Lessons From the First 'Hedged Fund'

A short work week... A possible bottom in bonds... 'More Money Than God'... The point of hedge funds... Inflation killed the buzz... The same, but worse... The case for gold...

It's a short but potentially pivotal trading week...

With Memorial Day closing the markets yesterday (and thank you to all our veterans out there), it's a short work week for Wall Street. But it could be an important few days, especially as the weekend nears again.

On Thursday, Uncle Sam will report a "first revision" to its first-quarter GDP number, which stands at 1.6% as of the first estimate several weeks ago. The government posts two estimates (one each month) before settling on a final quarterly number.

Even more important, on Friday, we'll see the April update for the Federal Reserve's preferred inflation gauge – the personal consumption expenditures ("PCE") price index.

As I (Corey McLaughlin) have reported, the pace of inflation has been running "hot" so far in 2024, and this has implications for stocks, interest rates, and pretty much all assets.

Despite what you might hear elsewhere, the current annualized inflation rate of "core" PCE – the one the Fed says it weighs the most – is closer to 4.5% now than to the central bank's supposed 2% goal. This is based on the month-over-month data from the first quarter (0.5% inflation growth in January and 0.3% in February and March).

Another set of numbers on the current pace would suggest inflation is still running high(er). Alternatively, a more "modest" inflation growth of 0.1% or 0.2% could ease concerns about inflation rebounding.

Remember, we're talking about the pace of price increases... They are always happening.

Whatever the news and its real-world impact, the inflation report Friday morning will likely resume the debate about the Fed's monetary policy: whether the central bank has let inflation get out of control again... or could cut interest rates sooner than expected (possibly inciting further inflation).

So, expect some volatility toward the end of the week.

Our Ten Stock Trader editor Greg Diamond is preparing...

As Greg shares in his Diamond's Edge video series this week – available exclusively to Digest readers each Monday (or Tuesday in the case of Monday holidays) – he's eyeing the path of interest rates and bonds in the context of these upcoming economic reports.

This week, Greg shares what signals he is looking at, including a possible indicator that could confirm whether bonds (which trade inversely to yields) may have finally bottomed out. They've suffered a multiyear drawdown since the Fed began hiking rates in 2022.

If bonds do stop falling, this could lead to a huge move higher for stocks, Greg says. But he's considering other alternatives, too. As he explains in this week's video...

The other side of the argument is that if inflation is starting to come down, and maybe the Federal Reserve starts cutting rates, this is a sign that the economy is weakening... I don't doubt that for a second, but that's probably 12 to 18 months out...

What we would have in the beginning is [the market] saying the interest rate has changed. This is going to be good, at least in the short term, because interest rates are going to come down and stocks are going to react positively to that.

After six months, 12 months, whatever it might be, if indeed inflation is coming down because the economy is cooling off and is not as robust as some might think, yes, that's when you see an increase in bond prices probably start to be priced into stocks as a bad thing.

But in the short term, this is what I'm looking at in terms of a trading setup...

Check out Greg's video for more.

For now, it's 'higher for longer'...

Remember, the story since 2020 has been high(er) inflation than Wall Street and many mainstream talking heads expected. Eventually, but far too late, the Federal Reserve began raising interest rates to "cool" the economy.

As rates rose in 2022, folks clung to false hope that inflation would instantly plummet and rate cuts would quickly follow. Now, it's the middle of 2024... and rate cuts still haven't happened yet.

The annualized pace of "official" inflation is around 4.5% over the past three months. The unemployment rate is under 4%. Second-quarter GDP estimates – for whatever the GDP metric is worth, even if not much – stand at 3.6%.

Today, in the latest "Fed speak" signal, Minneapolis Fed President Neel Kashkari said he wants to see "many more months" of data pointing to easing inflation before the central bank would cut rates. This repeats that precise phrase from another Fed member last week.

They're telling you something...

