Editor’s note: During bull markets, stocks climb a ‘wall of worry’, it is said. But what happens once stocks make it over the wall? Tomorrow, Fat Tail Investment Research releases a definitive guide to the End of the Everything Bubble from an Australian perspective. We think every investor in Australia should heed its warnings. Today, we publish an essay by Charles Hugh Smith, a contributor to the US version of The Daily Reckoning. It looks at how this all might go down Stateside…
A key weakness of our system is its reliance on debt, leverage, and speculation. The more debt that’s been piled up, the greater the instability of the entire system. Risk always appears low until the system destabilises, and then all the hedges fail, and risk breaks out, flooding through the entire financial system.
Leverage is great fun on the way up, as it magnifies gains. Since the Federal Reserve implicitly guarantees that ‘buying the dip’ will generate massive gains, why not ramp up leverage 10-fold to maximise those Fed-guaranteed gains?
Leverage is less fun on the way down. When the underlying collateral has shrunk to 20% of the leveraged bets being made, a 21% decline in the asset wipes out all the collateral holding up the palace of leveraged debt.
And that’s a massive problem…
Old hands on Wall Street have been wary of being bearish for one reason, and no, it’s not the Federal Reserve. The old hands have been waiting for retail — the individual investor — to go all-in stocks.
After 13 long years, this moment has finally arrived: retail is all in.
If you doubt this, just look at record highs in investor sentiment, margin debt, and valuations. Current valuations are so extreme that the previous extreme in the 2000 dotcom bubble now looks modest in comparison.
I have my own sure-fire indicators for when retail is all in. One is my mum’s financial advisor recommends shifting her modest nest egg out of safe bonds into the go-go stocks that are topping out.
Back in late 1999, it was Cisco Systems and the other dotcom leaders; today, it’s the FANGMAN stocks. Sure enough, my mum just informed me her advisor recommended moving money from bonds into a FANG-dominated stock fund. Bingo, we have a winner.
Second indicator: average people who have never traded stocks are all in and supremely confident they can’t lose. When 20-year-old college students are trading based on a ‘genius’ 22-year-old friend’s advice, retail is all in. When a worker cleaning a wooden deck pauses to put $100,000 in a company he knows nothing about (yes, true story), retail is all in.
Much is made of meme stocks, but the real driver of retail going all in is the complete collapse of risk/moral hazard: the Fed will never let the market go down is not a meme, it is an article of secular faith, supported by 13 long years of ceaseless Fed intervention/stimulus, all in service of elevating the stock market.
Since all evidence supports this secular religion — stocks never go down because the Fed will never let them go down — the trick is to rotate into the next blow-out winner or buy the dip in Big Tech or a meme stock. And since something is always shooting up like a rocket, the way to become a millionaire is to simply buy what’s hot and buy the dip.
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This time is different!
In this secular religion, nothing else matters, all the old stuff is just a distraction: price-earnings ratios, valuation, cash flow, future earnings — none of that old stuff matters. Technical analysis is also a waste of time: just buy the dip and rotate into what’s hot, and the millions just pile up on their own.
Every generation that experiences a speculative mania feels it’s unique. This is the pattern that repeats. The confluence of forces driving the mania to unprecedented heights is so obviously unique and uniquely powerful that it is literally crazy not to grab a board and ride the wave to riches.
What the newly minted millionaires don’t understand is they’re the marks and bagholders. Wall Street has been patiently waiting for retail to go all in so the pros can sell all the overvalued stocks to the euphoric, trusting retail traders, who will continue to buy the dip and rotate into the next hot meme-stock until their fortunes have dwindled to spare change.
The con requires euphoric confidence that stocks only go up forever, and every retail trader is confident in their ability to ride the wave to riches. We’re finally at that summit of euphoric confidence, where faith in the Federal Reserve is literally a religious experience.
Robbing Hoods going public is a scriptwriter’s touch. (Forgive me if I got the name wrong, I’m working from memory.) Stocks never go down is absolutely true, take it to the bank, until they do.
Every share of stock ends up in somebody’s account, and the ideal bagholder is one who adds more on every downturn (buy the dip) and who refuses to sell (diamond hands), holding on for the inevitable Fed-fuelled rally to new highs.
That’s how accounts are destroyed, and the wreckage isn’t just financial. The scars of being a bagholder can last a long time. But Wall Street is patient, and a new crop of bagholders eventually catches Fed Fever, and the transfer of overvalued equities to a new generation of bagholders will play out according to the same script.
The one thing the Fed can do
The Fed can print money, but it can’t create collateral, nor can it make insolvent entities solvent. All the Fed can do is increase the debt and leverage, which is not the solution, it’s the problem.
Speculation is also inherently unstable, as the euphoric herd, once startled, turns in panic and stampeded in fear. Markets that appeared liquid — ie: sellers could count on someone buying as many millions of shares as they desired to sell — become illiquid, as buyers vanish like mist in Death Valley. With buyers gone, prices plummet to levels the herd reckoned ‘impossible’ just days before.
The Fed’s entire strategy in the 21st century has been to inflate asset bubbles that generate the illusion of wealth — the so-called wealth effect, which is presumed to inspire voracious borrowing and spending.
The US economy is dependent on the Fed for the ‘juice’ of monetary stimulus. It’s dependent on incredibly unstable bubbles in assets, debt, and leverage, bubbles which have generated extremes of wealth/income inequality that are destabilising the social and political orders.
The fragility and instability are well hidden until it’s too late: bubbles, debt, leverage, budgets, and revenues can only click higher because the system breaks down if there is any sustained decline (the rising wedge model of breakdown). Once the subsystems fail, there’s no putting the eggshell back together.
The loss of redundancy, the decay of maintenance, the loss of experienced workers — all of these are hidden from public view until the system breaks down.
But by then it’s too late.
Charles Hugh Smith,
For The Daily Reckoning Australia
Editor’s note: There have been ‘Code Reds’ aplenty for some time now. They’re all around us. But what should you do — practically — to protect your savings and investments if you think 2022 might be the year the cycle finally turns? Tomorrow we publish a five-part strategy guide.