When Dorothy and her gang of misfits finally meet the Wizard of Oz in the Emerald City, they discover that the mythical figure is just a feeble man operating machinery behind a curtain.

I can’t help but draw parallels between this classic parable and the unraveling of the world’s preeminent AI company, OpenAI.

Several big pieces of news came out from the company this week:

1. On Monday, the company announced a new funding round that would raise $6.5 billion at a $150 billion valuation

2. Sam Altman and the board wants to upend its non-profit corporate structure to become a for-profit corporate entity

3. In the same stroke, Altman is dropping all pretenses of running OpenAI for altruistic reasons and wants a 7% equity stake in the company

4. On Wednesday, the company’s star CTO Mira Murati suddenly resigned from the company. Two other senior research executives, VP Research Barret Zoph and Chief Research Officer Bob McGrew, joined her in bowing out

To put it lightly, this is turning into an absolute clown show.

Murati’s departure seems abrupt and unexpected by the company’s management and investors. They just announced a new astronomical $150 billion funding round and there seems to be no succession plan for Murati. Having two senior research executives follow her out the door just makes the whole affair look even worse.

At this point, this latest funding round might be in jeopardy, and there would be significant egg on the face of the lead investors who clearly didn’t perform sufficient Due Diligence.

If the deal has already been solidified, then it’s even more disastrous for the lead investors.

How on earth does any respectable money manager with billions of dollars on hand sign off on the largest VC investment deal ever, $6.5 billion at a $150 billion valuation, only for the CTO to walk away just two days after the news breaks?!

You. Can’t. Be. Serious.

Ignoring the sudden high profile departures from the company, this $150 billion deal is just all around a terrible deal for all involved.

Here are some simple reasons why:

1. OpenAI’s state-of-the-art model (OpenAI O1) is only marginally (+5%) better than Google and Meta’s previous generation models. There is no moat.

   

2. No one has found a profitable AI-driven business model so far, besides Nvidia.

3. This deal will end OpenAI’s access to top talent. How will OpenAI hire any reasonable talent at a $150 billion valuation? Only financially illiterate tech workers would be willing to take illiquid equity at a $150 billion valuation for a salary.

4. If OpenAI is indeed close to AGI (Artificial General Intelligence), why have so many core co-founders and employees left. Only 2 out of the original 11 co-founders remain at the company. If your company is close to transforming humanity with AGI, wouldn’t you want to stick it out to see it happen, no matter how tough it gets?

I think it’s clear we have a Wizard of Oz situation on our hands.

OpenAI pioneered a brute force, duct-taped, and grotesque representation of a brain that could regurgitate human language, and soon learned that the more they talked in vague terms about AGI, hiding behind complicated (but very mechanical) math, the more mystical and profound they seemed, and the more money and prestige they could get for themselves.

It’s not that different from the behavior of your average greasy suburban car salesperson, except that this particular sales team is armed with bespoke, pedantic, and convoluted linear algebra.

Yet it’s just a grand performance, and the curtains are slowly being pulled back.

I am back!

Apologies for another pause in writing recently. I have been busy in the last month making a big move across the continent (back to San Francisco, from Toronto) and acclimating to a new apartment and a new job.

The good news is that things are going well. I’m loving the new job and my apartment is (mostly) fully furnished.

The apartment looked like this a month ago…

And now it looks like this!

I’ve been guilt-ridden for the hiatus from FinanceTLDR and the itch to publish grows more intense by the day.

Today feels like the right time to restart. As a matter of perfect, it’s about time!

Before I dive into the financial markets, one more piece of important housekeeping. Given that I’m a Canadian on a work visa in the US, I probably shouldn’t be charging for FinanceTLDR so I’m going to convert the newsletter to a fully free newsletter once again.

I will continue to put the same effort into the writing and research, because I simply love it, and I am immensely grateful for everyone that has financially supported the newsletter over the past few months.

Without further ado, let’s talk about Matters of Big Money.

The market has been dominated by two big narratives lately: political turmoil (Biden stepping down, Harris stepping up, conflict in the Middle East and Eastern Europe, Trump almost getting shot) and how fast interest rates will fall.

Both are incredibly volatile narratives and the market of the past few months has been bipolar.

My modus operandi has been to ignore the political noise and focus on a thesis that interest rates must fall, and fall soon.

Last week’s Federal Reserve meeting was a big validation of this strategy: the Fed cut interest rates by 50 basis points (huge!) and signaled that they want to cut another 50 basis points by the end of the year.

A 50-basis-point sized cut is unusual since the “normal” rate of adjusting interest rates is 25 basis points at a time. Anything larger than that and it signals an urgency from the Fed.

So why is the Fed in a rush to cut interest rates? What are they seeing but not saying?

The market is currently obsessed with reading into the Fed’s motivations.

There are two ways to interpret this unexpectedly large interest rate cut:

1. The economy is in trouble

The last two times the Fed opened a rate cut cycle with a 50-basis-point rate cut, the economy was 3-4 months away from a massive downturn (i.e. 2001 and 2007).

Extrapolating from this trend, did the Fed see serious trouble ahead to compel them to rush rate cuts?

In addition, if you zoom out even more, almost every rate cut cycle in the past few decades started right before or right at the start of an official recession.

Rate cuts should be a good thing for the economy, so why are they so often tied to economic downturns?

Well, the effects of a rate cut on the economy are delayed by many months, around a year or more, and it’s almost a self-fulfilling prophecy that the two will be paired together since the first thing the Fed does to front run and support a dangerously teetering economy is to cut interest rates.

Second, rate cuts can cause immediate second order effects that hurt the stock market.

For example, when interest rates fall, call option prices fall and put option prices rise. This results in the net-selling of stocks by options market makers.

Another example is the ending of currency carry trades (short non-US currency, buy US dollar, long US stocks) as the value of non-US currencies rise. We saw this recently when the Bank of Japan raised Japanese interest rates. This put significant pressure on Japan→US carry trades and caused a steep sell-off in the US stock market.

2. The business cycle is about to boom again

The other narrative, which is simpler, is that falling interest rates is good for stocks since it’s easy for companies to borrow money when interest rates are low.

Falling interest rates also immediately make high-growth companies more valuable (since future dollars become more valuable).

What do I think?

It’s hard to say where the economy is headed. We don’t have access to the same amount of information as the Fed.

So my market strategy is to not over-index on what the Fed knows but isn’t saying. I’m strictly focused on the direct impact of falling interest rates on economic sectors that are highly sensitive to interest rates.

One example is the real estate industry. This industry is disproportionately driven by interest rates and falling interest rates is directly beneficial for real estate.

This is why I established a significant long position on Zillow a couple months ago in anticipation of falling interest rates and this position has been doing very well as of late.

Where’s the market headed?

The Presidential election is coming up in two months and I think the US government will work hard to keep markets stable and interest rates falling until then.

As such, I feel comfortable maintaining this long position in real estate and will likely re-evaluate after the election.

Fin

I’ll keep this issue short and sweet since I’m not fully caught up with the details of what’s going on in markets and only have a high level perspective in mind.

I hope to do deeper dives on markets in future issues as I catch up. Very glad to have more time to research and write about markets again.

To start, I’d like to introduce you to James Wang, an accomplished venture capitalist and Bridgewater and Google X alumnus. James authors this issue’s guest post where he attempts to answer whether OpenAI is overpriced.

He writes a newsletter called Weighty Thoughts where he shares his unique and on-the-ground perspectives of AI and “deep tech” investing. I highly recommend it.

Without further ado, here’s James’s guest post, “What AI really is—and is OpenAI overpriced?”.

What AI really is—and is OpenAI overpriced?

What is AI, really?

There’s an old USSR joke of an old man answering questions about cities.

Where were you born? “St. Petersburg.” Where did you grow up? “Petrograd.” Where do you live? “Leningrad.” Where do you want to live? “St. Petersburg.”

The joke, of course, is these are all the same city in different eras of Russian history.

In a way, the same thing is true of “artificial intelligence” today. What used to be simply statistics became machine learning, which then became artificial intelligence. “Old timers” like me—which is weird, since it wasn’t that long ago—who were in the statistical/machine learning era were always leery of applying the concept of “AI” to what we did. After all, most popular machine learning textbooks start with GLMs (generalized linear models)… which includes linear regression, which every high school student learns.

So, what are we actually talking about today?

But enough history: why do we care about this?

Well, the problem with hype and bubbles is one of over-extrapolation. Below is a stylized chart I made for my piece about AI/tech bubbles. It’s hard to say when a bubble will pop (… maybe it’s already starting to given how the public markets are trending!), but one thing an informed investor can do is compare one’s knowledge of a technology’s capabilities with what the market expects.

This is all well and good, but it’s very abstract. Are the companies today valued in a reasonable way, or are we in fantasy-land? You can at least look at public company valuations, but what do they even mean?

Beyond that, can you do anything to value a private company?

Well, it’s rough but it’s doable. Let me show you how.

The steps are:

1. Have some idea what the real capabilities of the technology are.

It’s never going to be perfect—by definition, a new technology is… well… new. But if we have a grasp of how it works, we can know when expectations are far past reasonable.

From there, we can then:

2. Look at companies—even private ones—and have a sense of if they are valued fairly or not. This article will examine the top AI startup right now, OpenAI.

So, let’s first get into the capabilities.

Large Language Models

In the simplest conceptual terms, an large language models (LLM) is an imitation machine. The more data it has, the better of an imitator it is.

In reality, an LLM does not think. It’s just a statistical machine that pops out the next predicted word, similar to your smartphone’s autocomplete, just with much more data and power.

That’s not to diminish how impressive some capabilities of this “fancy autocomplete” are.

For example, with the power of transfer learning, LLMs have been able to answer “novel” questions incredibly robustly by remixing knowledge (language, domain, etc.) from different fields to come up with answers.

However, it’s important to distinguish what is and is not happening. In a way, you can say that a lot of human behavior is just novel remixing. However, analysis and computation is not that. This is why LLMs generally, even if they get some math problems right, will make perplexing errors randomly. They aren’t actually reasoning. It’s still a statistical predictor, just like if you typed in a particular math problem on your smartphone a lot, it too would get the right answer, but you would never expect it to consistently do so.

Additionally, you’d never rely on these models for something like actual business or financial analysis. You may have heard about “hallucinations” where LLMs “make up” knowledge (including, famously, court cases by a hapless lawyer who tried to have an LLM do his homework). This isn’t a “bug” though—it’s fundamental to how LLMs work and why they can do interesting things to begin with. It also means that it’s hard-to-impossible to “remove” that behavior. How useful would your autocomplete be if you removed all ability for it to predict on things except within a narrow subset of existing documents? Not very.

Even so, there are still plenty of interesting applications.

Most customer service chats are indeed similar, even in terms of when the situation turns extreme. Most essays, grants, and even mass-produced internet articles are also indeed similar and can easily be produced by an imitation machine.

However, this is quite a different problem set than designing new materials. Or protein folding. Or solving novel math proofs. AI can be applied here (e.g. AlphaFold and AlphaProof), but not LLMs.

Because LLMs aren’t reasoning machines, the areas in human life where they can be safely and effectively applied to are limited.

Now, with that rough sense of the capabilities of LLMs, let’s get into valuations.

Is OpenAI Overpriced?

It's always difficult to use financial projections on startups in new markets.

Take it from me—how do you reasonably "smoothly" project the valuation of a company that goes from $0 in revenue to signing a $1B+ contract (an actual case in my venture firm’s portfolio)?

This is obviously even harder with companies that are private and do not regularly report standardized financial metrics.

What I’m about to do is more art than science—but all valuations must start somewhere.

As a roadmap to valuing OpenAI, we will:

1. Gather information

2. Use that information to derive valuation estimates

3. Work backwards from those valuations to determine expected revenue growth

1. Information Gathering

Here’s some (limited) information on how the market approximate values OpenAI:

• OpenAI is reported to be on track for around $3.5B in annualized revenue.

• It was on track to burn $5B this year (after revenue)—so, reported -$5B in earnings

• OpenAI's last reported valuation was $80B (Feb 2024), tripling from their last valuation early 2023. This was a tender, though, so was mainly for liquidity of insiders/secondary sales. We can assume it raised no additional cash.

• The best data seems to suggest that OpenAI raised $11-12B (with $10B from Microsoft in early 2023—though some substantial portion was probably credits, or was going to be poured right back into Azure).

We can start to get a hazy picture of the company’s financial circumstances with all of this information and “typical convention” in private markets and venture.

2. Estimated Valuation

What information do we have? Well, we literally have valuation. So, are we done? Not really. First off, not all valuation is equal (as we’ll get into). Second, we have the old valuation, which includes a risk premium. What we want is the future valuation that the startup is expected to achieve—and hence, understand what the implications for the startup’s expected growth are.

Startups/private equity deals inherently have common expectations/risk premia built into them, so we can start there.

First off, all of finance is built around time value. As such, we need to know what horizon investors are budgeting/valuing for.

Most startups raise to last 18 months until they hit their next round. This latest round was a tender, allowing employees to cash out at the high valuation, which doesn’t count—it didn’t infuse in capital. The last actual capital raise was probably the $10B from Microsoft in January 2023.

