Liquidity Drain

My portfolio’s down another 3.7% this week. Its actually even in value though because I put in more cash. One of the good things about having a margin account is that you can use it to buy up crazy dips, which I’ve done a bit these past couple weeks, particularly with Uranium miners. The downside is that a market built on high margin can just keep draining liquidity and dropping lower. In this case, those mining stocks didn’t bounce back, they just kept dipping. If you overdo it with margin, you end up being forced to sell at the worst possible time, and I’m a bit too risk averse to want to get close. Last week I was around 1/3 of the way towards my limit, now that’s closer to 1/4, so if all my stocks were cut in half from here I still wouldn’t trigger a margin call quite yet.

Right now we’re in a world of highly aggressive central bank tightening. The Fed is tightening because they’re under tremendous pressure to bring the CPI down, which has sent the US Dollar roaring higher, and other central banks have been tightening to shore up their own currencies in response.

The Federal Reserve was supposed to start shrinking their balance sheet last month, and they have talked about selling mortgage-backed securities (MBS) on the market. So far, that balance sheet has clearly topped and looks to be trickling down, but the data is choppy. I really doubt that they’ll end up selling much MBS.

This video has a number of important things from the standpoint of the mortgage market: Mortgage Lenders are going BANKRUPT (2022 Housing Crash Just Got Worse): https://youtu.be/KYF6lTbxx6U

Nick does a great presentation here where he shows that “shadow banks,” which are not backstopped by the federal reserve, have been funding 2/3 of the mortgage loans. Mortgage rates more than doubled since the beginning of the year, putting steep losses on anyone holding mortgage-backed securities, and pushing a number of these companies into bankruptcy. Big banks like JP Morgan and Wells Fargo are tightening lending standards further in response.

Back in 2008, bear sterns went under when mortgage-backed securities became illiquid and they had to post a lot more collateral to fund their operations off the repo market. There are a lot of shadow banks like that who are going to need to sell these morgages, and a number of house-flipping companies who are going to need to sell homes, just as buyers are vanishing. I think we’re very close to seeing a number of debt markets seize up here.

Meanwhile we have people comparing the CPI with the 1970’s and talking about raising rates past the CPI as the only way to beat it down, as if the enormous difference in debt levels and demographics don’t matter. Here’s a chart I put together for Twitter showing how different our situation is here:

Note that the CPI (blue) has come down despite much lower interest rates (green) in every instance before 1960 and after 2007. Why? Debt levels matter. If interest rates sharply rise, then in becomes very difficult for banks (and shadow banks) to conduct lending activities as their balance sheets begin to look like trash. Meanwhile, the debt-fueled asset bubble starts to reverse leading to different forms of margin calls in the stock and repo (interbank lending) markets as the collateral backing those loans loses value. All lending markets face these pressures as home loans become higher than property values, auto loans start seeing sharp credit risk increases as used car values fall, corporate loans are based on shrinking earnings, etc.

The latest in GDP estimates has shot down to -2.4% for Q2, after a -1.6% drop for Q1. For most people, this fits the definition of recession.

Right now, the big debate is still about inflation. This is not only the hot-button political issue, but an important issue for investors, even though everyone has a slightly different idea of what it is. As I have strong ideas on the topic, I might as well lay out my views.

