills (GIS) hike prices to account for increased overhead.'

"Farmers don't get to set prices. We are price takers. General Mills uses it as an excuse to raise theirs, but it doesn't flow through to the farmers.

"They sure like to blame the farmers for the increases though, and when the crop prices fall why don't the food prices fall?" – Paid-up subscriber Todd D.

"Let's be real about farming: It's the only industry in America whose business model is to buy at retail and sell at wholesale. It's a hard business. Consequently, it's impossible to raise prices just because costs go up.

"Remember, it's all about demand and supply for commodities, which is what farmers produce. Now, if the supply declines because acreage is taken out of production because of unbearable costs or, say lack of water, then prices go up because the equation tips." – Paid-up subscriber Neil B.

"Even with the price of oil over $100 a barrel, the oil companies that operate in the Bakken oil shale fields of North Dakota are being very slow to improve their fields.

"Once opened, a shale oil well needs to be kept open, by pumping, otherwise it'll collapse, and need to be re-drilled. Hydraulic pressure needs to be maintained to keep it open. That is equilibrium.

"Due to variable-speed control of motors that power the pumps, wells have been running, to keep open at a very small percentage of total output. A small tweak of the speed dial goes from 5% [above 'minimum flow requirements'] to 10% speed, without the need to drill a new well. Price rises? Dial up to 15%!

"Stopping pipelines is a major portion of their distrust in the future of oil. Where will civilization be in the future without oil of some kind? Lubricants for every machine that make modern life possible require oil of some sort.

"Chicken fat derivatives? Not whale oil, as in the past. [That whales are an] endangered species, especially a mammal, is understood. Vegetable oils? Where are we going to grow them? Do they stand the pressures involved in our modern machines? Short answer: No.

"We can now manufacture diamonds at less cost than mining natural diamonds. That comes from pressing carbon at phenomenal pressures, at very high temperatures, due to petroleum oil derivatives, both hydraulic pressure and (mostly) oil derived electricity.

"Just think about it!" – Paid-up subscriber Gerald F.

Good investing,

Dan Ferris
Eagle Point, Oregon
April 7, 2022