Skip to Content

A Serious Probability Error

Editor’s Note: As you’ll read today, our “leaders” aren’t the powerful beings they think they are. The result is an investing environment fraught with uncertainty and, frankly, ass backward. This means you need to seek out control of your investments where you can. You can’t control the markets. You can’t control the companies you invest in. But you can control the trades you make – short- term grabs at profits. Our Freeport Society friend and Master Trader Jonathan Rose recently taught investors like you how to do this with less risk and greater return. He’s kindly agreed to let us share a replay of this event with you. You can watch it here.

I love dystopian sci-fi.

Maybe I’m just the melancholy sort, but a good technology doomsday story really keeps me on the edge of my seat.

If you haven’t seen it already, Leave the World Behind, which premiered on Netflix last year, is a good look at the fragility of the modern world… at how easily it could all come apart. We watch Julia Roberts’ and Ethan Hawke’s stay at an Airbnb turn into a nightmare when America suffers a cyberattack and the lights go out.

Besides the self-driving Teslas piling up on the road out of town, there was one exchange that really stuck with me. It was between Julia Roberts’ character, yuppie mom Amanda Sandford, and successful financial advisor G.H. Scott, played by Mahershala Ali.

Scott says that one of his wealthy and well-connected clients called him just before the attack and asked to move a lot of his money. Sandford asks if he thought the client was responsible for the attack… 

Scott’s response is perfect::

G.H. Scott: A conspiracy theory about a shadowy group of people running the world is far too lazy of an explanation… especially when the truth is much scarier.

Amanda Sandford: What is the truth?

G.H. Scott: No one is in control. No one is pulling the strings.

No one is in control.

Remember this whenever you see Federal Reserve Chair Jerome Powell speak. 

Powell presents an image of being in control. He may even believe it himself! But the events of the past four years have made it clear that Powell is no shadowy puppet master bending the economy to his will. He’s a hapless schmuck reacting to every crisis while never managing to get ahead of it. 

He bumbled his way into the highest inflation in 40 years, and he may now be bumbling his way into stagflation.

No one is in control.

My Freeport Society friend, TradeSmith Chief Research Officer Justice Litle, had a lot to say about this recently. You can keep up with Justice’s regular missives here.

Read and enjoy. 

To life, liberty, and the pursuit of wealth,

Charles Sizemore

Chief Investment Strategist, The Freeport Society

Investors are Losing Faith in the Fed (and Rightly So)

By Justice Litle, Chief Research Officer, TradeSmith

When it comes to raising or lowering interest rates, the Federal Reserve is not in control. They only have the appearance of control.

External factors shape the Fed’s course of action… and sometimes force a course of action whether they like it or not.

This is why persistent inflation pressures are a problem. Wall Street wants the Fed to cut interest rates. Fed Chair Jerome Powell also wants to cut interest rates. But because of persistent inflation pressures against the backdrop of a still-strong economy, the Fed has to hold off.

And if inflation pressures persist for long enough, they may even have to raise rates again.

Soft landings are rare — and incredibly hard to pull off — because the balancing act is so tricky.

  • If the Fed cuts interest rates prematurely, “sticky” inflation can become entrenched or even accelerate. If that happens, inflation expectations (the belief that prices will continue to rise) can become a self-fulfilling prophecy, at which point the inflation problem is worse than before.
  • If the Federal Reserve waits too long to cut, however — the current federal funds rate is at a 23-year high — the hidden stress effects of high rates can eat away at interest-rate-sensitive areas of the economy, creating the potential for a sudden sharp downturn in housing or manufacturing or autos and the like. If that happens, a hard-landing recession or even a financial crisis can materialize out of the blue.

There are no safe stances here: Whatever path the Fed chooses, including the path of doing nothing, has the potential to be a mistake.

The debt-and-deficits situation further complicates the picture.

Heavy debt issuance (via record budget deficits) increases the volume of net Treasury supply: The government has to issue large quantities of newly minted U.S. Treasuries at auction on a monthly or quarterly basis to fund its ongoing spending needs.

If, at some point, net Treasury supply exceeds demand by a large amount, interest rates at the long end of the curve can spike as bond prices suddenly fall (interest rates rise when bond prices decline).

Picture a shockingly low-demand U.S. Treasury auction creating a sudden interest rate spike in which the 10-year yield rockets to 6% or even (per JPMorgan CEO Jamie Dimon) as high as 8%.

When it comes to the path of short-term interest rates, then, the Fed has choices it can make — and yet the central bank is more like the conductor of a speeding freight train than an entity with real control. The conductor can throw levers, but a 20,000-ton freight train, barreling down a track, will do what it is going to do.

In brief, this explains why we are so bearish on stocks. It is largely a function of nosebleed-level equity valuations coupled with extremely dangerous macroeconomic conditions.

Good Things, Bad Things

As value investors like to say, “good things happen to cheap stocks,” meaning that a stock that is cheap (in terms of valuation) can benefit from a wide array of upside surprises.

But the opposite also applies: “Bad things happen to expensive stocks,” in the sense that an overvalued stock with irrational expectations built in can get the daylights hammered out of it for a slight misstep (witness ARM Holdings Plc (ARM) and Super Micro Computer Inc. (SMCI) in recent weeks).

At the May 1 post-FOMC meeting press conference, Powell tried to maintain an optimistic tone, but clearly hedged his bets.

Powell wants to get on with interest rate cuts… but the data is holding him back.

And Powell really, really wants to rule out an interest rate hike… but he can’t rule one out entirely.

In this sense the inflation data is in control, rather than the Fed.

That in turn means factors like geopolitical impacts on the oil price or a sudden deterioration in the housing market could have more to say about whether the Fed cuts interest rates — or feels forced to hike them — than the Fed itself.

And historically expensive stocks, meanwhile, are still broadly priced for a probability space where everything is magical and wonderful, and everything works out perfectly.

This looks like a serious probability error.

Until next time,

Justice Clark Litle

Chief Research Officer, TradeSmith

P.S. If you enjoyed this commentary from Justice, you can find out more about his service, Decoder, here. Thanks, Justice. Always insightful hearing from you.