Don't Fly Too Close to the Sun

A shocking revelation in the data... But it's about more than just history... One of the biggest financial mistakes you can make... Don't fly too close to the sun... There's no such thing as a free lunch... Exploiting the seemingly Fed-induced equity returns... The perfect ways to prepare today...

Uh-oh, maybe I'm wrong about the Fed...

I (Dan Ferris) shared a bit of my macro investing framework in our November 13 Digest.

In a nutshell, as I explained, I view the Federal Reserve as a group of financial arsonists masquerading as a company of crackerjack firefighters.

I also made it clear that the Fed is guilty of the greatest hubris... the belief that it can manage a hopelessly complex $20 trillion economy from the top down by printing money and buying bonds. Ultimately, in that Digest, I concluded...

Mankind cannot manage nature from the top down – including the societies and economies that emerge within it.

But earlier this week, I read an intriguing take from my friend Enrique Abeyta of our corporate affiliate Empire Financial Research...

You see, Enrique posted some data on Twitter that suggests my view about the Fed's inferno-starting actions might not be quite right. On Tuesday morning, he said...

Since 1997, if you remove the [S&P 500] returns on [Federal Open Market Committee ("FOMC") meeting] day and the day before – a total of 394 days out of 6,000 total days – the S&P would currently trade at the 1750 level! -53% lower than current prices.

I was shocked.

As I write, the S&P 500 is at roughly 3,700. But as Enrique noted, this information suggests that the stock market would be less than half its current level had the Fed not acted as it did these past 23 years...

Maybe...

It's no secret that most of the market's gains over the long term have occurred on a paltry few trading days...

On the Stansberry Investor Hour podcast this week, I spoke with Wall Street legend Chris Davis... He's a passionate value investor and advocate of regular, systematic investing.

His firm's website features a graphic showing that missing the best 30 days of the past two decades would've turned a $10,000 stake into $6,749. Not missing them and staying invested the whole time would've turned the same $10,000 into more than $32,000.

If you think you can time the market, you had better be right.

Even so, the idea that missing the day of and the day before FOMC meetings would cut the S&P 500 by more than half blew me away... It seems to make me look silly for thinking that the Fed is a malignant presence that does more harm than good.

If my view were solely an interpretation of the past 23 years of stock market history, I'd agree...

But I'm not only thinking about history...

I view my macro framework as a common-sense view with a deep appreciation for financial and economic cycles... and the cycles of investor sentiment that follow them.

I'm not looking backward and saying the Fed hasn't influenced the stock market. I'm looking at history as well as the present moment... and then entertaining future scenarios to decrease my chances of getting blindsided in the financial markets.

As I look back... yes, the past couple of decades have been the era of "the infallible central bank," in the words of Stansberry Investor Hour guest David Levine.

When the market collapsed after both the dot-com and housing bubbles, the Fed stepped in... It printed more money and bought securities to push interest rates lower. And both times, the stock market bottomed and entered into a new multiyear bull run.

Lower interest rates make saving less attractive, encouraging increasingly imprudent market speculation. But eventually, too many people come to believe it's easy to make money in stocks because the Fed has their backs... That sets the stage for another collapse.

Cycles are inevitable in finance and economics... Nothing goes up or down forever.

Since the Fed's activity is no substitute for real economic activity – and encourages imprudent financial behavior – I believe the cycle will peak and Fed-induced easy credit will eventually backfire. Instead of keeping the stock and bond markets propped up, the Fed's activities will eventually prove to be too little too late.

Overconfidence in the Fed is a giant mistake... It's perhaps the biggest financial mistake investors worldwide are making today. And I'm not the only one who thinks this way...

In fact, one of the quintessential examples of the status quo now feels the same way...

I'm talking about Mohamed El-Erian.

El-Erian previously served as CEO of PIMCO, the world's biggest bond-fund manager that was co-founded by "bond king" Bill Gross and is now owned by German insurer Allianz. He helped grow PIMCO from $1 trillion of assets under management to $2 trillion.