  1. Everyone has a different idea of what “inflation” means.
    1. The news media and politicians define inflation as the latest CPI reading.
    2. Most people define inflation as cost of living going up.
    3. Economists like Milton Friedman and Jeff Snider, define inflation as costs going up due to a reduction of purchasing power in the currency.
  2. Milton Friedman’s famous line “inflation is always and everywhere a monetary phenomenon” is one of the most mis-understood quotes of all time.
    1. The CPI = inflation crowd interprets this as “every time the CPI goes up it means the value of the US dollar has dropped”
    2. The “cost of living” crowd interprets this as “every time stuff I buy and bills I pay cost more it means the value of the US Dollar has dropped”
    3. Economists try to divide the CPI hike into supply shocks, demand shocks, and currency devaluation with the general idea that only currency devaluation has lasting power because supply and demand shocks will shift spending patterns, production patterns, and work through the system.
    4. The Federal Reserve calls supply and demand shocks “transitory” for this reason. But they also believe that inflation and the economy are driven by psychological factors they term “animal spirits”, that consumers strapped for cash will spend more just because they expect prices to rise leading to a cycle of price hikes, and that misleading the general public on the state of the economy is the best way to manage this phenomenon. This is why their predictions are generally dead wrong, why they never predict recessions, and why investors comb through their speeches for hidden meanings.
  3. The actions of the Federal Reserve definitely affect markets. In fact, the easiest and smartest market-timing strategy is to take a 401k, send it into money market funds at the beginning of every Fed hiking cycle, and move it back to 100% stocks at the beginning of every Fed easing cycle. The fed is charged with reacting to “employment” and “CPI” which both heavily lag the economic cycle, and their actions tend to be pro-cyclical feeding the frenzy of the cycle peak and draining liquidity after the cycle has clearly turned. Stocks follow market liquidity much more than fundamentals like earnings, and that follows the movements of the federal reserve.
  4. “Costs of Living” have been soaring for decades as housing bubbles have driven rents higher, especially post GFC with money flooding into the housing boom. Food, fuel, mandatory health insurance costs, healthcare costs, tuitions, and cars have also become much more expensive during this time. This effect has been hidden by things like globalization flooding the world with cheap consumer goods, hedonic adjustments from new cars requiring more things considered higher tech, televisions getting bigger, computer chips getting faster, etc. At the same time, the average person has lived with the feel of a being on a treadmill with the speed set ever faster as he still gets nowhere. The idea circulating that “inflation hasn’t been a problem for decades” is misleading and ludicrous in cost of living terms.
  5. “CPIs” have been driven higher as the lockdowns produced some of the biggest supply and demand shocks ever seen when people shifted almost all their spending from services to goods, and a flood of workers moved out of expensive cities and fixed up home offices for remote work. The disasterous energy policies of the G7 have made the situation critically bad, as they consider “environmentally friendly” to mean “block all infrastructure investment.”
    1. We produce much less oil in that US than we did pre-pandemic, we cancelled most new pipeline projects and have seen the supply of “drilled-but-uncompleted wells” drop precipitously as no one is investing in drilling new fracking wells.
    2. We have seen desalination projects blocked in California as Lake Mead dries up and our water from the Colorado River is about to be cut off.
    3. We have seen a number of nuclear plants shut down permanently this year alone, 2 of them after Putin’s invasion of Ukraine.
    4. We have seen the diversion of farmland to biofuels despite a food crisis raging through emerging markets and critical shortages in fertilizer.
    5. We have seen coal-dependent countries like Australia push big “windfall profits” taxes on producers causing prices of energy to soar.
    6. Unfortunately we’re stuck with these problems getting worse as our leaders continue to make it so. These policies will drive CPI higher by reducing supply despite the demand destruction that is also happening.
  6. “US Dollar Devaluation” is not happening, even though most people believe it is. The enormous “money printing” of the fed balance sheet is merely taking one form of money – treasury bills – and turning into a more restricted form of money – bank reserves. The enormous stimulus that went out in some part to people and in large part to big corporations was a big one-off, not leading to a virtuous cycle of increased incomes.
    1. People are not flush with cash and spending like crazy, hence the enormous inventory buildups in stores like Target and Walmart and the negative GDP growth.
    2. The US Dollar has been the best-performing asset of the year (aside from oil) as almost all asset classes have been dropping in dollar terms including most foreign currencies, gold, silver, and Cryptocurrencies.
  7. The labor market is broken in many ways. The job losses from the pandemic have still not been recovered – we still have LESS jobs than Feb 2020 despite working-age population growth!
    1. After the lockdowns & layoffs, prices of rents and real estate soared 30% in many areas, and people have been leaving in droves. Many of these workers will never return to the overpriced cities from whence they came, and those places will struggle to find new low-end workers with no places they can afford to live.
    2. Many of the workers displaced in the pandemic had job skills that take years to acquire. Nurses, longshoremen, construction workers, mechanics, pilots, etc. They will not be easy to replace, especially as high costs of gasoline make commuting expensive while high rents prevent people from moving back to those areas.
    3. Most people are NOT getting huge wage hikes and bonuses like the unionized workers of the 1970’s. Many people are paid in more variable terms with things like bonuses that can easily disappear, and the wages that have moved have been tiny in comparison to the cost of living and stilll fairly small compared to the increases in CPI.

