I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Friday Flash, I share an epiphany or aha moment from the past week.
This week was productive. I got an initial review package of author’s notes, introduction, and chapter one of my book manuscript to a trusted reader. In the process I largely figured out how the Scrivener compile function works. That turns the manuscript contents I’ve created into a structured and formatted output of my choice, whether it’s an EPUB book (an open-standard digital format), rich text format that I can import into Google Docs, a print-ready paperback format, or something else.
And I also completed my monthly portfolio update for a small IRA account I hold, after completing the same for my non-retirement brokerage portfolio last week. The majority of my retirement assets are managed by a financial advisor. That brings discipline and an informed perspective that complements my own. But I enjoy managing some of my money myself, and I think I might eventually get better returns than he does, using my various momentum and trend approaches to avoid massive losses in case of a crash, and also to overweight assets that have strong momentum (as does gold right now).
In the portions of my investments that I manage, I am evaluating myself not just on my returns (which will play out over years) but on how well I develop and follow strict rules. Following strict rules works around the human tendency to panic when asset prices are low and get too euphoric and buy more when asset prices are high. But it’s hard to do. This week, my rules triggered for some Bitcoin holdings I had. I ended up selling all of my Bitcoin in my non-retirement account (it was held in via an ETF). That was a good move in the short run, as it is down a few more percent since then. I didn’t want to sell it though because I have a conviction that Bitcoin will actually eventually come back and go far beyond the all-time-high price it recently reached around $125K. It doesn’t matter what my conviction is, though. My conviction has been wrong so many times. So I just need to follow the rules regardless of what I think.1
Financial advisor and pundit Lance Roberts published a helpful article today The Psychology of Investing in a Zero-Risk Illusion. He notes that we’re in an investing regime where people seem to believe risk has been eliminated from investing. Buy and hold the S&P 500, and then you’ll easily compound at 9 or 10% returns a year.
During bull cycles like we are in, investors start to believe that they can’t lose except by not being invested. The Fed has contributed to this belief by “flooding the system with liquidity at the first sign of stress,” leading to a distortion in beliefs and behavior among investors:
The Federal Reserve’s well-intentioned interventions have created one of modern finance’s most powerful behavioral distortions: the conviction that there is always a safety net. After the Global Financial Crisis, zero interest rates and repeated rounds of quantitative easing conditioned investors to expect that policy support would always return during volatility. Over time, that conditioning hardened into a reflex: buy every dip, because the Fed will not allow markets to fail.
But liquidity doesn’t imply stability. “It masks fragility the way calm seas hide strong undercurrents,” Roberts writes.
One area of concern for asset prices is a potentially frothy credit market, where investors are buying up corporate debt without seeing a significant risk premium (compensation for likelihood of default) on the yield.
Historically, major stock market crashes are often preceded by, or intertwined with, credit crises. After a period of excessive borrowing and risk taking, lenders start tightening credit standards or investors demand higher yields as stress in the system builds up. Liquidity dries up. Borrowers have a more difficult time refinancing. Leveraged investors are forced to sell assets to meet obligations. The deleveraging hits equity markets, as investors needing money are forced to sell assets. Prices drop; volatility spikes. Even those investors who don’t face margin calls or another need to meet debt obligations sell too, as they watch their portfolio values decline.
Historical examples (from ChatGPT):
- 1929: Margin debt-fueled speculation collapsed when lending tightened, triggering the Great Depression.
- 2000: Venture and corporate credit dried up as dot-com business models failed, causing a broader equity meltdown.
- 2008: A full-blown credit crisis (subprime, derivatives, bank funding) cascaded into a global stock market crash.
- 2020: A rapid liquidity freeze in credit markets forced central banks to intervene, averting a deeper crash.
You can tell that corporate credit investors are complacent by looking at credit spreads—the difference between the yield investors demand to buy debt for non-investment grade credit over and above what they are getting on U.S. Treasuries. Right now the benchmark high-yield credit spread the ICE BofA High Yield Index Option-Adjusted Spread (OAS) is around 2.9%, showing that high-yield bonds on average yield just 2.9 percentage points more than Treasuries of similar duration (adjusted for bond call features). Less than three percent indicates investor complacency. The rough long-term average is around 5% and greater than 8% indicates serious stress or recession risk (which would lead to bankruptcies and defaults).
There have already been a couple high-profile defaults, but so far no one seems to think there’s a bigger problem. I wonder about the private markets space (private equity, private credit, and other private assets) which has reached about $11.87 trillion in size globally. For comparison, the market cap of the entire S&P 500 is at about $57 trillion right now.
This is an area where a credit crisis blowup could happen. Private equity funds buy companies using debt, typically financing 50 to 70% of the purchase price. They may use private lenders (i.e., not banks) to borrow with floating rates. Cheap debt, rising valuations, and low defaults have led to a boom in both private equity and private credit, but these assets are illiquid and opaque.
If interest rates rise or growth slows, borrowing costs could increase or earnings struggle to keep up with debt payments. Default risk would climb. Private credit funds and private equity funds may have to mark down their loan and company values.
The recent bankruptcies of U.S. auto parts supplier First Brands and car dealership Tricolor led JPMorgan CEO Jamie Dimon to comment:
When you see one cockroach, there are probably more, and so everyone should be forewarned of this one….
We’ve had a credit market bull market now for the better part of since 2010. … These are early signs there might be some excess out there because of it. If we ever have a downturn, you’re going to see quite a few more credit issues
While both these companies were privately held by groups of individual investors (not private equity held, which is a little different) they are examples of the increasing stress that private credit is facing.
Much investor chatter happening these days is around whether we are in an AI capex spending related bubble or not, leading to inflated stock valuations for the likes of Google, Amazon, Microsoft, Meta, and Oracle along with AI-specific companies like Coreweave. AI capex spending is partially funded by private credit, not just the earnings flows of the Mag 7.
How could a bubble burst play out, across private and public markets? If institutional investors in private markets face markdowns on illiquid PE and PC holdings, they may be forced to sell liquid public assets, especially mega-cap AI stocks which have been the best performers.
Alternatively, if something causes AI valuations to crack first, wealth destruction in the public markets could lead to a decrease in availability of financing for PE and PC. In absence of being able to refinance debt, we could see widespread defaults.
What does all this mean for my portfolio management? Not much, because I have rules that will get me out of any positions in the case of a crash, especially a slow moving one. And, more important, I have rules that will get me back in. Every investor who has sold out at a low knows how difficult it is to buy again when things are looking better. We saw that especially in the flash crash after Liberation Day this year. People who sold didn’t know when to get back in and missed out on a historic rally.
Meanwhile, I’m very happy that gold is one of my large positions. I’ll keep riding that as long as it goes up.
- I do have to decide which assets I even include in my portfolio though, that’s where my beliefs come in. Right now I have a pretty well diversified portfolio across all major asset classes: U.S. stocks both large and small cap, global stocks, fixed income, precious metals, commodities, and a lot of cash. ↩︎