If we were to take the normal “18 months” rule of thumb, they’d already be out of cash. So, is this wrong? Let’s take a closer look, especially in light of their earnings.

Let’s assume the company burned a similar amount last year. That would leave them with $5B to work with for 2024.

Interestingly, most reporting seems to suggest $3B revenue was higher than expected. If so, as it got realized, it could have helped push out OpenAI’s 18-month timeframe.

How far? Well, $3B/$10B = 30% so “saving” that amount (by earning it in revenue) would then increase your cash runway by that much.

That would turn 18 months into around 23 months—and roughly square with the picture we have now (reported by The Information, which did a similar analysis though a different way). As such, this horizon seems right.

Let’s move on then to triangulating what valuation they were meant to have for their next raise.

In 2023, Microsoft valued OpenAI at $29B. Using expectations for PE/VC, an investment should at last have around 35% IRR at minimum (given risk, one would usually require more than this, but let’s take a lower bound), which lands OpenAI at around $45B within an 18-month timeframe.

Given this, the company likely has leeway between this figure and $80B.

I’m not going to bother up-valuing the $80B to a next round, and just keep it as the “top end” estimate (… these kinds of tender offers often don’t go well for investors).

3. Implied Revenue and Growth

Multiples of various kinds are popular in finance because they’re easy. The problem is they aren’t particularly accurate and they can only tell how a stock is valued relative to another one—not how good a stock is on an absolute basis. Nonetheless, it’s a useful tool when we have very limited information, like in our case here.

At a $45B valuation and a $3.5B revenue, OpenAI has a 13X revenue multiple, which is rich, but not completely insane. If we go with $80B, this is a 27X revenue multiple, which is starting to get to ridiculous-land (it resembles inflated earnings multiples of hot tech companies).

For comparison, see the index on annualized recurring revenue multiples for SaaS companies below. Yes, I know AI isn’t “SaaS” but many investors still use SaaS multiples—which are the most prevalent within tech—to roughly benchmark companies in widely disparate fields.

This chart only goes until the end of 2023, but from my own observations in the market, this is still roughly right, with 6-7X revenue multiples being market mid-point.

So, this says that even at the “reasonable” valuation expectation, OpenAI is inflated. 13X revenue multiple is basically twice the average. What does this actually mean, though? Does it mean OpenAI is overvalued?

Now, as said, you can’t directly turn revenue or earnings multiples into earnings expectations, but you can use them on a relative basis.

So, let’s ask: why would you pay a higher revenue multiple for one company vs. another? Well, if the company is expected to grow much faster, of course. It’s the same reason why you would pay a relatively lower earnings multiple on a “value stock” but be willing to pay a much higher one for a high-flying tech or “growth stock.”

A common way in public markets to compare earnings multiples is to divide them by 3-year forward earnings growth. If you end up at similar numbers, the stock is priced similarly relative to growth. Applying a similar concept, we can “solve” for X: in this case, implied revenue growth for OpenAI given its multiple.

We just need what the market is pricing in for revenue growth for the “average” company sitting at around 6.5X revenue multiple. Again, from SaaS Capital’s helpful data:

20%+ growth expectations on the high-end for “average” multiples is around right from my experience in private markets.

Ok, so what does OpenAI’s revenue multiple range of 13-27X mean? Well, that implies (relative to market average of 6-7X) between 2–4 times an equivalent private SaaS’s expected growth rate.

This means the market is expecting 40-80% growth for OpenAI over the coming years. Let’s look at what this means for the company’s top line revenue.

Does this mean OpenAI is overvalued?

In a world where Google and Microsoft’s annual revenue are >$250B, this might not look insane. However, these are also the most massive companies in the world, who dwarf many countries’ GDP.

Let’s instead look at another massive VC unicorn, Salesforce, who in April 2024 had a trailing 12-month revenue of $35.7B. Meaning, recently, like 20 years after its IPO.

Is $30B in 2027 revenue reasonable for OpenAI?

I mean, maybe! OpenAI is a new, innovative company that could keep expanding to new industries and application areas and monopolize the new AI world.

Except, of course, as we explained, LLMs have their limits. That expansion potential is far from limitless. Even Goldman recently came out with a report questioning whether or not Gen AI is actually worth much at all.

Additionally, that “monopoly” is likely quite fragile—or non-existent. OpenAI isn’t alone in having powerful LLMs. In fact, open-source models, as I’ve written recently and as Maxime Labonne nicely illustrates, have mostly caught up.

As such, there are many reasonable questions about whether OpenAI can actually double annual revenue from $5B in two years.

Now, to be fair to OpenAI, it’s a new technology and they’ve already grown a lot. It isn’t in the realm of “completely insane.” It is a stretch, but it’s a conceivable stretch.

As you would expect from a round priced by professional investors, it’s not so ridiculous as to be laughable. It’s just unlikely given the headwinds that have already shown up—including the limits of the technology which we discussed. If you look at the LLM performance chart above, you can see it’s already leveling off.

Now, the tender offer’s $80B valuation with 3X revenue in 2 years and SalesForce-revenue in 3? That’s a much larger stretch. But, as said, investors often don’t do great in these tender offers…

… But who cares? After all, companies miss lofty expectations all the time.

Well, relative to a company that’s in a more secure cash position, or in public markets with more financing options, this is a more serious problem if OpenAI misses growth expectations.

OpenAI is a vibe check, every fundraising round

OpenAI is going to run out of cash and need to raise again. As Sam Altman said, OpenAI is “the most capital-intensive startup in Silicon Valley history.” They need to keep raising, and expectations must continue to stay high for them to maintain the funding treadmill.

If they miss… well, things will get messy. Probably disastrously so.

So, is it actually overvalued?

Wait, so after all of this, is OpenAI overvalued?

Well, you tell me based on some (quick) understanding of the tech, and now a benchmark for the kind of growth OpenAI needs to achieve. Whether that number looks eminently achievable or utterly insane is in the eye of the beholder—or market participant.

I think it’s clear that I think it’s a stretch, at best. But you may disagree. The point was to be able to work out the analysis to get something we can actually think about—and clearly debate—versus some opaque last-round valuation that’s meaningless on its own.

Now, keep in mind, all of this is rough to an extreme. There’s a lot of flaws. Multiples-based estimations are crude by nature. The information gathered could be wrong. We may be (and likely are) missing some major inside product/roadmap information. SaaS is not the exact right industry. One could find other comparables for the multiples. You could think the Singularity is about to happen. And so on and so forth.

But, as an investor, you have to start somewhere. And, as an investor within the deep tech space (including AI), with both some sense as to the tech and the market, this is how I’d break it down with just public information.

You could very well entirely disagree for either analytical reasons (you could use different kinds of multiples/methods), or for fundamental reasons (like your expectations about the technology and the achievability of the implied growth).

Well, that’s what makes a market. And hopefully, this was helpful for readers to think about how they might start valuing something as gigantic and nebulous as OpenAI.

And that was James Wang from Weighty Thoughts!

If you liked what you saw, definitely head over and take a look.

Hello! It’s been a while since the last FinanceTLDR issue. A month and a week to be precise.

I’ve been busy with personal life matters and decided to take a break (apologies for the absence!) but will try to get back into a regular pace of publishing starting from this issue.

Let’s start.

The Big Picture

Earlier in the year, I was worried about geopolitical risks hampering the market.

Although there indeed were problems stemming from volatile geopolitics (e.g. Russia banning gasoline exports in March causing a major rally in oil prices), the global situation quickly cooled again.

The cooling of global tensions helped the market stage a massive rally in the summer with the S&P 500 climbing a whopping 12% since May!

Here’s my mental framework for what’s going on.

Everything stems from the fact that this year is a US presidential election year with high levels of populism.

Both sides of the political aisle think the other party will seriously damage the country.

When populism is high leading up to an election, the incumbent government is greatly incentivized to crank up the money printers to increase its chances of winning.

The stakes are high, you’re in control of the federal government and have the power to do so, so why not?

Populism + election = more money printing

This is exactly what we’re seeing happen this year:

1. First, the Federal Reserve announced a massive cut to quantitative tightening earlier this year, even as inflation remains stubbornly high.

   1. The change: reducing monthly treasury runoff from the Federal Reserve’s balance sheet from $60 billion to just $25 billion.

   2. In other words, the Federal Reserve is adding $35 billion in treasury buying demand per month. This is the Federal Reserve’s way of subtly but significantly cutting long-term interest rates.

   3. There’s no reason to cut interest rates now with inflation still above the 2% target. Yet, oddly enough, the Federal Reserve still feels compelled to do so. Perhaps this is why they’re opting to cut rates in a 'low key' way to avoid headlines.

2. Second, quasi-government agency Freddie Mac is on track to launch a program that will flood the financial system with potentially over a trillion dollars of new liquidity through “second mortgages”.

   1. This program aims to allow home owners that locked in low interest mortgages to access their home equity without losing the original mortgage’s low interest rate.

   2. As such, it can unlock potentially over a trillion dollars stuck in low interest rate mortgages that could then be put to use in the financial system.

   3. Freddie Mac was just cleared to launch a pilot program for this late last month.

   4. With inflation still stubbornly above the Fed’s 2% target, the broad economy growing nicely, and the stock market continuously pushing all-time highs, there is no need to do this. But they’re doing it.

Populism + election = stabilizing global geopolitics

On geopolitics, even though global conflict is at unprecedented levels in recent history, we shouldn’t discount the extraordinary power the US has in both igniting and cooling conflicts.

As the world’s largest producer of fossil fuels and the world’s preeminent military and financial power, the US can easily make problems go away if it wants to.

Perhaps the best recent example of this is how the US forced Ukraine to stop targeting Russian oil refineries.

Ukraine’s bombardment of Russian oil refineries took down an estimated 30% of the latter’s refining capacity. This caused a large spike in global oil prices from March to May that threatened to reignite global inflation.

On first impression, this move seems nonsensical. Russia’s energy revenues directly helps to finance its war efforts.

Second-order thinking suggests this move is a symptom of a publicly unspoken but pivotal US government objective for this year: do as much as possible to keep global inflation down, even if this means protecting Russian energy revenues.

Why? We can only guess at the motives but it’s not a stretch to say that they could be election-related.

A Key Learning

As such, a key learning for me from this summer’s events is that if the powers-that-be want low inflation and a rising stock market, we need to not only become less bearish but also lean in and go with the flow.

For the rest of this newsletter, I'll share a few interesting market observations and trade ideas.

Quantifying China Risk

The US stock market has been booming on AI hype and this entire nascent industry hinges on a continuous supply of top-end semiconductors from Taiwan’s TSMC factories.

As such, China is top of mind right now given the incessantly rising tensions in the South China Sea and China’s ambiguous rhetoric on the matter of Taiwan.

In fact, because of this risk, major hedge funds divested from Chinese stocks at a record pace last year:

1. Ray Dalio's Bridgewater, the world's largest hedge fund, liquidated nearly a third of its holdings in Chinese stocks in the second quarter of 2023.

2. Multiple U.S.-based hedge funds: Coatue, D1 Capital, and Tiger Global reduced their positions in Chinese stocks in the second quarter of 2023.

3. Berkshire Hathaway has been rapidly selling off its large BYD investment.

However, it’s not that useful to say that a black swan event could happen without quantifying the probability. I didn’t know how to do this in a rigorous way until I had a recent insight to use prediction markets.

The good news is that popular prediction market platform Polymarket has a market exactly for this called “Will China invade Taiwan in 2024?”. It’s currently trading at 10%; low but not low enough to be of no concern.

The most valuable opinions are ones where money is at stake so I really like the idea of using prediction markets to quantify event probabilities.

A Currency War in Asia

The Japanese Yen has fallen precipitously in the past few years. This trend continued in recent days.

Normally, US government officials would be up in arms accusing Japan of engaging in a currency war. This is a major faux pas in our “rules-based world order”.

For example, when Vietnam allowed its currency to devalue in 2021, Treasury Secretary Janet Yellen was quick to publicly accuse the Southeast Asian nation of currency manipulation.

Oddly enough, Yellen has been mysteriously silent now that Japan, an economy much larger than Vietnam’s, has allowed its currency to rapidly depreciate over the last 2 years (USD/JPY has fallen 28% since 2022).

I think we can interpret Yellen’s silence as a tacit approval of what Japan is doing. Japan is, in essence, conducting a currency war with China.

A weaker Yen increases the competitiveness of Japanese exports over Chinese exports. This hurts China’s export-heavy economy.

However, at the cost of its domestic economy, China has been reluctant to race Japan to the bottom since it wants to promote the Yuan over the US Dollar as a major currency for global trade. For this to happen, the Yuan’s value must be stable.

Japan’s ongoing rapid currency devaluation puts China in a tough spot.

Should China maintain the strength of the Yuan, which could hurt its own economy but support its long-term global ambitions, or should it allow the Yuan to weaken to ease short-term economic pressures?

Idea: Zillow

I’ve been interested in the Zillow idea for a while.

In line with The Big Picture narrative I discussed above, the US government seems keen on cutting interest rates (and has already started to by reducing QT) and stimulating the housing market (Freddie Mac second mortgages program).