Right now, a financial crisis like 2008 is much more likely than any kind of sustained inflation. Fiscal intervention in the US is unlikely, as the Democrats believe that higher energy costs will be better in the long run and the Republicans believe that workers are lazy and flush with cash that we need to drain from their hands so that they’ll get back off their butts and work. They’ll fight and have government shutdowns and budget battles even as the cracks in our economy become more obvious.

So, what can I say. My strategy remains the same really …

  1. If the economy tanks like I expect, and the Federal Reserve is the only game in town to act, and their only real tool is the interest rates set by their Reverser-Repo-Rate window, then rates will collapse in the next year and my TLT call hedges should soar.
  2. If the federal reserve manages to re-kindle the asset bubble, finding new ways to get more money to rich investors, then my precious metals miners should soar as these investors will again crowd into limited resources rather than investing in long-term infrastructure or production for a shrinking economy.
  3. Uranium demand is absolutely set to increase like clockwork, and the tiny but volatile mining sector will soar over the next decade. Who knows when exactly, but I’ll be there.
  4. US Cannabis is still a sector that big investors are blocked from due to federal law, so many of these investors go to Canadian cannabis companies instead. The Republicans and Democrats both want to make it federally legal in some way so they can get that sweet tax revenue, but Senator Schumer has been blocking it so far in hopes of a big comprehensive reform. I believe that they will end up with some kind of bipartisan compromise here that does the trick, allowing these companies to operate as federally legal enterprises with access to the banking sector, and allowing major investors to participate in the sector. It’s a falling knife until then, and the bleeding is so bad I’ve stopped adding to my holdings here back in February, but I plan to hold what I’ve got.
  5. Battery metals – mainly copper and nickel – are so undersupplied it’s insane, especially with the extremely wasteful use of them that our ESG-infected politicians are pushing. I expect downward pressure until we get to massive infrastructure spending in earnest, but I’d rather have something in too early than miss the move.
  6. Crypto I rarely talk about, but I’m in XRP with some buddies who are crazy bullish and I’ll leave it at that. Many coins will die off, but the sector will remain as long as its legal and it will have wild swings to the upside as well as the downside.

If I had new money to add, I would probably put the bulk of it in Uranium Miners because the long-term story is the most bullish by far. If you wonder why, start here: Uranium Market Minute: https://youtu.be/qkEhOYl9nCg

Here’s where my portfolio ended up.

  • HEDGES (16.4%)
    • 16.4% TLT Calls
  • PRECIOUS METALS (35.8%)
    • 4.3% AG
    • 4.2% MTA
    • 4.2% SILV
    • 3.2% LGDTF
    • 2.7% EQX
    • 2.8% SLVRF
    • 2.7% SAND
    • 2.1% MGMLF
    • 1.9% SSVFF
    • 1.8% RSNVF
    • 1.7% BKRRF
    • 1.6% HAMRF
    • 1.6% MMNGF
    • 1.3% DSVSF
  • URANIUM (24.1%)
    • 4.7% CCJ
    • 3.5% DNN shares & calls
    • 3.3% UEC
    • 3.0% UUUU
    • 3.1% BQSSF
    • 2.7% UROY
    • 1.9% ENCUF
    • 2.0% LTBR
  • US CANNABIS (13.4%)
    • 1.8% AYRWF
    • 1.5% CCHWF
    • 1.3% CRLBF
    • 2.2% CURLF
    • 1.4% GTBIF
    • 2.1% TCNNF
    • 1.2% TRSSF
    • 2.0% VRNOF
  • BATTERY METALS (11.4%)
    • 5.4% NOVRF
    • 4.4% SBSW
    • 1.6% PGEZF
  • CRYPTO (2.3%)
    • 2.3% XRP
  • OTHER (3.3%)
    • 2.5% DOCN (w/ covered calls)
    • 0.6% OGZPY
    • 0.1% TWTR call
    • 0.0% ATCO calls
  • CASH (-6.7%)

Keep a cool head during this cycle. The overall market losses and coming crisis are scary, but money will be moving like crazy. Lots of risk to take on the upside as well as the downside if you’re keen to take it. If you like my TLT calls play, please don’t get into calls dated before November (you’ll want the seasonal TLT bull market in Sept-Oct) and consider the high duration Jan 2024 calls if the premium isn’t too high because the move in rates might take longer than you expect. Be extremely careful with margin accounts here, and good luck!

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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