Putting our heads together is what Stray Reflections does best. Here’s a summary of the most helpful insights gained from the community in our members-only Slack group last month. 

We continue the conversation daily in our members-only Slack group. Here’s a summary of the most helpful insights gained from the community last month. All of us are smarter than any of us.

1. Long Fear (#policy)

2. Short Conflict (#economy)

3. Long Patience (#crypto)

4. Short Naval (#life)

Long Fear

VS: What if the Fed staying tighter for longer as inflation lingers unacceptably higher for longer leads to a very inverted curve for longer?

JM: Interesting, I didn’t consider that. Are you referring to 2-10s? What do you think an “inverted curve for longer” would imply? It certainly would be broken as a policy or economic signal.

VS: 2-10s, 3m-10 year. Whatever. It would all look the same once the Fed gets to 4 percent and stays there. Right now, the market is at 3.2 percent for end of 2023. Guys like Charlie Evans are at 4 and they are all telling us they don’t see cuts next year. 

If you believe inflation settles somewhere north of 3.5 AND you believe that the Fed finds that unacceptable, then the front end has some work to do (go higher). What the long end does is up for more debate.  

And I don’t think it would be broken as a signal because the shape of the curve impacts the economy. A deeply inverted curve does not incentivize a lot of liquidity induced risk taking. Hard to borrow short and lend long.

JM: I don’t see rate cuts either. The market is starting to reduce those expectations as well, but it’s still early. I can frankly see a path to 4 percent Fed funds rate. There are also ten countries with inverted curves. It’s not just a US policy phenomenon.

VS: Right, so the market has rate cuts in the front end. The Fed may have just done a “soft pivot” which the minutes confirm. But that seems like a climbdown from 75 to 50 and MAYBE leaving the door open to being above (short end) neutral for a while. But that is quite a gulf from the market. I am pretty confident on this.

Where I am less confident is what about the long end? If they really want to tighten its probably more important what the long end does than the short end. They have a $9 trillion balance sheet now versus $4 trillion pre-pandemic. Why are they not using this lever more aggressively? What will happen should they decide to do this?  

My best guess is they have no clue how markets would react. They are hesitant to take the risk to find out. If they do decide to step up QT we will see a quick move higher in rates (taper tantrum like) which ultimately fizzles as the market moves to price lower long term inflation expectations. More QT is tightening after all.

How does this leave one in their speculation right now at 2.85 percent in the 10 year and 17.5 multiple in the SPX?  Beats me. I’m clueless. The tape is telling you to buy dips, but I am not comfortable doing that without some more fear in the long end of the bond market.

Short Conflict

MB: So many data points like wages and loan growth are significantly above levels consistent with a 2 percent inflation target. Both risk bulls and bears are under the view that rates have topped. I have the opposite view. What if the Fed has to hike to 5 percent eventually? The Fed funds rate is being significantly underpriced.  

At Jackson Hole the Fed may actually cite that the neutral rate is too low. If that occurs, the window for risk is closing fast even if inflation falls going forward. If the Fed takes a relatively laid-back approach, then I see the upside case for risk assets. 

JM: Raising the neutral rate is good, not bad. It will only happen with a supportive economic backdrop. I don’t think that’s negative for markets.

MB: This is where I struggle. If survey data and economic data are going to improve how is the Fed going to pause?  

JM: This is my conflict. I don’t get this common assertion that unless the Fed pivots or pauses, risk can’t rally. It’s turned into a belief for many and that’s what’s prevented them from participating this far. 

Core inflation peaked in March and will trough at some point. When and at to what level are the most important insights. I don’t think rates have topped. It’s just that we’re possibly going to be in a large sideways consolidation in 10-year yields, from 2 to 3.5 percent or maybe even up to 4 percent. 

But if we get to 3.5 percent again, will valuations fall back to where they were in mid-June or lower? No. Yields can move gradually higher on a surprisingly better economy and risk appetite improving without harming multiples.

Historically, tightening cycles aren’t necessarily periods where the best course of action is to avoid risk. 

SG: One doesn’t need to complicate things. Both earnings and multiples are going down. And cost of debt is going up. Defaults will be high. Drawdowns will be large.

The recession won’t be deep, but the starting point of overvaluation makes this a catastrophic situation for most markets. In the end we will all be better for it. Think of it as a rebirth, not an end.

JM: I like the “rebirth” framing, but I don’t see it as dramatically. If earnings flop, you could be right about markets. But the picture is not as bad as many think. In many ways we are misreading the consumer and economy.

MB: While the labor market has been strong and the recovery has been rapid, the problem is that labor participation rate has yet to recover, and I don’t think it will because the shortfall is situated in the 55yr+ cohort. Let me explain. 

Covid was not a balance sheet recession. Therefore, the lower participation labor force rate will prove to be inflationary as the supply of jobs is and will continue to be above pre-covid levels while the supply of workers will not.  

The 55+ cohort likely has a new perspective on life such as work is secondary, and some are likely to continue to be uneasy to return to work given that they are at most risk to covid whether vaccinated or not.  