Zillow, as a growth + technology + housing market stock, greatly stands to benefit.

Idea: GM

The market has long ignored GM and given it a tight valuation relative to Tesla. Now, the company is printing money and is taking matters into its own hands.

Did you know that GM earns 20% of its market cap every year? Yup, $10 billion in annual net income vs $50 billion in market cap. The company is now rightfully deploying its massive earnings to buying back stock. In Q4 2023, GM bought back $8.6 billion worth of its stock in an accelerated share repurchase plan and then bought back another $1.4 billion of stock this year. Last month, the board approved yet another $6 billion share buyback plan.

That’s $16 billion of share buybacks in a year, which is over 30% of the company’s current market cap.

This is equivalent to Apple buyback over $1 trillion of its stock in a year!

GM can do this because its printing cash. $10 billion of annual net income with a $50 billion market cap is nothing to scoff at and it can really force the market’s hand with these massive buybacks.

Idea: Intel

Here’s an interesting observation: Intel’s stock was pinned to $30 for two months! That’s very unusual price action. Only in the past week did it suddenly wake up and climb over 10%.

I see Intel as being well-positioned for a strong showing in the second half of this year.

Earlier in the year, the company announced $45 billion in US government grants to build state-of-the-art semiconductor fabs in the US and Europe.

$45 billion might sound like a lot but this is future money, money held behind specific milestones that the company must meet, and thus the market shrugged off the good news.

Intel predicts that this grant money will start to show up on its financial statements later this year and when it does, sentiment for the stock should improve significantly.

S&P 500 Prediction

In my last Market Pulse issue published on June 4th, I shared this prediction for the S&P 500.

Below is how the S&P 500 has moved since then. I’ve also added a new prediction (in blue).

Although I got the general direction right, the S&P 500 moved up a lot higher than I thought and continues to rocket upwards.

I anticipate that it will cool off a bit since its pushed past the top Bollinger Band. After some consolidation, the upward trend will resume as we near the presidential election in November.

In this issue I write about how US and global liquidity is changing. I think this is the defining factor affecting US stock markets this year.

Before I start talking about US and global liquidity, I want to discuss a rather interesting tit-for-tat between Coinbase and the CME Group (the company operating the US’s largest financial derivatives and commodities exchange).

As you know, Coinbase runs the US’s largest crypto exchange and earns most of its revenues from trading fees.

The CME Group, on the other hand, runs an exchange that trades commodities (e.g. oil, orange juice, coffee beans) and derivatives (e.g. options).

Interestingly enough, on May 16th, both companies launched opening salvos into each other’s markets.

The Financial Times reported that the CME Group plans to launch spot markets for cryptocurrencies and Coinbase announced that it’s launching markets for oil and gold.

Caveat: technically CME Group already runs Bitcoin and Ether futures markets but these markets have been active for a long time and Coinbase earns a large chunk of its trading revenues from spot markets rather than futures.

At face value, it’s surprising that Coinbase would find itself facing staunch competition from a company that’s as foundational and deeply embedded into the traditional financial markets as the CME Group but on closer inspection, it does make sense.

Bitcoin and Ethereum are considered commodities by US financial regulators so why shouldn’t the CME Group run spot Bitcoin and Ether markets?

At a high level, I think Coinbase will be fine. It’s still the retail investor’s most trusted company for the trading and storage of crypto and the company has always faced staunched competition from other crypto exchanges.

The CME will be slow to grow its market share, partly because it’s a new entrant to a market with entrenched habits and partly because it doesn’t have as long of a track record as Coinbase of securely storing cryptocurrencies.

At the same time, Coinbase is working hard to diversify its revenues away from trading fees, which is crucially important for the company’s long-term growth.

📈 Liquidity Bazooka

Okay, back to the matter at hand.

We’re discussing how the US stock market is moving based on global money flows.

There are three important factors that will drive global money flows in the next few months:

1. First, the US housing market is getting a big boost from the US federal government.

2. Second, there’s a strong possibility that Japan’s rapidly devaluing of the Yen is being used as a tool to pressure the Chinese economy. There are interesting second effects based on how China counters.

3. Third, the Ukraine War continues to escalate and it presents the most pressing, yet undefined, risk for markets.

Let’s start.

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Let me be direct.

The US government is current implementing a series of significant policy changes with the end goal of legitimatizing cryptocurrencies as an alternate global financial system backed by the full might of Washington DC and Manhattan.

Why?

The reasons for doing so stem from a US Dollar that’s losing global influence and an uncontrollably growing US government debt burden (more on “The Why” later on in this issue).

First, let me present evidence of this very under-reported seismic policy shift within the US government.

Then, I’ll expand on what the end goal of all these changes are.

Finally, I’ll discuss The Why. Why did the US government suddenly fall so deeply in love with a burgeoning asset class that it once treated as renegade and contraband?

Let’s start.

The Under-Reported Evidence

The most overt evidence of the US government’s sudden about-face on cryptocurrencies comes from the approval of Bitcoin ETFs last year.

This was rapidly followed by the approval of Ethereum ETFs last week.

“The SEC’s approval [of the Ethereum ETF applications] on an accelerated basis caught many off guard as just the week prior almost everyone, including the Bloomberg ETF analysts, had predicted that… there was little chance of an approval by the Thursday, May 23 deadline” - Lexology

The US government moved so fast on the latter that it even surprised the typically-overly-optimistic cryptocurrency industry.

These ETF approvals come after years and years of feet-dragging by the SEC.

In fact, Grayscale, the asset manager behind the long-running Grayscale Bitcoin Trust, first tried to file for a Bitcoin ETF in 2017. The SEC soundly rejected this application.

Subsequent attempts kept failing, prompting the company to hire Obama’s top White House lawyer, David Verilli, to bolster its efforts to sue the SEC in 2023.

Then, suddenly, the SEC changed its mind.

It not only signaled a willingness to approve cryptocurrency ETFs, but it also started working with US federal prosecutors to bring the myriad of global swashbuckling crypto firms in line with US financial regulations.

Ripple, Consensys, Coinbase, Binance, Kraken, Robinhood, etc. all received lawsuits from the SEC in a span of about a year.

Besides policy changes in the SEC, cryptocurrency legislation has also been showing up a lot on Capitol Hill and on the Presidential desk in the past couple years.

1. In early 2022, Biden issued an executive order calling “on federal agencies to take a unified approach to the regulation and oversight of digital assets” and to, in particular, “explore a digital version of the dollar”. The US Treasury called this executive order “historic”.

2. In September 2022, the White House released the “First-Ever Comprehensive Framework for Responsible Development of Digital Assets”. Around the same time, the US Treasury published three reports on cryptocurrencies in accordance with Biden’s executive order earlier in the year.

3. In just the past couple weeks:

   1. “The Senate, with bipartisan support, votes to repeal SAB 121 through H.J. Res. 109, marking the first

      standalone crypto bill to pass both chambers of Congress”

   2. “House approves landmark FIT21 Bill with wave of Democratic support”. Even Nancy Pelosi voted for the bill, commenting that this is a “first step” and that “digital currency is already integrated into our economy and will only grow in significance in the years to come”.

   3. “SEC approves Spot Ethereum ETFs”

In sum, it’s very clear that Washington DC has significantly warmed up to cryptocurrencies and is moving at a rapid pace to not only embrace the burgeoning new asset class but at the same time also bring it closer under US laws and regulations.

The End Goal

I think the end goal of all this is to legitimize cryptocurrencies as an alternate global financial system that’s fully regulated by the US government.

This might sound questionable at face value, but there’s significant impetus for the US government to do so. More on this in The Why section below.

First, let’s answer some house keeping questions on cryptocurrencies.

1. What about all the illegal money flows that happens with cryptocurrencies?

Well, it turns out, because of the public and immutable nature of blockchains, it’s actually very easy to monitor who is doing what with cryptocurrencies.

There are many blockchain analysis companies that have been deeply cooperating with US intelligence and law enforcement agencies for many years now to identify illicit blockchain activity. The most famous of which is Chainalysis.

Cryptocurrencies have a bad rep but if you really think about it, they’re one of the worst ways to send illegal money around because every single one of your transactions will be visible to everyone else for the rest of time.

If you wanted to hide dirty money, you’re much better off carrying bags of cash around and laundering them through casinos and fake businesses.

2. What about all the volatility?

Another misconception about the dangers of cryptocurrencies is their high volatility.

A highly volatile asset means more risk and greater danger for investors and the overall financial system, right?

Well, the financial system is filled with much, much more volatile assets. Options, for one, have insane volatility, yet the market loves trading them and the options market’s volume has grown tremendously over the past few years.

In addition, Bitcoin’s volatility has been falling a lot over time and this trend is expected to continue as the asset matures.

“[B]itcoin’s price volatility has been declining for a significant period, and this has had nothing to do with ETFs. The market itself has been maturing, prices and market cap have been rising, and more participants trading and investing, which have all brought down the volatility.” - WisdomTree

3. Don’t cryptocurrencies challenge the dominance of the US Dollar?

Cryptocurrencies don’t challenge the status of the US Dollar.

First of all, cryptocurrencies make for poor currencies and thus shouldn’t be thought of as currencies. Their value is too volatile and, in the case of Bitcoin, transact way too slowly for day-to-day payments.

Cryptocurrencies are more like commodities or investment assets.

Bitcoin, for one, very much acts like a digital form of gold and no one today thinks gold has any chance of supplanting the US Dollar in its preeminent role in global trade.

This is a good segue into the next section where I share why cryptocurrencies not only don’t challenge the US Dollar, they’re actually accretive to the Dollar’s global dominance.

The Why

So why is the US government trying to legitimize cryptocurrencies in the first place?

Why don’t the Big Wigs in Washington DC just maintain the status quo, keeping the industry at arms length and subjecting its top companies to constant legal scrutiny?

It turns out, making cryptocurrencies a more legitimate alternate global financial system has significant benefits for the US Dollar.

And the Dollar needs all the help it can get right now.

My claim: by officially incorporating cryptocurrencies into the US financial system, the US government significantly increases global demand for both US Dollars and US government debt.

Why?

Cryptocurrencies have this feature where they can host blockchain-based US Dollars (US Dollar stablecoins) that allow users to convert between these dollars and other cryptocurrency assets like BTC or ETH directly on-chain (i.e. without the need for any centralized middlemen like banks or currency exchanges).

As a result, in theory, anyone with Internet access and the ability to buy cryptocurrencies will be able to buy US Dollars.

This, in effect, circumvents any capital controls that a nation has in place to protect its currency.

If a poor Argentina farmer or Venezuelan shopkeeper lost faith in how their governments are managing their national currencies, they can directly and quickly access US Dollars through the Internet (!).

You can bet there are billions of people in the world living in deeply fiscally-mismanaged nations that are chomping at the bit to own more US Dollars and use US Dollars in their day-to-day commerce.

This is why the deeply established, deeply mainstream politician, former Speaker of the House Paul Ryan is currently working hard to proselytize US Dollar stablecoin legislation on Capitol Hill.

Even without formal legislation, US Dollar stablecoins is already a major global asset class with $160 billion in market cap and $73 billion in daily trading volume.

Ranked among countries, US Dollar stablecoin providers are the 16th largest buyer of US treasuries today (they use these treasuries to back their issued blockchain dollars).

When US Dollar stablecoins are fully legitimized by the US government, the idea is that their global demand will skyrocket, which directly increases both demand for US Dollars and much-needed demand for US government debt.

Below are some quotes from Circle, the largest and most regulatory compliant US Dollar stablecoin provider, from its “State of the USDC Economy” published earlier this year:

“In the coming years, we expect millions of businesses and billions of people to begin using this new, open Web3 internet layer to transact trillions of dollars in value.”

“Last year marked a major turning point for the future of blockchain-based, internet native finance. Bad actors began to bear the full weight of their nefarious activity, frauds were uncovered, yet the underlying technology matured, and mainstream businesses deepened their involvement with technologies like USDC.”

“The dollar’s global role means the overwhelming majority of stablecoin activity today is denominated in dollars. USDC makes it possible for nearly anyone, anywhere, to access, hold, and transact digital dollars over the internet.”

“USDC is a payment stablecoin that combines the strength, trust, and network effects of the US dollar with the superpowers of the open internet.”

If I may speak in slight hyperbole, I think the marriage of the US government and cryptocurrencies will culminate in the merging of the US Dollar with the Global Internet. This will elevate the US Dollar to a higher level of prominence in global finance.

In the short term, it doesn’t hurt that it will help forestall the US government’s urgent debt problem (I’ve written at length on this problem in prior newsletter issues).

What are US Dollar stablecoins being used for today?

So US Dollar stablecoins are already a massive global asset class today, $160 billion in market cap and $73 billion in daily trading volume, but what exactly are they being used for right now?

From the Circle “State of the USDC Economy” report, stablecoins are mostly being used for:

1. On-chain trading (probably the biggest use case for stablecoins in the US)

2. Remittances

3. Cross-border payments

In this issue I write about where I think markets are headed given recent news, and share strategic ideas based on this news.

Before I start, James Gorman, 14-year CEO of Morgan Stanley, recently announced his retirement.