In my view, if current trends continue, meaning "hot" inflation and growth, interest-rate cuts from the Fed won't or shouldn't happen until next year, at the earliest. In the meantime, the economy could see more inflation and perhaps even another rate hike down the road...

As Greg explained, though, expectations for interest rates could remain steady. Given that the central bank seems disinclined to even consider another rate hike, the "Fed pause" trade could have even longer legs. And that's typically bullish for stocks.

Stock prices, generally speaking, could go up until the story changes. Inflation hedges like gold and other commodities could do the same. And this brings to me a point about hedging...

Lessons from the first 'hedged fund'...

Earlier today, I was listening to some of Sebastian Mallaby's 2010 book More Money Than God. The book is about the start of the hedge-fund industry decades ago, along with its rise and influence on finance over the years. The narrative includes many worthwhile investing lessons.

The first? When former Fortune magazine journalist A.W. Jones set up a then-innovative firm structure in 1949 using leverage for bullish bets and short-selling protection, he called it a "hedged fund."

He outperformed the market and leading mutual funds in good times and maintained capital in bad times – losing money in only three of 34 years. That's because his bearish bets on U.S. stocks properly weighed against the bullish part of his portfolio.

The second lesson: Near the end of the boom that lasted from the end of World War II into the late 1960s, Jones' model was relatively quickly copied (with an important distinction to their detriment) by hundreds of imitators.

The slightly adjusted term "hedge fund" entered the Wall Street lexicon, and it was a hot new movement. But as Mallaby explains, many of these new hedge funds weren't "hedged" at all.

Many were just using leverage (borrowing to buy more stocks) to make bets in a bull market. Many of these fund managers were relatively young and knew nothing but stocks going higher. They were caught up in greed, and they abandoned short selling.

Then the market sank about 35% from a high in December 1968 to a low in mid-1970, and most of these un-hedged funds got wiped out. Overall, 28 of the largest hedge funds lost two-thirds of their capital. (This was one of the few periods when Jones lost money, too, as his firm also got overly aggressive, but not enough to put him out of the game completely.)

This brings me to lesson three, which is tangential to "hedged funds" themselves but relevant to today's market. The catalyst for the "surprise" losses for many of these early funds was... inflation...

As Mallaby writes...

The nation had brimmed with confidence in the previous two decades. Jobs were plentiful, wages rose, and finance was almost quaintly stable. The dollar didn't fluctuate because it was pegged firmly to gold. Interest rates moved within a narrow range and were capped by regulation. But starting in the late 1960s, inflation tore this world apart.

Having stayed below 2% in the first half of the decade, it hit 5.5% in the spring of 1969, forcing the Federal Reserve to jam on the monetary brakes and squeeze the life out of the stock market. The bear market that followed was only the first shock.

In 1971, the Nixon administration was forced to acknowledge that inflation had eroded the real value of the dollar and it responded by abandoning the gold standard. Suddenly, money could be worth one thing today, another tomorrow.

The realization inevitably fueled further inflationary pressure.

Another round of "tightening" soon followed from the Fed, and the market crashed again in 1973 and '74... with the benchmark index losing more than 50% of its value from peak to trough.

This financial history anecdote offers multiple lessons. First, always remember that the original (and successful) purpose of the "hedge fund" was to be sufficiently "hedged" and not just leveraged, an important part that many of Jones' imitators ignored.

By January 1970, after the bear market of 1969, Wall Street had an estimated 150 hedge funds, down from as many as 500 the year before. And the second crash a few years later "wiped out most of the rest of them," Mallaby wrote.

And there's an embedded point about gold and today's environment as well...

As we've written here before, August 15, 1971 was the "day the dollar died."

And if you're anything like me, I'm willing to bet many of you might be recognizing the similarities between the period of the late 1960s to the early 1970s and today...