When you have that much money and you're heavy into bonds – the most macro-sensitive asset class – you tend to spend a lot of time hoping the status quo can be maintained...

El-Erian echoed Levine recently in the Financial Times, expressing concerns that investors are overlooking financial-market risks "due to sky-high faith in central banks' ability to shield asset prices from unfavorable influences." He said central bank interference "alters market conditioning and inverts traditional cause and effect." And finally, El-Erian worries that "central banks' deepening distortion of markets will be harder to defend in a recovering economy amid rising inflationary expectations."

Amen.

When a guy who has spent much of his career investing in the Fed's favorite asset class (bonds) says he's worried that investors put too much faith in the Fed, you might want to pay attention.

Like El-Erian, I worry that the Fed is too confident in its ability to control inflation...

The Fed was unable to hit its 2% inflation target in the past. So earlier this year, the central bank said that it would aim higher than 2%, implying that it would let inflation run higher for longer before attempting to keep it in check.

The string-pullers at the Fed are doing what no good trader would ever do... They're doubling down on a losing bet, promising to do more of what is not working.

The Fed is like the Greek myth of Icarus, flying straight toward the sun with wings made of wax, telling himself, "So far, so good." And I'm like Icarus' father Daedalus, who warned him not to fly too low or too high... The sun melted his wings, and he fell into the sea and drowned.

When it comes to the Fed, we as investors must remember the lesson of Icarus...

Don't fly too close to the sun.

The Fed's hubris was punished soundly in late 2018, roughly two years into its attempt to unwind its era of quantitative easing by selling bonds and raising its short-term interest rate target. The stock market couldn't take it anymore by September 2018... The S&P 500 fell 19% before bottoming out on Christmas Eve that year. The Fed finally capitulated and started cutting rate targets again in September 2019.

In other words, the Fed simply couldn't get interest rates back to normal without doing enough economic damage to make the stock market extremely nervous.

The federal funds rate's recent peak was just 2.5% in July 2019. And of course, it's back to near zero today. (It peaked at about 20% in the early 1980s. I promise you nobody thinks we'll ever see that level again... But they probably had similar thoughts in July 1954, when it was 0.8%.)

The Fed's target rate has made lower and lower highs over the past 30 years, as the market has grown accustomed to easier and easier money, making it harder and harder for it to tolerate even slightly higher interest rates. You can see what I mean in the following chart...

It's in mankind's nature to overdo anything that seems to work...

Commenting on the "protective nature of the [Fed] umbrella" to the Financial Times, El-Erian said, "It is an extremely powerful dynamic, and one that inevitably overshoots."

Former New York Fed President Bill Dudley sounded off about inflation in a December 3 opinion piece for Bloomberg... Among other factors, he cited the Fed's targeting of higher inflation and the likelihood that the federal government has shifted its focus from worrying about debts and deficits to worrying that it won't spend enough to stimulate the economy.

If the former head of the New York Fed doesn't think the central bank can keep inflation in check – and even thinks that the Fed is a substantial part of the problem – again, you might want to pay attention.

So while history alone suggests that the Fed has elevated stock market returns... a modicum of wisdom is all you need to remember that there's no such thing as a free lunch.

Sooner or later, the bill must be paid.

I'm afraid that the more the Fed interferes in markets, and the more confident investors become in its ability to backstop their losses... the worse the ultimate reckoning will be.

And to be fair, I've never advised completely exiting the stock market and sitting on the sideline...

So taking my advice overall would've exploited seemingly Fed-induced equity returns.

In fact, on the current episode of the Stansberry Investor Hour, I encouraged investors to hold stocks in companies that earn high returns on capital ("ROC") as one way to prepare for an extended bout of inflation...

If you own a piece of a business that can consistently earn a 30% ROC, inflation can run into double-digit territory... and you'll still be well-positioned for a high rate of inflation-adjusted compounding.

Inflation is the big enchilada of potential Fed-induced risk. Dudley specifically noted that...

A lot of people believe that inflation in the U.S. is dead... They could be setting themselves up for an unpleasant surprise.