Here are some fun and informative excerpts on M&A deal-making from his parting public interview:

“I flew to Japan overnight to meet with my counterpart, Nobu Hirano (Chairman of Mitsubishi UFJ Financial Group).

We met at the Westin Hotel in Tokyo and it started with me pulling out a napkin, literally on the table, a paper napkin drawing a line down the middle of it and putting on the left hand side of it ‘Nobu wants’ and on the right hand side ‘James wants’.

And I said, What would you want? What do you want out of this?

And he told me his things, and I told him my things and I crossed off the ones that sort of matched and put circles around the ones that didn't.

I said, ‘This is where we need to focus.’

We got a deal done which resulted in what has been phenomenal for Morgan Stanley and phenomenal for MUFG.

You've got to seize the moment to get deals done.”

To get deals done…

“To get deals done, there are four things that matter.

One is the strategic fit. If it’s off strategy, just don’t do it.

Number two is the culture can’t be damaging. It can be neutral, doesn’t have to be additive.

…

The third is the timing of it.

When the door opens, you walk through it. You don’t wait for when it’s convenient for you. You have to act.

…

And finally, obviously, price, and I would say price is the least important.”

Okay, back to the issue at hand.

The Federal Reserve is facing significant domestic and foreign pressures to ease monetary policy (cut interest rates, print more money etc.).

At the same time, the inflation battle is far from over yet.

Energy prices are high and geopolitical risks are the highest they’ve been for years.

The Federal Reserve has recently caved to pressures to ease monetary policy rather than stay tough on inflation.

The Headline: the Federal Reserve has signaled that it’s going to support financial markets for the foreseeable future. The reason is unclear, though it has many good reasons to do so.

This issue dives into the second order effects of this and also discusses an ongoing significant shift in US government policy that must not be ignored.

The Macro Details

Imagine the US financial system as a classroom.

The players in the system are students milling about the room.

In this scenario, the US Treasury is the biggest student in said room, waddling around, clumsy under his own weight, and pushing everyone else around.

The US Treasury was not always like this. Only since a major sickness 4 years ago did he really start overindulging in culinary delights and sized up.

Now, everyone else has to make space for him.

This includes the Federal Reserve, who’s the coolest kid in class. The Federal Reserve sets the mood and the energy of the whole class.

These days, the Federal Reserve constantly has to accommodate the US Treasury.

As awkward as this off-the-cuff analogy I came up with is, it’s quite an accurate representation of the US financial system today.

The US Treasury is indeed the largest player in the financial system. It has to not only refinance $34 trillion in existing debt this year (by reissuing the same treasuries), it also has to issue $2 trillion of new debt.

$2 trillion is a LOT of new debt to push onto the rest of the system.

The schedule for the new debt issuance this year looks like this:

1. Q1: $850 billion

2. Q2: $260 billion

3. Q3: $850 billion

4. Q4: $100 billion ← Presidential Election in November

It’s no wonder the Federal Reserve decided to add ~$50 billion of extra US treasury buying demand each month starting in June.

Inflation is still far from the Federal Reserve’s 2% goal, but the Federal Reserve has signaled that supporting the market is a higher priority than fighting inflation.

Not only does this benefit the US financial system, foreign economies benefit as well.

When the Federal Reserve lowers interest rates / prints money, it weakens the US Dollar. This gives foreign central banks the ability to loosen their own monetary policy without their currencies depreciating too much against the Dollar.

And foreign central banks, especially Japan, are currently chomping at the bit to loosen their own monetary policies.

They’re just waiting on the green light from the US Federal Reserve and the US central bank has given them the green light.

Alright, so what I just wrote about is a super high level view of what’s happening with the global financial system.

Now let’s discuss its second order effects on the US stock market.

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In this issue, I write about last week’s CPI report, a quick macro overview, and investment updates from Warren Buffett and Stanley Drunkenmiller.

🥶 April CPI: Saving On Used Cars

TLDR: the April CPI report came in cool. However, a lot of this coolness is caused by steeply falling Used Car prices while Energy remains hot. Nevertheless, a falling topline number gives the Federal Reserve much needed cover to loosen monetary policy, which it sorely needs to do.

In a big win for the Federal Reserve, April’s CPI report came in exactly in line with expectations, instead of being hotter-than-expected.

This was the first CPI reading in the past 4 months that came in line with expectations, rather than being hotter-than-expected.

Falling inflation means the Federal Reserve can ease monetary policy (i.e. slow quantitative tightening, lower interest rates).

Here are two important views of this CPI report that explains this cool inflation reading.

(1) You can see here that the “Used Cars and Trucks” category is really pulling the overall number down, while almost everything else continues to grow.

(2) Here’s another view of CPI. You can see that Core Goods (which Used Cars and Trucks are a part of) have been negative while services remain hot.

Is inflation really falling? Or is it just used cars? How often does one buy a used car?

The most worrying component of the CPI is Energy. It continues to remain hot as geopolitical conflicts keep oil prices high.

A snippet from a JP Morgan analyst on the April CPI report:

“We expect energy to stay elevated and volatile in the near-term given looming geopolitical tensions and the approaching summer months. High energy prices could provide a headwind for consumer confidence going forward and dampen consumer spending.”

The Federal Reserve, the US Treasury, and Inflation

TLDR: It’s hard to fight the Federal Reserve.

They are staring down the barrel of inflation, and beholden to geopolitical risks, but they’ll try their best to keep monetary policy loose to help the US government fund itself, to stabilize foreign economies, and for the Presidential Election in November.

This means markets are likely to keep going up in the next few months.

There are heightened geopolitical risks, but it’s always a losing trade when one accounts too heavily for them.

The top macro story of the day continues to be a Federal Reserve that’s forced to navigate the treacherous passage between:

1. Keeping monetary policy tight to cool inflation

2. And easing monetary policy from pressure from a slew of titanic foreign and domestic forces

These other forces include:

1. Foreign central banks

2. And this year’s Presidential Election

While inflation remains high in the US, inflation has cooled elsewhere in the world and their central banks are chomping at the bit to cut their own interest rates.

But they can’t cut as much as they’d like, since cutting interest rates before the Federal Reserve cuts US interest rates will weaken their currencies against the US Dollar, making imports more expensive, which ultimately hurts their economies.

Finally, the Presidential Election later this year is another force pushing the Federal Reserve to cut.

In theory, the Federal Reserve should be apolitical. In practice, this is not always the case.

In fact, the Federal Reserve has a track record of keeping monetary policy loose during Presidential Election years, and this is especially true during a time of high populism. This year is unlikely to be different.

The Federal Reserve is already succumbing to the pressures to loosen monetary policy.

In May’s FOMC meeting earlier this month, they announced a sudden and massive cut to Quantitative Tightening, reducing US treasury run-off from its balance sheet from $60 billion a month to a mere $25 billion a month.

By the way, the announcement of this cut gave the Japanese Yen a big boost after its massive slide against the Dollar over the past few months.

You can bet that Japan’s economic policymakers had been frantically calling the Federal Reserve, as the Yen slid aggressively against Dollar, for the Federal Reserve to give the Yen some reprieve.

As for us investors, it’s important to know that it’s hard to fight the Federal Reserve, it’s hard to fight the US Treasury, and it’s hard to fight central banks all around the world.

Buffett and Druckenmiller’s portfolio updates

Warren Buffett and Stanley Drunkenmiller’s investment firms recently filed 13F forms which reflect the firms’s holdings at the end of Q1 (end of March).

Both investors have made some very interesting adjustments to their portfolios.

Here are the highlights.

Druckenmiller cut his exposure to Nvidia by 72%

In his recent interview on CNBC, Druckenmiller mentioned that he started a position in Nvidia even before the launch of ChatGPT, sized up the position over time, and rode the stock from $150 to $900.

As much as he’s bullish on AI for the long term, a 500% gain in under 2 years is just too good to not lock in.

“[W]hen the stock went from 150 to 900, I’m not Warren Buffett. I don’t own things for 10 or 20 years. I wish I was Warren Buffett. And 150 to 900, yes, we did -- we did cut that position and lot of other positions in late March. I just need a break. We’ve had a -- we’ve had a hell of a run… But no, long-term, we’re as bullish on AI as we’ve ever been.”

Druckenmiller put on a massive bet on small cap stocks

Druckenmiller bought $664 million worth of call options on the Russell 2000 (small cap stocks) in the past quarter.

Small cap stocks are highly sensitive to interest rates, given that many are reliant on debt to grow / sustain themselves.

Druckenmiller’s bullishness on small cap stocks shows that the thinks monetary conditions are likely to loosen in the next few months, which is in line with what I wrote about above.

Buffett started a massive position in Swiss insurance company Chubb

Buffett’s bread and butter investment sector is Insurance. Berkshire Hathaway has owned insurance companies throughout its history of growth and today owns several insurance giants, the most famous of which is Geico.

Insurance companies are not only an investment for Berkshire Hathaway, their large insurance floats (pools of cash built up from premiums collected from customers that have not yet been paid out to claimants) also serve as a source of cheap leverage for the investment firm.

Buying a large stake (6.7% of the company worth $6.7 billion) in Chubb is Buffett going back to his roots.

This is yet another example of Buffett’s increasing conservative stance in his approach to the current US economy and stock market.

Buffett continues to sell Apple

Berkshire Hathaway’s cash pile is growing faster than he’s investing it. Much faster.

This growth is brought on by an ongoing, incessant trimming of the firm’s largest investment, Apple.

Buffett had this to say about building Berkshire’s cash pile at its annual shareholders meeting earlier this month:

“So our cash and treasury bills were $182 billion at the quarter end. And I think it’s a fair assumption that they brought probably about $200 billion at the end of this quarter. We’d love to spend it, but we won’t spend it unless we think we’re doing something that has very little risk and can make us a lot of money.”

General Motors Buyback

Did you know that General Motors recently bought back and retired 13% of the company’s outstanding shares in just one quarter (Q4) last year?

After last year’s 1.5 month long workers strike affecting several GM factories that ended in October, management decided to leap the company out of the throes of the strike by increasing dividends by 33% and launching a $10 billion accelerated share buyback plan.

To execute this buyback plan, the company gave $10 billion to a group of banks, including Bank of America, Goldman Sachs, Barclays, and Citigroup.

The first step of the buyback plan is an immediate retiring of $6.8 billion of the company’s shares, with $3.2 billion held in reserve to buy back shares over time.

At the end of last year, GM’s market cap is $50 billion. As such, this initial $6.8 billion share buyback was about 13% of the company’s outstanding shares at the time!

Massive.

I’ve said this many times before: one mustn’t overlook GM as the most promising underdog that can challenge Tesla’s throne as North America’s most valuable automaker.

“How much US government debt is too much debt?”

At face value, this seems like a very simple question, yet there doesn’t seem to be any satisfactory answers out there.

Time and time again, I have heard financial media talking heads struggle with this question, either sidestepping it altogether or giving indirect answers.

For example, David Friedburg, one of the 4 hosts of the largest (probably) finance and tech podcasts out there, the All-In Podcast, posed this question to his fellow hosts in an episode a few months ago.

None of the podcast’s centi-millionaire/billionaire hosts gave a good answer to the question.

I found this very surprising.

These podcast hosts are incredibly accomplished, wealthy, and intelligent people, yet this question stumped them.

This newsletter issue aims to correct the record. I’ve pondered on this question for a while and I think I’ve reached a pretty definitive answer.

So, without further ado, let’s answer the question: how much US government debt is too much debt?

💡 Bad Measures

Before discussing the answer, let’s go over some commonly thrown around but, in my opinion, ineffective measures of US government debt.

They include:

1. Raw debt level (the US government has about $34 trillion of debt as of writing)

This is probably the worst measure of US government debt to gauge when it has become Too Much.

US government had $6 trillion of outstanding debt in 2001.

$6 trillion sounds unwieldy. $11 trillion in 2008 sounds even worse. $20 trillion in 2017 is daunting. $28 trillion after the pandemic must be catastrophic, right?

Yet here we are today with $34 trillion of outstanding debt.

The US government still has its lights on, the US Dollar is still the global reserve currency, and your neighborhood McDonald’s stands ready to take your order.

The total debt number is meaningless.

2. Debt-to-GDP ratio

The debt-to-GDP ratio is another popular metric to gauge the level of a country’s indebtedness.

This one is quite meaningless too, especially for the United States, i

If one wants to understand when debt levels are too high, this one is quite meaningless too, especially for the United States

I’ve shared a chart of the US’s debt-to-GDP ratio below showing data from the late 1960’s to today.

The ratio went from 60 to over 100 between 2008 and 2020 and it’s now 120. When is it too high?

150? 200? 300? Who knows.

Japan’s debt-to-GDP ratio is at over 210 right now and the country is nowhere close to a debt crisis. The falling Yen might seem like a problem but it’s really by design.

A controlled demolition, if you will, as a way to boost exports and spur inflation.

3. Fiscal Deficit as a Percentage of GDP

The fiscal deficit as a percentage of GDP is yet another measure of government indebtedness. It’s also Not Very Useful for the United States government.

The US has been running a deficit since the turn of the 21st century.

Like the US, Japan has been running a persistent deficit over the last couple decades.