These two factors wouldn’t be as strong in my view if net wealth wasn’t elevated. But reality is that net wealth has surged post-covid and real net wealth despite the inflation we’ve seen is at levels that is above the pre-covid trend.  

This cohort will be on the sidelines permanently or for far longer than the Fed can remain patient imho, and high wage levels will continue to surprise most. 

I continue to see one way risk for rates—higher. And the longer the Fed is potentially cautious (like reducing the pace of hikes to see the impact from previous hikes), the higher rates will go. 

The Fed will then have to reaccelerate hikes next year if they continue to be adamant about inflation targeting. This only increases the probability of a hard landing and why I think risk assets have started a structural derating process. 

JM: The labor market has recouped all the jobs lost during the pandemic. Overall employment is now 32,000 jobs higher than in February 2020. Yet prime age labor participation is not back to pre-pandemic levels. I expect that to recover so we’re not completely out of slack either.

Implicit in what you’re saying is that the markets are “at the effect of” of what the Fed does and almost like nothing else matters. The “rate limit” for the economy is higher given relatively low key debt ratios and stronger household finances. It can be a while before something breaks. 

Sequencing matters. Can’t stress that enough.

Long Patience 

JM: I’ve got a good grasp of the mood and positioning in the Bay Area and among L/S managers. CT, can you please fill us in on the mood in crypto and Puerto Rico? 

CT: Crypto mood is pretty mixed, but the common theme is that most are waiting for the merge to dictate direction. It’s very hard to find bulls that are not larping (Arthur Hayes types) and easy to find bears that have weak conviction. 

Most people are still hopeful and optimistic about the future of crypto which is rather troubling—I would like to see more people having the “wait this whole thing is kind of a scam” type of realization that happened in 2018. As of now most are still okay with waiting it out, no matter how bad their losses have been.

PR is a different beast. Very high concentration of libertarians who sound like zero hedge and people who have so much money they don’t really care about the cycles anymore. 

One trend I do see, however, is a renewed interest in NFT community type projects. I believe that the next big shift in online trends will be a move from social media to gated communities. The smart people I know are focused on this.

Short Naval

ML: “Happiness is being satisfied with what you have. Success comes from dissatisfaction. Choose.” - Naval Ravikant on Learning Happiness

SO: Something I always struggled with. Should I prioritize happiness or go long success… 

KC: What stops them both from being achievable? I will ruminate more but I disagree with Naval on success being driven from dissatisfaction. But perhaps his definition of success is different than mine.

SO: The way I see it the drive for success comes from identifying and closing a gap (where I am versus where I want to be). The bigger the why—more dissatisfied of where I am and/or more desirous of where I want to be—the bigger the drive.

KC: Perhaps it’s that I define success in another way. If I’m doing what I feel called to do, I experience flow or bliss when doing it, and if my experience with others helps them breathe a little easier then I have success. Well, my version of it anyway. 

Our current culture and a lot of the “top role models” use a measuring stick that doesn’t seem to actually engender equanimity, happiness, or peace of mind. I think the world has a definition on what success is but is it true? Each of us must define it for ourselves. 

I have worked with many people that have so-called “success” and yet they are not happy. It saddens me but it’s because they have their wants met but none of their needs. 

I think real success is when you have many of your needs met, certainly the nonnegotiable ones. But I don’t see most folks even knowing what their basic needs are. They know their wants. But if you have all your wants met and none of your needs met one can’t expect happiness. 

SO: Let me share my personal journey and why I see this the way I do. Since my early thirties, I was conscious of friends who started to develop health conditions and I told myself I will start living healthily before I develop any disease. 

I listed “health” as one of the life successes I will strive for. However, I love good food and decided that I will exercise more and trim the worst food offenders but continue to live a happy life eating the food I love. I realize the drive wasn’t enough in hindsight. 

My hospitalization few months ago changed my perspective and drummed into me that the gap between my current state and my desired “healthy” state was not small (which was my previous sub-conscious belief), but huge. 

I became very dissatisfied with my current state and aspired to close the gap as fast as possible, creating a huge drive for change. I did things my wife and even I thought impossible, cutting out my most favorite foods (that were causing me the health problems) and keeping to it. 

I redefined success as being fit and healthy from now until I die. I still love and enjoy eating but it cannot compromise my path to success. I am now happy that I’m working on my success and seeing results. So, happiness and success can be together. But this change couldn’t have been possible without a big dissatisfaction and desire/drive to change the status quo. 

Seems similar to what Jawad mentioned before about investing? “When things are going our way, we get comfortable in our views and feel our portfolio is safe. But experience tells us something bad is about to happen.” 

Success in investing depends on us being slightly anxious and paranoid. When we are happy, because we are doing well or comfortable with our views and decisions, bad things happen.

KC: What a journey you’ve had, I’m so happy that you’re happy and are experiencing good health now! What an extraordinary success to have been able to do what you did. I can feel how these go hand in hand with your story.  

I believe dissatisfaction can be a great motivator. I think I initially read Naval’s quote as an either/or, and I strive to view things from the “yes and” perspective.

SO: Thanks KC. Agree with your “yes and” approach. Maybe we can add to Naval’s quote “… And happiness can come from the path to success; after dissatisfaction has created a big enough drive for success.”