Maybe the 'unpleasant surprise' is already here...

Last week, I saw a chart from the Wall Street Journal that showed a roughly 300% gain in iron-ore prices since late 2015. So I quickly grabbed five-year charts of gold, silver, lead, zinc, and copper prices.

Iron ore is the clear outperformer over that stretch, but the others are all higher, too. And the story is more dramatic when you look at a chart for just this year. Based on FactSet data, all those metals have risen between 7% (lead) and 66% (iron ore) since January 1...

Mind you, they're all higher than their pre-COVID-19 crash levels. I have to wonder how the chart would look without the disastrous COVID-19 episode. Would they all be even higher?

And then, of course, there's bitcoin...

I recommended bitcoin to my Extreme Value subscribers back in April, when it was at around $10,200... And it's up roughly 125% since then to about $22,800 today.

Bitcoin rallied sharply after Fed Chairman Jerome Powell said on Wednesday that the Fed would continue buying at least $120 billion in bonds per month – more than $1.4 trillion per year. Powell also reiterated that he expects interest rates to be stuck at zero until 2023.

While gross federal debt is nearly $30 trillion, the marketable Treasury debt is around $20.7 trillion (as of November 30). So the Fed is committing to buy roughly 7% of marketable U.S. Treasurys per year (based on the most recent figures from the Dallas Fed).

Can you imagine how much the stock market would soar if the Fed committed to buying 7% of all outstanding shares? (And yes, I realize the U.S. Treasury will issue new debt securities... I'm just showing you that's a lot of buying.)

Considering Enrique's post on Twitter about market performance around FOMC meetings, asset prices seem to be telling us something...

In addition to bitcoin, stocks and silver also moved higher on the news. The S&P 500 gained about 1.5% from Monday's close through Wednesday's close, while silver jumped 5.3% in that span. And bitcoin climbed 10.7% during the same period. Gold – often considered the ultimate "safe haven" asset – rose 1.4% in that stretch, less than stocks.

Interest rates have stayed roughly flat to slightly higher over the past few days... And since rates and bond prices move inversely, it means bond prices drifted slightly lower. The yield on the five-year Treasury note rose from 0.36% to 0.37%, while the 13-week Treasury bill yields rose from 0.06% to 0.075%.

Strength in the more volatile asset classes (stocks, silver, and bitcoin) and weakness in the traditional safe havens (gold and U.S. Treasurys) suggests the Fed has reinforced what markets already seem to believe... We're solidly in "risk on" mode.

No worries...

If you took advantage of my Digest-only macro trades in recent months, you were prepared...

You'll recall that I suggested buying bitcoin and cannabis stocks as "election-related trades" in the October 23 Digest... I said I expected the value of both to rise for months after the election uncertainty dissipated.

And then, in the November 6 Digest, I suggested the iShares 20+ Year Treasury Bond Fund (TLT) as a way to speculate on a stronger U.S. dollar. (Yes, a strong dollar is the opposite of inflation, but the apparent conflict is only one of time frames – expected short-term dollar strength and expected long-term inflation. You might recall that I presented the TLT trade as a countertrend trade.)

If you executed those trades, you're likely doing quite well so far... The three trades are up an average of 36% since I highlighted them, compared with an average gain of 7% if you would've instead just bought into the S&P 500. Here's how it all looks right now...

The TLT trade stumbled immediately out of the gate... Then, it looked good for a while, as TLT climbed to more than $161 per share on November 20... But it has backtracked once again in recent weeks, as investors put safe havens on the back burner.

I'll consider this particular trade a bust if TLT closes at less than $155 per share. I still believe a stock market correction of at least 5% to 10% is coming at some point in the near future... And when that downturn happens, the value of TLT will rise as investors search for safety.

My macro framework runs counter to a solid multidecade trend of Fed market influence. But as you can see, the trades I've pinpointed in recent weeks here in the Digest based on that framework are doing well overall.

Right now, my perfect trade would involve assets that should do well over the long term with or without rising inflation...