How long and how deep can the US government run deficits for? Who knows.

Cutting To The Case

Below is what I think are the best measures to tell when US government debt is too much. They’re simple, yet effective.

🙌 Thank you, from FinanceTLDR.

FinanceTLDR is not a financial cure-all.

What I can promise you, however, is my full and unbridled curiosity for how our financial system works.

If you’ve found the research and writing useful or interesting, you can financially support my work for a very small amount of $7 a month (or $70 a year for the annual deal).

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🙇 Support The Work

In the past few issues, I’ve written about:

1. Summarizing rare and prescient market insights from two legendary investors

2. The Japanese Yen End Game

3. How the Federal Reserve is being torn asunder by a global tug of war of epic proportions

4. How multi-strat hedge funds are so wildly and consistently profitable

5. Why the US stock market won’t stop rising despite interest rates being at multi-decade highs

6. How the US Treasury rebelled against the Federal Reserve to stimulate the financial system

7. How the Bank of Japan is able to print an infinite amount of money without crashing the Yen

1. Interest expense as a % of the total budget

2. Occurrence of failed treasury auctions

When government interest expenses get too high (especially when interest rates are high), more and more of the budget needs to be funneled just to service interest expenses.

This is Not Good.

A Catastrophic Debt Spiral happens when this gets out of control and interest expenses subsume the budget. In this case something drastic, like a debt default, needs to be done to save the government from the impossible debt burden.

The measure, interest expense as a % of the total budget, is great as a way to watch out for when interest expenses are close to subsuming the budget.

The second measure, occurrence of failed treasury auctions, is also a very effective measure.

The US Treasury raises debt by selling treasuries through treasury auctions. It runs many many auctions a year. In each auction, the US Treasury has a target amount of debt it plans to raise.

When the Treasury has to raise a lot of debt, the frequency and sizes of auctions increase.

A failed treasury auction occurs when demand for the offered treasuries in an auction is so weak that they can only be sold off at absurdly high interest rates.

Historically, treasury auctions don’t fail. If one fails, it’s a Very Bad Thing and will instantly crush confidence in US government debt.

In Q3 of this year, the US Treasury needs to raise $847 billion in new debt ($2 trillion of new debt for the year).

$847 billion in new debt means the US Treasury needs to hold many many large treasury auctions. The larger and more frequent auctions are, the greater the chance of one failing.

It’s hard to tell when exactly buyers have lost appetite for treasuries and don’t show up to an auction.

The Bottomline

US government debt is too much when:

1. Interest expenses become an uncontrollably growing portion of the budget.

2. When a treasury auction fails because the US Treasury has been offering too much debt to a market that can’t absorb the supply.

As always, let’s start by reviewing my prediction last week for where the S&P 500 is headed.

Below is the chart of the S&P 500 at the end of last week, annotated with my prediction arrows (the red arrow is the new prediction, the orange arrow is from the week before).

This is how the S&P 500 looks today.

It’s gone up a lot higher than I thought it would, back to the top Bollinger Band.

I think a big part of this upwards climb was driven by the Federal Reserve’s surprise massive cut to Quantitative Tightening in the May FOMC meeting last week.

Although a large reduction of the pace of QT doesn’t make headlines as much as changes to interest rates, this was nonetheless a significant easing of monetary policy.

On wards to next week. I’ll share where I think the S&P 500 at the bottom of this newsletter issue.

In this issue I want to talk about US government debt issuance.

As I alluded to in the prior newsletter issue, “Market Pulse: Buffett and Druckenmiller Speak”, I think US government debt issuance is the most important issue facing the market in the next couple years.

The US Treasury has to dump a colossal amount of debt on the market at historically very high interest rates.

Just this year alone, the US Treasury needs to issue $2 trillion in new debt.

As an aside, this is the Treasury’s quarterly debt issuance plan for this year:

• Q1: $816 billion in extra debt issued

• Q2: $243 billion in extra debt issued

• Q3: $847 billion in expected extra debt issued

• Q4: $100 billion in expected extra debt issued

Why is debt issuance so low in Q4? I don’t think it’s a coincidence that the Presidential Election takes place squarely in the middle of Q4 on November 5th.

If interest rates don’t fall, then the US government’s annual interest burden will rise from $1 trillion this year to $1.7 trillion next year!

The big open secret on Capitol Hill and on Wall Street is that this debt situation is going to become untenable.

Warren Buffett is talking about it, Stanley Druckenmiller is talking about it, Jamie Dimon is talking about it. And many more.

👉 The Big Story that I’m talking about here is that the trillions and trillions of dollars of US government debt that is going to be unleashed on markets in the next few years is going to significantly move markets in a bad way. Policymakers will try to get ahead of this by finding new and creative ways to shore up treasury demand. This will move markets in other ways.

These moves are unavoidable because the scale of the problem is on the order of multiple trillions of dollars. This issue starts a conversation on how one should think about and prepare to navigate this US government debt crisis.

Read more

This newsletter issue summarizes what legendary investors Stanley Druckenmiller and Warren Buffett had to say about markets in recent public interviews.

I read through 41,700 words from the two interview transcripts so you don’t have to.

Druckenmiller and Buffett are two of the most long-running, consistently profitable investors in the world.

Warren Buffett needs no introduction, but fewer people know about Stanley Druckenmiller.

As a hedge fund manager, Druckenmiller somehow achieved 30%+ returns for over 30 years in his hedge fund Duquesne Capital Management.

If I told you that a hedge fund manager was able to do this, at the scale of billions of dollars, you’d think he was a financial crook! But no, Druckenmiller is just that good and he really did it.

Druckenmiller closed Duquesne to outside investors in 2010 and now manages the fund as a family office.

Fun fact: Druckenmiller worked with George Soros in 1992 to famously break the Bank of England by shorting the British pound sterling until the bank’s ill-advised peg of the pound broke.

Druckenmiller recently gave an interview on CNBC where he shared his thoughts on the market and economy right now.

Here’s a summary of what he said (you can find the full transcript here):

• The US government is spending too much.

  • They’ve spent and spent and spent

    • “The private sector could not be more different today than it was in the Great Depression. Their balance sheets are fine. They’re healthy. All government needed to do was get out of their way and let them innovate. Instead, they’ve spent and spent and spent, and my new fear now is that spending and the -- and the resulting interest rates on the -- on the debt that’s been created are going to crowd out some of the innovation that otherwise would have -- would have taken place. We’ve got a 7 percent budget deficit at full employment.”

  • The US Treasury is to blame but the Federal Reserve is the great enabler

    • “I’d say it’s definitely the fiscal, but the Fed’s been the great enabler. And the latest thing is, we’re going to apparently -- well, we’ve already started. We’re going to shrink QT from $60 billion to $25 billion, and we’re going to land apparently at $7 trillion. Somehow because of the plumbing, all of a sudden, we need a $7 trillion balance sheet just to function.”

• The Federal Reserve made a grave mistake pivoting in December.

  • Surprised with the Federal Reserve’s decision to make a dovish pivot in December

    • “I was perplexed with the December pivot if that’s what you’re referring to. It seemed to me the Fed was in a perfect position. Inflation was coming down, financial conditions were tightening. And to some extent, I feel like they fumbled on the five-yard line with the game on the line.”

    • “Look, I don't know where inflation’s going to be in a year. Jerome Powell doesn’t know where inflation is going to be. I don’t think anybody knows. But they worked so hard, and they did so much work when they went from basically zero to 5 percent. I’d hate to see them all throw it away here.”

  • You’re the Fed chair, you’re not a rockstar:

    • “No, because there’s not a zero percent chance that inflation has the bottom. I don’t know. What I would do is just say nothing and do Fed chair used to do. When you need to raise rates, raise ‘em. When you need to cut ‘em, cut ’em. Don’t go on “60 Minutes”. You’re not a rockstar, okay? You’re the Fed chairman. You’re supposed to be running monetary policy for the good of the country, not to be going on “60 Minutes”.”

  • Inflation looks like it’s going back up:

    • “We’re not guaranteeing you’re going to cut, but it’s weighted that way. And for the life of me, I can’t figure out why because if you look at the six-month rate of inflation, the chart’s very clear, it comes down from very rapid rates. And now, if anything, it looks like it’s turned up.”

  • Get rid of forward guidance:

    • “He says, we got to get rid of forward guidance. All this talking and all this forward guidance -- first of all, we’re all wrong on the economy quite often, me included, and when you put forward guidance out, unlike me when I’m wrong who tend to change my mind very rapidly, they sort of get trapped into the forward guidance and stuck in it.”

  • Don’t be obsessed with nailing the soft-landing. You can decades of prosperity from some short-term pain:

    • “I do worry that this obsession with nailing the soft landing, okay, my favorite Central Banker was Paul Volcker. He was not worried about nailing the soft landing. He put us into a terrible recession and we got 20 years of prosperity because of the pain we took for 18 months.”

• Very bullish on AI. Very bullish on Perplexity AI as a Google competitor.

  • “But no, long-term, we’re as bullish on AI as we’ve ever been.”

  • On Perplexity AI (Google search competitor): “I love Perplexity. Again a funny story -- my young partner, the one who has basically been behind all our AI play with his -- with his staff. He told me, I don’t know, in January, that all the kids on the West Coast weren’t using ChatGPT or Google anymore. They were using this thing called Perplexity AI. I fell so in love with it. We tried to get in on a round, that we were lucky enough to be accommodated. I love the founder Aravind Srinivas. He’s super aggressive, and with his team super innovative, but he’s also got humility. He’s everything we love in a founder. So there’s a land grab going on now in the answer machine business. It’s obviously a big task to take on Google, but if you think about it, Google has $300 billion in sales. If Perplexity even goes to $2 billion in sales, it’ll be a huge winner. Frankly, I’d say 90 -- 95 percent of my searchers now I use Perplexity, probably the best thing I could do for the viewers today, unless they’re listening to all my other stuff. Try this thing out, you’ll love it.”

Note: I tried Perplexity AI myself and love it. I’ve found that it’s significantly better than ChatGPT or Google Search in getting the up-to-date answers that I’m looking for in my research.

• Sold out of most of his long positions in March.

  • “yes, we did -- we did cut that position and lot of other positions in late March. I just need a break. We’ve had a -- we’ve had a hell of a run. A lot of what we recognized has become recognized by the marketplace now. Powell was -- we expected Powell to come back and re-pivot which he subsequently did.”

• On international markets, he’s very bullish on Argentina and Japan. He thinks China is uninvestable.

  • On Argentina: “The only free market leader in the world right now bizarrely is in Argentina of all places. Javier Milei. It’s going to be an interesting experiment. This is a highly, highly intelligent leader who was taught in the School of Austrian Economics… I’m not only invested in Argentina. By the way, do you want to hear how I invested in Argentina? It’s a funny story. I saw -- I wasn’t at Davos, but I saw the speech in Davos and it was about 1:00 in the afternoon in my office. I dialed up Perplexity and I said, give me the five most liquid ADRs in Argentina. It gave me enough of a description that I follow the old Soros rule, invest and then investigate. I bought all of them. We did some work on them. I increased my positions and so far, it’s been great.”

  • On Argentina: “By the way, do you want to hear how I invested in Argentina? It’s a funny story. I saw -- I wasn’t at Davos, but I saw the speech in Davos and it was about 1:00 in the afternoon in my office. I dialed up Perplexity and I said, give me the five most liquid ADRs in Argentina. It gave me enough of a description that I follow the old Soros rule, invest and then investigate. I bought all of them. We did some work on them. I increased my positions and so far, it’s been great. But we’ll see.”

  • On Japan: “I’ll just say we -- we’ve been, we’ve been invested in Japan, oh, since middle to late last year. I was lucky enough to start Duquesne in 1981 and those were the era of Boone Pickens and Carl Icahn changing corporate governance, and just multiply that times 10X what’s going on in Japan. It’s an amazing situation.”

  • On China: “We exited China in 2018. We haven’t made a single trade in security there other than their currency once in a while, I won’t say which way. I will never invest in China as long as the current leader is there. The reason I’ll never say never is if they had a change in leadership, I’d at least consider the situation. But to me -- I didn’t invest in Russia, and I’m not investing in China.”

• On commodities, he’s very bullish on copper

  • “Copper is a pretty simple story, takes about 12 years, greenfield to produce copper, and you got EVs, the grid, data centers, and believe it or not munitions. These missiles all got enough copper in them and the world’s getting hot that we just think the supply-demand situation is incredible for the next five or six years.”

👋 Hi, from FinanceTLDR.

FinanceTLDR is not a financial cure-all.

What I can promise you, however, is my full and unbridled curiosity for how our financial system works.

If you’ve found the research and writing useful or interesting, you can financially support my work for a very small amount of $7 a month (or $70 a year for the annual deal).

Thank you!