Inflation hit nearly 10% in 2022, according to the consumer price index ("CPI"). Core PCE peaked at 5.5% in September 2022... and is running around 4.5% in the past three months. The market experienced a bear market "shock" in 2022 as the Fed hiked rates from near zero to 5%.

The pace of inflation, after coming down in 2023, has accelerated in the first part of 2024.

Today, the U.S. can't abandon the gold standard, because the government already did in 1971. Now, Uncle Sam is running multitrillion-dollar deficits annually (inflation fuel). Could another "shock" be on the way?

It appears as if Uncle Sam's only answer for financial troubles is to let loose more money into the economy – "temporary policy," it's often called – which permanently reduces a dollar's value when each new dollar (or trillion dollars) is created.

And this is precisely why owning "hard assets" – like gold or other commodities – or having exposure to them in an investment portfolio is worthwhile today. The government may have abandoned the gold standard decades ago, but that doesn't mean you have to give up on the concept of hard assets being valuable for years to come.

In fact, gold has a place in a "hedged" portfolio – for multiple reasons.

Inflation may come from Fed cuts that juice the economy in the longer run... or just prices continuing to rise in the shorter run. Either way, the expectation for "more inflation" has been a tailwind for gold prices.

Inflation isn't the only reason that gold's price has soared. With geopolitical tensions at seemingly new highs, too, central banks have also been buying gold at substantial rates. It's happening in China, the Middle East, Russia, and more countries around the world as they look for alternatives to the dollar-based system.

Put it all together, and gold is up 15% this year alone. It's trading near an all-time high around $2,400 per ounce, set just last week. And here's the thing... This run could have much further to go.

For more about this, be sure to check out this free new presentation from Stansberry Research senior analyst Brett Eversole and gold-research icon John Doody.

Together, they'll explain to you much more about the factors behind gold's recent move, why it could continue... and, importantly, how you can take advantage of it in your own portfolio.

Specifically, Brett and John see a remarkable opportunity in gold stocks today. These companies still trade at major discounts despite the metal's rise in value and have the chance to deliver even greater returns than simply owning gold itself.

All in all, they say it's not too late to position yourself for the upcoming gold resurgence. Click here to get more details right now from Brett and John. They even share the ticker symbol of one gold stock that they say is a buy right now.

New 52-week highs (as of 5/24/24): ABB (ABBNY), Applied Materials (AMAT), Booz Allen Hamilton (BAH), Alpha Architect 1-3 Month Box Fund (BOXX), Constellation Energy (CEG), Costco Wholesale (COST), Crocs (CROX), Dell Technologies (DELL), Denison Mines (DNN), iShares iBonds December 2024 Term Treasury Fund (IBTE), Intuitive Surgical (ISRG), Micron Technology (MU), Neuberger Berman Next Generation Connectivity Fund (NBXG), Novo Nordisk (NVO), ProShares Ultra QQQ (QLD), RadNet (RDNT), Construction Partners (ROAD), Sprouts Farmers Market (SFM), VanEck Semiconductor Fund (SMH), Teradyne (TER), Trane Technologies (TT), ProShares Ultra Semiconductors (USD), Veralto (VLTO), Vertiv (VRT), Vistra (VST), and Zebra Technologies (ZBRA).

In today's mailbag, feedback on Dan Ferris' Friday Digest that highlighted Robert F. Kennedy Jr.'s recent appeal to the "apes"... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"I appreciate the political commentary that highlights the pandering... Some of [RFK's] claims about Wall Street wanting to own the whole housing market are hyperbole at best, some downright false... Most single-family home operators are now adding new supply through development as opposed to buying existing homes. I like some of RFK Jr.'s positions and thoughts on some things though. I do agree that corporate capture of agencies is a real problem that creates all kinds of favoritism in government policy. I also think he understands our debt problem more than any candidate. It's unfortunate we can't have candidates that are not total narcissists." – Subscriber Robert C.

All the best,

Corey McLaughlin
Baltimore, Maryland
May 28, 2024