As I showed you earlier with the metals prices, inflation has been rising lately. And these assets should position me (and others) well if inflation were to take hold over the next several years...

I spoke about three inflation-protecting asset classes on the current episode of the Stansberry Investor Hour. I told you about one of them (businesses with high ROC) earlier in this Digest. And I've mentioned a second one (investing in gold, silver, and bitcoin) many times.

That brings me to the third idea that I mentioned on the podcast...

I believe you should also own a diversified portfolio of royalties on the production of useful commodities like copper, zinc, lead, iron ore, and potash (for fertilizer). This type of asset will do well whether we get a lot of inflation or not... as long as the global economy keeps growing, generating higher demand for the raw materials of modern civilization.

In my Extreme Value service, I've been covering a company with such a portfolio of royalties since 2009...

It's one of my all-time highest conviction recommendations. I've never used trailing stops on this position – and likely never will. No matter how it has performed over the short term, I've always stuck with it because I know the management team personally... and they're the very best in the business.

I won't mention the stock here because the Digest audience is gigantic, and it's a small-cap name that's less liquid than our usual fare... So you'll have to do a little digging to find the name of it. (Hint: It's mentioned in my opening rant of the current episode of the Stansberry Investor Hour.)

That stock, companies with high ROC, and stores of value outside the U.S. dollar (like gold, silver, and bitcoin) are assets that you should own already. It just so happens that they'll also help you maintain and grow the value of your wealth if my concerns about the Fed are realized and inflation takes hold over the next several years.

My ideas about the Fed don't seem to be supported by the past 23 years of market history. But as I hope you've seen today, I think I can still use those ideas to help you construct a common-sense, highly diversified portfolio that'll do well for the next several years.

And if my Fed view turns out to be spot-on, you'll thank me for helping you make a fortune.

New 52-week highs (as of 12/17/20): Altius Minerals (ALS.TO), ARK Fintech Innovation Fund (ARKF), Asana (ASAN), ProShares Ultra Nasdaq Biotechnology Fund (BIB), BlackLine (BL), Siren Nasdaq NexGen Economy Fund (BLCN), Cognex (CGNX), Corteva (CTVA), Curaleaf (CURLF), ProShares Ultra MSCI Emerging Markets Fund (EET), Eagle Materials (EXP), Gravity (GRVY), Green Thumb Industries (GTBIF), Innovative Industrial Properties (IIPR), Intuit (INTU), Jushi (JUSHF), KraneShares MSCI All China Health Care Index Fund (KURE), LCI Industries (LCII), MongoDB (MDB), OptimizeRx (OPRX), Palo Alto Networks (PANW), Flutter Entertainment (PDYPY), ProShares Ultra Technology Fund (ROM), Southern Copper (SCCO), Sabina Gold & Silver (SGSVF), Silvergate Capital (SI), First Trust Cloud Computing Fund (SKYY), Scotts Miracle-Gro (SMG), Square (SQ), ProShares Ultra S&P 500 Fund (SSO), Constellation Brands (STZ), Trulieve Cannabis (TCNNF), The Trade Desk (TTD), Take-Two Interactive Software (TTWO), Vanguard Inflation-Protected Securities Fund (VIPSX), Vanguard S&P 500 Fund (VOO), Vestas Wind Systems (VWDRY), and Zendesk (ZEN).

In today's mailbag, feedback on my Digest from last Friday and more thoughts on Kim Iskyan's essay about a potential Cold War 2.0. Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"Bravo Dan! Time is the one currency we all have yet I see so many people who spend it without purpose and intent. I understand you are an avid reader and I appreciate the insights you share in your Digests. I share your perspective on time and wish I could convey that to all of my young co-workers at Trader Joe's.

"All the best to you and your family this holiday season!" – Paid-up subscriber Scott W.

"Hat tip to Kim for including China's demographic train wreck. 2035 is their crunch year when there will be only two working age [people] to every old person. And yes, that could make China dangerous." – Paid-up subscriber Colin S.

Good investing,

Dan Ferris
Vancouver, Washington
December 18, 2020