🙇 Support The Work

In the past few issues, I’ve written about:

1. The Japanese Yen End Game

2. How the Federal Reserve is being torn asunder by a global tug of war of epic proportions

3. How multi-strat hedge funds are so wildly and consistently profitable

4. Why the US stock market won’t stop rising despite interest rates being at multi-decade highs

5. How the US Treasury rebelled against the Federal Reserve to stimulate the financial system

6. How the Bank of Japan is able to print an infinite amount of money without crashing the Yen

7. How the Federal Reserve’s $7.5 trillion balance sheet is not a bug but a feature of the new Ample Reserves central banking regime

Now for what Warren Buffett, and his lieutenants, said in the Berkshire Hathaway’s recent 2024 shareholders meeting (you can find the full transcript here).

• The Federal Reserve is doing a good job but the US Treasury is spending too much.

  • “It’s interesting, I think media enters into this and the focusing that focuses on the Fed and they, you know, they just love it because things are always happening and economists are always saying what’s going to happen with the fed and everything else. But the fiscal deficit is what should be focused on. And Jay Powell is not only a great human being, but he’s, he’s a very, very wise man, but he doesn’t control fiscal policy.”

  • “And every now and then he sends out a kind of a disguised plea for please pay attention to this because that’s where the trouble will be if we have it.”

  • “And I would say with the present fiscal policies, I think that something has to give, and I think that higher taxes are quite likely, and the government wants to take a greater share of your income, or mine or Berkshire’s, they can do it. And they may decide that someday they don’t want the fiscal deficit to be this large, because that has some important consequences, and they may not want to decrease spending a lot, and they may decide they’ll take a larger percentage of what we earn and we’ll pay it.”

• Buffett is very bearish. Berkshire Hathaway has $182 billion in cash and this is up from $168 billion a quarter ago. Buffett expects this to reach $200 billion by the end of June.

  • “I don’t think anybody sitting at this table has any idea of how to use [the cash] effectively. And therefore, we don’t use it. And we don’t use it now at 5.4%. But we wouldn’t use it if it was at 1%.”

  • “So our cash and treasury bills were 182 billion at the quarter end. And I think it’s a fair assumption that they brought probably about 200 billion at the end of this quarter. We’d love to spend it, but we won’t spend it unless we think we’re doing something that has very little risk and can make us a lot of money.”

  • “…I don’t mind at all, under current conditions, building the cash position. I think when I look at the alternative of what’s available, the equity markets, and I look at the composition of what’s going on in the world, we find it quite attractive.”

• Trimming the Apple position.

  • A lot of Berkshire Hathaway’s large cash position comes from the trimming of its largest investment, Apple.

  • Berkshire Hathaway sold another 115 million in Apple shares last quarter.

  • Buffett continues to call Apple a “wonderful business”, and an even better business than Coca Cola, but his large Apple stock sales for cash tells a different story.

• Wait-and-see approach for AI. Sees lots of potential. Compares it to nuclear weapons.

  • “And last year I said that we let a genie out of the bottle when we, when we developed nuclear weapons, and that Genie has been doing some terrible things lately. And the power of that genie is what, you know, scares the hell out of me. And then I don’t know any way to get the genie back in the bottle. And AI is somewhat similar.”

  • “But I do think, as someone who doesn’t understand a damn thing about it, that it has enormous potential for good, an enormous potential for harm. And I just don’t know how that plays out.”

• Climate change is causing problems for the Insurance and Utilities industries, which Berkshire Hathaway has a lot of exposure to.

  • PacifiCorp

    • PacifiCorp is facing $30 billion in new claims made last month from 1,000 plaintiffs who blame the company for causing the 2020 Labor Day wildfires in Oregon. PacifiCorp has already paid or owes $825 million in claims due to other wildfire-related lawsuits.

    • Berkshire Hathaway owns more than 90% of PacifiCorp

    • “When I think of PacifiCorp, we’re in a place where, first and foremost, all that litigation will be challenged because the basis for it, at least we believe, there are places where it’s unfounded”

  • Insurance. Prices have to go up because of climate change

    • Solution? Do it one year at a time: “Climate change. Climate risk is certainly a factor that has come into focus in a very, very big way more recently. Now, the one thing that mitigates the problem for us, especially in some of the reinsurance operations we are in, is our contractual liabilities are limited to a year in most cases. So as a result of which, at the end of a year, we get the opportunity to reprice, including the decision to get out of the business altogether if we don’t like the pricing in the business. But the fact that we are making bets that tie us down to one year at a time certainly makes it possible for us to stay in the business longer term than we might have otherwise because of climate change.”

    • “Clearly, prices need to go up. It is difficult to be very scientific about how much the prices need to go up. They need to go up a lot. And we keep increasing prices and hope we stay ahead of the curve. But that doesn’t happen in all cases.”

    • “…certainly for the next several months. I think the insurance industry, in spite of climate change, in spite of increased risk of fires and flooding, it’s going to be an okay place to be in. Climate change increases risks and in the end it makes our business bigger over time. But not if we, if we misprice them, we’ll also go broke. But we do it one year at a time, overwhelmingly.”

• Not surprisingly, succession is top of mind.

  • On succession for Buffett, Berkshire Hathaway executive Greg Abel will take Buffett’s spot

    • “I think the responsibility ought to be entirely with Greg [for making capital allocation decisions]. The responsibility has been with me, and I farmed out some of it, and I used to think differently about how that would be handled, but I think the responsibility should be that of the CEO.”

  • There are also concerns about Ajit Jain retiring from leading Berkshire Hathaway’s insurance business

    • “We won’t find another Ajit, but we have an operation that he has created and that at least part of it. There are certain parts of it that are almost impossible for competitors to imitate, and if I was in their shoes, I wouldn’t try and imitate them. And so we’ve institutionalized some of our advantages, but Ajit is. Well, his presence allowed us to do it and he did it. But now we’ve created a structure that didn’t exist when he came in 1986. Nothing close to it existed with us or with anybody else. And insurance is the most important business at Berkshire.”

  • Overall, Buffett had this to say about succession concerns:

    • “When you’ve got somebody like Greg and Ajit, why settle for me, basically? So it’s worked out extremely well.”

    • “And I almost can’t imagine anything working better because Greg in a year accomplishes. I mean, he sees more of them, understands more about their problems, you know, can give them suggestions. He’s got incredible amounts of energy and nobody has more wisdom than Ajit about insurance. And they’ve got access and insurance to him now. They had it before we stuck some of those titles on insurance.”

    • “And I think at the end of the day, as Tim Cook has proved to us, it will be the biggest non issue of the day. The earth will still keep revolving around the axis.”

Having read through and summarized both speaking events, I’ve noticed several important common themes.

💡 First, both Druckenmiller and Buffett think that fiscal spending is a massive problem.

Druckenmiller was harsher towards Federal Reserve Chairman Jerome Powell, accusing Powell of making a grave mistake by pivoting monetary policy too early in December and this is threatening to reignite inflation. He even goes so far as to accuse Powell of trying to be a “rockstar” by talking too much to the media.

Buffett was kinder to Powell, calling Powell a “very, very wise man”. He thinks that Powell is doing the best job he can but he’s currently under the mercy of the fiscal policy makers over at the US Treasury.

💡 Both Druckenmiller and Buffett are also very bearish on the market right now.

Druckenmiller sold out of most of his long positions in March. At the same time, Buffett is aggressively trimming Berkshire Hathaway’s large Apple position to build a massive cash position instead ($182 billion now and he expects this to reach $200 billion by the end of June).

💡 Druckenmiller is more bullish on AI and is much more willing to invest in new technology than Buffett.

For example, while Buffett admits that he doesn’t “understand a thing about [AI]” and doesn’t know how the technology will play out, Druckenmiller bought Nvidia even before ChatGPT came out and rode the stock from $150 to $900. Now he’s made a venture investment in an AI-powered Google search competitor, Perplexity AI.

Buffett appears to be at risk of missing the AI wave like he missed the FAANG wave but he doesn’t seem concerned about making the same mistake twice.

💎 A Word To Premium Subscribers

We are approaching a period of significant global financial volatility.

Central banks and national governments worldwide will implement broad-sweeping financial policies to avoid or, at the very least, attenuate the effects of this coming surge in volatility.

I reckon this is similar in order of magnitude to how the markets moved around the Great Financial Crisis and around the pandemic.

Being ahead of the curve of this volatility, and understand what could be done and what mostly likely will be done to fix the situation, will be immensely rewarding.

I’ve noticed that this is very rarely discussed in financial media, but there are so many Brief Important Snippets about it from Very Important People that don’t make the headlines.

For the next few Premium newsletter issues I will be focused on researching and sharing everything I can about this event.

As always, FinanceTLDR is not a financial cure-all. What I can promise you, however, is my full and unbridled curiosity for how our financial system works.

Recently, the Japanese Yen has yet again been making headlines.

The currency continues to slide against the US Dollar. The JPY/USD currency pair has fallen 30% over the past 5 years and 17% in the past year.

It might be easy to draw the conclusion that something is wrong with the Japanese economy given the Yen’s rapid and prolonged decline against the Dollar.

This could not be farther from the truth.

This newsletter issue dives into why the Yen is falling and why this isn’t a problem.

📉 Why Is The Yen falling?

Two major factors determine the Yen’s value relative to the Dollar.

First, the difference between US interest rates and Japanese interest rates plays a large role.

Second, the price of oil also plays a significant role.

US-Japan Interest Rates

US interest rates are currently significantly higher than Japanese interest rates. The Fed Funds Rate is at 5.25% while the Bank of Japan’s policy interest rate is at 0%.

0%!

This creates a trade opportunity, commonly referred to as the Japanese Yen Carry Trade, where traders borrow Yen for cheap, convert Yen to Dollars, and lend Dollars (i.e. buy US treasuries or US corporate bonds) to earn the higher interest rate.

The profit in this case is the difference between the lend (US) and borrow (Japanese) interest rates.

Price Of Oil

Japan is an export economy with no natural energy resources. As such, its large export economy is primarily powered by imported oil.

When global oil prices (generally denominated in US dollars) go up, more Yen needs to be sold for Dollars to import oil and the Yen weakens as a result.

Back To The Falling Yen

You can probably guess where I’m going with this.

The recent depreciation of the Yen against the Dollar is largely the result of:

1. A widening gap between US-Japan interest rates (or at least rising expectations of a widening gap, as US inflation remains hot, making it difficult for the Federal Reserve to cut interest rates, while the Bank of Japan insists of 0% interest rates)

2. The recent rise in global oil prices.

The biggest short-term driver of this recent depreciation though, appears to be the wide gap between US and Japanese interest rates, since the Yen spiked against the Dollar after Federal Reserve’s recent FOMC meeting where the US central bank signaled a significant easing of monetary policy.

👋 Hi, from FinanceTLDR.

FinanceTLDR is not a financial cure-all.

What I can promise you, however, is my full and unbridled curiosity for how our financial system works.

If you’ve found the research and writing useful or interesting, you can financially support my work for a very small amount of $7 a month (or $70 a year for the annual deal).

Thank you!

🙇 Support The Work

In the past few issues, I’ve written about:

1. How the Federal Reserve is being torn asunder by a global tug of war of epic proportions

2. How multi-strat hedge funds are so wildly and consistently profitable

3. Why the US stock market won’t stop rising despite interest rates being at multi-decade highs

4. How the US Treasury rebelled against the Federal Reserve to stimulate the financial system

5. How the Bank of Japan is able to print an infinite amount of money without crashing the Yen

6. How the Federal Reserve’s $7.5 trillion balance sheet is not a bug but a feature of the new Ample Reserves central banking regime

👍 It’s Not A Problem

As sensational as some financial media headlines have been on the recent slide of the Yen (“collapse“, “doom“, etc.), the weakening Yen is nowhere close to being a problem for Japan.

In fact, it’s actually somewhat of a Good Thing.

An Export-Driven Economy With Weak Inflation

Japan benefits two-fold from a weak Yen.

First, Japan’s economy is export-driven and a weak Yen makes the country’s exports more competitive.

Second, Japan has been struggling with anemic inflation ever since the late 90’s and so a weakening Yen is very much welcome as it spurs inflation.

Japan Holds A LOT Of Dollars

Japan spent the last few decades turning its vast export incomes into Dollar-denominated foreign investments and now own a foreign investment war chest with over $1 trillion.

This massive Dollar war chest now serves as a potent defense against any unruly selling of the Yen.

Note: the Government Pension Investment Fund (GPIF) is a Japanese government agency that manages the pensions for Japanese public sector employees. It’s the largest pool of retirement savings in the world with $1.5 trillion in assets under management.

When the value of the Yen falls too fast, Japanese policymakers could easily deploy this foreign investment war chest and sell Dollars for Yen to defend the currency.

That’s exactly what Japan’s Ministry of Finance did, twice, over the past week. On Monday and on Wednesday.

Large US Dollar Investment Income

Even as the Yen has been incessantly falling against the Dollar over the past few years, one of the best clues that Everything Is Okay comes from the country’s Balance Of Payments.

Japan’s Balance Of Payments has consistently been positive (in other words, aggregate flows of Dollar-denominated money into the country remains deeply positive year-on-year) despite the weakening Yen.

As I mentioned in a previous newsletter issue, The Curious Case of the Bank of Japan, the main reason for this consistently positive Balance Of Payments is significant Dollar-denominated investment income.

Japan’s once-mighty export economy has weakened quite a bit since its glory days in the 90s (China has taken a lot of its business), but the country made good investments during its economic hay days from all the export income and now those investments are paying off in a big way.

Real Narrow Effective Exchange Rate

The Real Narrow Effective Exchange Rate is an overall valuation of a currency relative to a basket of other currencies AND takes into account inflation differences between the different countries.

As such, the Real Narrow Effective Exchange Rate is a much better measure of the Yen’s value than by just looking at the JPY/USD exchange rate.

The Federal Reserve plots the Yen’s Real Narrow Effective Exchange Rate on its open data platform, FRED.

This measure of the Yen’s value is close to historic lows, but it’s certainly not in uncharted territory.

⏳ The End Game for the Yen

So what’s the End Game for the Yen?

What does Japan’s financial policy makers intend for the country’s seemingly free-falling currency? And what are the implications for the US stock market?

Read more

This is a story about the Federal Reserve being torn asunder by a global tug of war of epic proportions.

What the Federal Reserve ultimately decides to do, whether by choice or by force, will determine the fate of the market in the near-future (near as in 1-2 years).

Let’s start.

📝 Very Quick Primer: The Federal Reserve

The US’s central bank, the Federal Reserve, was created as an independent counterweight to the elected US federal government.

The Federal Reserve’s job is to manage the total US Dollar money supply to meet two goals:

1. Price stability (2% annual inflation rate)

2. Full employment

📉 Two Decades Of Low Inflation

The two decades before 2020 was marked by persistently low inflation.

It felt like no matter how much money the Federal Reserve printed, inflation just would not rise.

As a result, during these two decades, the Federal Reserve massively expanded its balance sheet from around $700 billion to $4.5 trillion.

👋 Hi, from FinanceTLDR.

FinanceTLDR is not a financial cure-all.

What I can promise you, however, is my full and unbridled curiosity for how our financial system works.

If you’ve found the research and writing useful or interesting, you can financially support my work for a very small amount of $7 a month (or $70 a year for the annual deal).

Thank you!

🙇 Support The Work

In the past few issues, I’ve written about:

1. How multi-strat hedge funds are so wildly and consistently profitable

2. Why the US stock market won’t stop rising despite interest rates being at multi-decade highs

3. How the US Treasury rebelled against the Federal Reserve to stimulate the financial system

4. How the Bank of Japan is able to print an infinite amount of money without crashing the Yen

5. How the Federal Reserve’s $7.5 trillion balance sheet is not a bug but a feature of the new Ample Reserves central banking regime

🔥 The Inflation Dragon Wakes Up

Then, in 2018, Trump started a trade war with China.

This was followed by a global pandemic which crippled the global supply chain.

At the same time, to save the US economy from a lockdown-induced collapse, the Federal Reserve and the US Treasury embarked on the largest money-printing operation the country had ever seen.

The Federal Reserve dropped interest rates to 0% and expanded its balance sheet from $4 trillion to $9 trillion while the US Treasury sent US citizens trillions of dollars of free money.

This resulted in a massive expansion in both the Federal Reseve’s balance sheet ($4 trillion to $9 trillion) and the US federal government’s annual budget ($4.5 trillion to $7 trillion).

At the same time, the second largest oil producer in the world, Russia, launched the first major land war in Europe since World War II.

Through this sudden perfect storm of global events, the low inflation of the past two decades was gone and US inflation spiked to almost 10% in 2022.

🛡️ The Federal Reserve Mounts A Defense

Starting in 2022, the Federal Reserve significantly tightened monetary policy by raising interest rates from 0% to 5% in about a year while at the same time, shrinking its balance sheet by $95 billion a month.

Tight monetary policy, a recovering global supply chain, and the US government turning a blind eye to Russian oil illicitly flooding global markets, helped cool inflation down to about 3% today.

🪢 The Tug Of War

TLDR:

1. The US government needs to raise a lot of new debt this year ($1.9 trillion in new debt vs $1 trillion last year). A lot of this goes to funding two major proxy wars.

2. This is a Presidential Election year.

3. To keep the government’s interest expenses under control amidst all this new debt issuance, the Federal Reserve needs to lower interest rates.

4. The Federal Reserve can’t lower interest rates if inflation remains high.

5. The proxy wars that the US is funding right now are next to major global oil-producing regions.

6. When oil prices rise, inflation rises, and the Federal Reserve can’t lower interest rates.

7. The wars must be funded, but the oil must also keep flowing.

Inflation falling from 10% to 3% in the past year and a half sounds good right?

Well, not really.

The Fed is now stuck in a disastrous policy quagmire.

Inflation has been stubbornly hot and won’t fall below 3%.

An increasingly desperate Ukraine is striking Russian oil refineries, forcing Russia to ban all oil exports for 6 months starting in March.

These Ukrainian attacks on Russian oil refineries surprisingly, yet also unsurprisingly, drew ire from the US!

Financial Times headline: “US urged Ukraine to halt strikes on Russian oil refineries”.

It’s like the US has one hand pushing Ukraine to fight Russia while with the other, it’s buying oil from Russia behind Ukraine’s back. Then it’s using this money to pay Ukraine to keep fighting!

When one takes this headline at face value, it’s expectedly nonsensical. Its rationality only becomes clear when looking at the second order effects of the relevant events.

Just look at how oil prices have risen since Russia’s gasoline ban that started in March.

Rising oil prices means high inflation. High inflation means the Federal Reserve can’t cut interest rates.

When the Federal Reserve can’t cut interest rates, it’s a lot harder for the US federal government to raise debt to fund its wars.

China and Japan, two of the biggest foreign buyers of US government debt, have largely cut back on their appetite for US government debt.

At the same time, the US government needs to raise more debt than ever.

This year, they need to raise $1.9 trillion in new debt. This is almost double last year’s demands and 9 times that of 2016!

So who is going to buy all this new debt?

Without buyers, long-term interest rates will rise and that greatly hurts the economy (and the stock market).

To add more spice to the boiling stew, there’s a presidential election this year and if the Biden administration wants to remain in power, it needs to keep long-term interest rates down.

📈 So What Does The Federal Reserve Do?

CHOICE 1: Keep monetary policy tight to fight inflation.

Tight monetary policy makes it very difficult for the US government to continue funding its proxy wars. It’ll also hurt the Biden administration’s chances at re-election.

CHOICE 2: Loosen monetary policy to help fund the US government.

This is a very precarious option.

If inflation reignites after the loosening of monetary policy, the Federal Reserve will lose a lot of credibility, the markets will fall from inflation fears, and high inflation may force the Federal Reserve to tighten monetary policy anyways.

RESULT: What does the Federal Reserve choose to do? It chose to loosen monetary policy.

On Wednesday, the Federal Reserve announced that even though it wasn’t going to lower the Fed Funds Rate, it was going to significantly slow down how fast it was shrinking its balance sheet.

Starting in June, the Federal Reserve will start shrinking the amount of US treasuries on its balance sheet by just $25 billion from $60 billion per month.

That’s a $35 billion reduction!

This, in effect, adds $35 billion more in buying demand for US treasuries to the market per month.

Why are they doing this?

Fed Chair Jerome Powell says he wants to get ahead of financial instability, but there are zero signs of financial instability.

Even if we do take the justification that this is a preemptive adjustment for financial stability, this is an extraordinarily large preemptive adjustment.

To get a feeling for how big this reduction in quantitative tightening is, just look at how hard the Japanese Yen bounced against the dollar after the FOMC press conference.

(At a very high level, the value of the Yen tracks how loose US monetary policy is. The looser US monetary policy gets, the more the Yen appreciates.)

The best explanation I have for why the Federal Reserve would choose to suddenly cut quantitative tightening by this much at this time is that they are playing politics. Nothing else makes sense.

💡 The Hidden Third Choice

The Federal Reserve is playing a very precarious game.

Read more

Below is the annotated S&P 500 chart that I shared in the previous Market Pulse Premium issue sent out last Friday (4/26).

Let’s see how the market has moved since then.

I expected the S&P 500 to consolidate around the mid Bollinger Band line after the large bounce last week and so far, despite lots of volatility over the past few days, it looks like it’s doing just that.

This was another successful probabilistic call for the past week, and now it’s time to look forward to what’s next.

To have a sense of where we’re headed next, it’s important to review the events of the past week.

This past week, we saw several major economic events happen. The three most important ones that I think should be discussed are:

1. The Federal Reserve’s May FOMC meeting

2. The US Treasury’s Quarterly Refunding Announcement (QRA)

3. The ongoing collapse of the Yen

As expected, we saw the US Treasury announce that the government needs to raise a significant amount of new debt in the next two quarters. Over $1 trillion!

The Federal Reserve wants to help the US Treasury with such a heavy lift in new debt issuance by make a massive surprise reduction in quantitative tightening, from -$60 billion in US treasuries each month to just -$25 billion.

At the same time, on the other side of the globe, the Yen has been free-falling as the Bank of Japan continues to insist on 0% interest rates.

What a busy week!

Here’s what I think are the second and third order effects of the events on the stock market.

💡 But First, Where Is The S&P 500 Headed Next?

Two weeks ago, we saw the market sell off aggressively.

Six red days for the S&P 500. This was something we haven’t seen since the summer of last year.

The market staged a big rebound after the massive selling and now we are going through sideways consolidation.

All this market volatility comes against a backdrop of sticky US inflation, war intensifying in Eastern Europe and the Middle East, and the US Treasury having to issue a huge amount of new debt over the rest of this year.

Given this context, this is how I think the market moves next week.

Chart with prediction arrow below.

Read more

This newsletter issue is about the secret sauce behind multi-strat hedge funds, a powerful new breed of money-making institutions that has, over the last decade, replaced investment banks as the top profit generators on Wall Street.

These hedge funds are as secretive as they’re sophisticated.

You might’ve heard of some of them (Jane Street, Citadel, Millenium Management), but they largely prefer to operate in the shadows of the financial system.

Whilst their public profiles are small, their trading profits are anything but small.

Jane Street made $10.1 billion in trading profits last year. Citadel CEO Ken Griffin paid himself a $4.1 billion salary in 2023 while Millenium CEO Izzy Englander made a more modest $3.2 billion.

This issue is about how these tremendously and consistently profitable multi-strat hedge funds work, at their core.

I’ll open this newsletter issue with a quick, relevant story.

Most of us have heard about the infamous cryptocurrency ex-billionaire Sam Bankman-Fried (SBF).

He was recently sentenced to prison for 25 years for the sudden collapse of FTX and its sister hedge fund Alameda.

While SBF is famous for his FTX story, much less people know about his tenure at Jane Street prior to his short stint as the richest person in the world under 30.

This is a story from SBF’s time as a trader in the preeminent Wall Street hedge fund, Jane Street.

Jane Street recruited SBF as a trader right out of college after they noticed his remarkable potential as a trader due to his strong mathematical skills, quick thinking, and remarkable lack of emotion.

Senior Jane Street traders saw significant potential in SBF and he was quickly given a lot of agency and capital.

During the 2016 Trump vs Clinton election, SBF noticed that every time there was positive news for Trump, the market will sell off a little bit.

Seeing this, he came up with the clever idea of programmatically plugging in to all the disparate state and federal election news sources to get election news ahead of everyone else. He’d then trade on this early information by being the first to short the market.

This idea worked very well all the way up to election night.

Florida was a key swing state for both presidential candidates and SBF’s system identified Trump’s surprising decisive win of the state several minutes before cable news announced the results.

Armed with this pivotal, early information, he massively shorted the stock market.

When the rest of the country learned about Trump’s Florida victory several minutes later, the stock market sold off aggressively. SBF’s large short positions went up hundreds of millions of dollars.

For a moment in time, SBF’s shorts become one of the most profitable trades in Jane Street’s history.

However, before he could close the shorts and lock in the profits (he took a nap after the Florida results were announced), Trump was declared victorious and the market unexpected rocketed up instead.

This abrupt market reversal turned one of Jane Street’s most profitable trades into one of its largest losses, overnight!

The most intriguing outcome of the whole affair was that SBF wasn’t reprimanded for bringing such a large loss onto the firm.

He didn’t even get a slap on the wrist.

Why?

I told this story as a way to describe one interesting and seemingly unintuitive phenomenon of the modus operandi of multi-strat hedge funds.

This one experience that SBF had in Jane Street seems nonsensical at face value for a firm that generates so much money, but this is exactly why these firms are so incredibly profitable.

This serves as a good segue into what I really wanted to discuss in this newsletter issue, that is, the secret sauce behind the incredible profit machines that are today’s multi-strat hedge funds.

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FinanceTLDR is not a financial cure-all. What I can promise you, however, is my full and unbridled curiosity for how our financial system works.

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🙇 Support The Work

In the past few issues, I’ve written about:

1. How the Federal Reserve has become significantly less influential in the financial system, and how the US Treasury is now in control

2. How the US Treasury sidestepped the Federal Reserve to stimulate the economy and stock market

3. How the Bank of Japan is able to print an infinite amount of money without crashing the Yen

4. How $7.5 trillion on the Federal Reserve’s balance sheet is not a bug but a feature of the new Ample Reserves central banking regime

5. How exactly does the Federal Reserve print and delete money on a whim

Multi-Strat Secret Sauce

Multi-strat hedge funds, like their namesake, run multiple trading strategies at a time.

More specifically, the fund is structured as a series of “pods”. Each pod is like a separate hedge fund within the overall hedge fund.

A pod is led by a small group of Portfolio Managers (PMs) and the PMs are supported by a team of analysts.

The firm also has a central technology team that’s responsible for building the core technologies that every pod in the company relies on (e.g. proprietary software that orchestrates trading strategies).

The salaries of a pod are tied to the pod’s overall trading profits. If the pod has a particularly profitable year, the profits will be reflected in everyone’s bonuses, with the lions share going to the PMs.

The PMs are the brains behind a pod and are responsible for coming up with and executing trading strategies.

The firm has one giant pool of capital and determines the amount of capital each pod has access to to execute their strategies.

Importantly, the firm often encourages pods to push risk to the max and it’s willing to lose all the capital assigned to any one pod.

This sounds reckless, but it’s actually mathematically sound.

Fractionalized Betting and the Arithmetic vs Geometric Mean

The math works out like this.

Say a pod has the potential to make 5 times its capital in one year if its PMs are especially capable.

If they’re bad or unlucky, the pod could lose its entire bankroll.

The arithmetic expected value of this example win-loss setup is 2.5x (5 * 0.5 + 0 * 0.5 = 2.5).

So, on average, this pod is expected to make 2.5 times its assigned capital each year.

However, notice that there is a significant chance of the pod losing it all. 50%!

This means that if one pushed the pod to the max and reinvested all returns consecutively hoping to maximize the gains from this great 2.5x expected value, after just a few rounds, the chances of losing everything balloons to dominate almost the entire probability distribution.

So how does a multi-strat hedge fund try to benefit from this 2.5x expected value without being subjected to a significant risk of losing it all?

The answer is found in the fractionalization of bets.

The more the firm splits its total pool of capital among its pods, the more the overall expected value of the firm approaches the average arithmetic expected value of all its pods and the less likely the firm will be wiped out in one go.

In addition to fractionalizing bets, the firm can further increase its returns by being very careful about how much capital it assigns each pod.

This is known as bet sizing.

Ideally, the best pods should get the most capital and the worst pods the least. At the scale that these funds operate at, sophisticated bet sizing is the difference between billions of dollars of profits.

Holistic Risk Management

One very important thing to point out with this bet fractionalization framework is that it doesn’t work if there is too much correlation among all the bets.

[content for paid subscribers below]

Very quickly, when trades are correlated, it means that they move together. For example, if inflation goes up and position A and B both go down, then we can say that the two positions are correlated.

As such, when there’s high correlation, a single market event could sink a majority of the pods at once and bring down the overall fund.

Not good!

The goal, after all, is to not suddenly go bankrupt before one makes a lot of money from trading.

Here’s one example of how this risk management could work.

Let’s say Jane runs a better pod than Bob, meaning that she has historically brought in better returns than Bob, and right at this moment, both of them are heavily exposed to oil. If the firm is too exposed to oil overall, the risk management team will force Bob to sell his oil position.

Too bad, Bob.

Conclusion

This multi-strat framework is why Jane Street didn’t reprimand SBF for the bad trade.

The firm wanted him to be willing to push risk to the max and was ready to lose the whole position if the trade went south. Although it was a multi-hundred-million dollar position, it’s still a small position in the firm’s multi-billion-dollar portfolio.

The overall trade idea was sound (getting election information before anyone else) and it worked spectacularly, at least for a while.

There were just improvements that could be made to how the trade was executed (e.g. short the Mexican stock market and long the US stock market, rather than short all markets).

In line with this multi-strat framework, Jane Street is in the business of collecting and nurturing the best talent in the industry and SBF certainly showed significant potential by coming up with the idea and orchestrating the trade.

For a more detailed explanation on how this multi-strat framework works, check out this FinanceTLDR issue:

So to summarize, the secret sauce of multi-strat hedge funds is that they try to hire and nurture the best PMs and analysts, intelligently fractionalize the firm’s bets across many pods, and risk manage across the pods to make sure the trades in aggregate have minimal correlation.

In this issue, I want to quickly discuss two things:

1. How Big Tech is unintuitively benefiting from high interest rates

2. And recent news around rising US-China tensions

Big Tech Dividends

Let’s start off with the lighter topic of the two, that of the recent emergence of Big Tech dividends and why certain Big Tech companies have started issuing them after decades of abstinence.

Earlier this week, I published a newsletter issue talking about how high interest rates could actually be benefiting the US economy.

Well, there’s one corner of the economy that’s certainly benefiting from them and it’s Big Tech.

Curiously, Google and Meta have both recently announced that they’re launching dividend programs.

This is a historical first for both companies.

The textbooks say that high interest rates are supposed to slow down the business cycle but they’re curiously having the opposite effect on the modern economy’s largest and most influential companies.

From both charts above, we see that just as high inflation has given both companies a big revenue boost, high interest rates have pushed the case farther and significantly increased their interest incomes.

Google and Meta are not hurting from high interest rates. Instead, they’re reveling in them.

Couple this with large efficiency improvements over the past year and it’s not surprising that both companies have found themselves with more cash than they know what to do with and are returning a record amount of cash to investors.

US → TikTok ← China

US-China relations will be the defining factor in how the global economy and markets move in the next few years.

As such, it’s important to review the recent flurry of high level US-China diplomatic activity that happened over the past month.

There is a diplomatic urgency afoot among top US government officials and they’re not sharing the reason for this urgency with the rest of us.

It’s up to us enterprising outsiders to pick up and analyze their furtive breadcrumbs.

Ever since Biden’s pivotal phone call with Xi Jinping at the start of the month (in which the two heads of state clashed on the topic of Taiwan), Biden has sent two of his most powerful cabinet officials to China to negotiate important matters of state.

Treasury Secretary Janet Yellen (representing US financial might) spent 6 days in China from April 4th to 9th and Secretary of State Anthony Blinken (representing US military might) just concluded a 3-day visit to the Middle Kingdom.

At the same time, back at home, the US government has been rushing to pass a pivotal foreign policy bill that combines a $95 billion foreign aid package (with $9 billion earmarked for Taiwan) with a clause that forces the transfer of TikTok from ByteDance into US hands.

What’s going on? Why the sudden intensity in high-level diplomatic discourse?

Although little is publicly discussed about the impetus behind the recent diplomatic flurry, here’s what we do know:

1. Russia is winning in Eastern Europe. This has forced Congress to rush the passing of a massive $95 billion foreign aid bill after months of partisan gridlock.

2. Russia is preparing for a major summer offensive that could significantly turn the tides of war. A Russian war victory would, in the preeminent US banking CEO Jamie Dimon’s words, cause the world to “enter a little bit of chaos as people realign alliances and economic relationships”. Without mincing words, Dimon added that “[i]t could be a potential disaster”.

3. The US is unhappy that China is indirectly helping Russia’s war effort:

   1. During her China visit, Yellen threatened sanctions against Chinese companies that are providing “provide material support for Russia’s war”.

   2. Blinken followed up Yellen’s threat with threats of his own during his recent visit. The most serious of them being sanctions on Chinese banks that the US thinks are helping Russia.

4. Taiwan is the most important and urgent issue between the two global hegemons.

   1. The Chinese government’s readout of Xi Jinping and Biden’s call earlier in the month had this to say about Taiwan: “President Xi Jinping stressed that the Taiwan question is the first red line that must not be crossed in China-U.S. relations. In the face of “Taiwan independence” separatist activities and external encouragement and support for them, China is not going to sit on its hands.”

5. Increasingly, we’re also seeing actions and rhetoric that don’t make sense.

   1. Even as inflation remains stubbornly hot in the US (forcing economists to reconsider the possibility of rate cuts this year when many were expecting up to 6 rate cuts at the start of the year), Yellen complained during her visit that China isn’t doing enough to constrain its domestic supply glut and that it should stop exporting deflation.

      1. Did the US suddenly stop caring about inflation? Couldn’t this complaint of Chinese overcapacity wait until after US inflation has definitively cooled down?

   2. With Biden signing the bill forcing TikTok’s divestiture on Wednesday, ByteDance shot back and declared that they’d rather have TikTok shut down than hand it over to the US for tens if not hundreds of billions of dollars.

      1. Did the money-loving private enterprise that is ByteDance suddenly hate money? Why Destroy rather than Exchange?

      2. FYI, TikTok generated $14 billion in revenue last year (40%+ year-over-year growth) and 170 million Americans are active users of the app. It’s a highly, highly valuable asset.

I can draw a few conclusions from this series of events:

1. There are escalating tensions between the two countries.

2. Both sides have strong desires to solve the differences via diplomacy.

3. Foreign policy from both sides have become increasingly aggressive. I presume this is to put weight behind the diplomatic overtures.

4. Any nonsensical diplomatic rhetoric is very concerning since they hint at urgent and important, but unpublished, conflicting agendas between the two global hegemons.

What does this all mean, practically?

I think the tail risk of more geopolitical conflict is increasing significantly.

Powerful US cabinet officials don’t often visit China, and especially not at such a high frequency.

Much was said, negotiated, and disagreed upon between the two nations in the past month that was not shared with the public.

By the way, did you know that if US interest rates don’t change, US interest expenses will balloon to $1.7 trillion next year (it’s at $1 trillion right now).

Crazy!

Knowing this, I was very surprised to hear that Yellen wants China to stop exporting deflation as a result of its domestic supply glut.

As Treasury Secretary, she’s fully aware that to keep the US government’s budget under control, interest rates must fall, and for interest rates to fall, inflation must first fall.

I shared this annotated daily chart of the S&P 500 in Sunday’s inaugural Market Pulse Premium issue.

How did the market move this week?

Looks like the annotated arrow was very prescient.

I mentioned that we were likely going to see the S&P 500 move up to the mid Bollinger Band line and that was exactly what it did (see the top wick in the last candle).

Sweet, this was a good probabilistic call for the past week.

Now it’s time to focus on the future.

ℹ️ Aside: Overall Framework

The overall trading framework that this issue is based on can be summarized as:

1. Having a point-of-view, with probabilities, is better than no point-of-view.

2. You cannot predict the future, so you must be okay with making wrong decisions.

3. Lean into the arithmetic mean over the geometric mean through fractionalization of bets.

   1. Each idea gets a small portion of capital dedicated to it. Ideas with more conviction get more capital. Ideas with less conviction get less capital.

   2. Concurrent bets should have minimal correlation so that a single market event doesn’t break several ideas at the same time and significantly hurt the overall portfolio.

4. Lean into asymmetrical risk-rewards.

   1. In other words, the pay-off for being right should be significantly larger than the loss for being wrong.

   2. If you’re only 10% better at coming up with right ideas than wrong ideas, with reasonable bet sizing and asymmetrical risk-rewards, you can generate significant returns.

   3. Options is an example of an asset with asymmetrical risk-rewards. When an idea is expressed as an options position, it can pay off tremendously if you’re right (Keith Gill turned $53,000 to $50 million in two years) while if you’re wrong, you’ll at most only lost 1x.

5. Iterate fast.

   1. Iterate fast on idea generation and trade execution. Fail fast, succeed fast, and review results often.

For more details, check out these two prior newsletter issues:

1. Two Key Principles of Effective Investing

2. Thinking In Probabilities

For premium subscribers, I elaborated on this framework in the document “Retail Multi-Strat Hedge Fund Emulation” that I’ve shared in the Premium Subscribers spreadsheet.

ℹ️ Aside: Determining Probabilities

I will share a series of probabilities below. You may be wondering how I came up with them.

They represent quick and rough point-of-views based on the qualitative aspects of the market’s recent historical behaviors.

One should interpret them as, “this is more likely to happen, here’s why”, instead of, “here’s a mathematical framework to show why the probability for this happening should be exactly X”.

Every new market environment is different from past environments with many unknown unknowns, so any process to quantify exact probabilities could itself be wildly wrong.

In the face of many unknown unknowns, I find it often better to rely on intuition (Daoism) rather than complicated and time-consuming processes to determine event probabilities.

However, I’m not saying that one should entirely eschew complicated and time-consuming processes. They have their place and I’ll use them when I feel that they’re appropriate.

As Charles de Gaulle observed in his meditation on leadership, The Edge of the Sword (1932), the artist ‘does not renounce the use of his intelligence’ – which is, after all, the source of ‘lessons, methods, and knowledge’. Instead, the artist adds to these foundations ‘a certain instinctive faculty which we call inspiration’, which alone can provide the ‘direct contact with nature from which the vital spark must leap’."

ℹ️ Aside: Fiscal Dominance

Don’t miss the latest newsletter issue on Fiscal Dominance.

I think it’s a very important concept for understanding what’s going on in the market. The Federal Reserve’s economic influence, although still significant, has become increasingly less relevant in this environment of Fiscal Dominance.

In the parting wake of the Federal Reserve emerges the US Treasury which is now dictating the tempo of markets and the economy.

Thoughts On Next Week

So where do I think the market is headed next week?

I think the probabilities are in favor of sideways consolidation around the mid Bollinger Band line towards the top BB band (2 standard deviation move from the 20 simple moving average).

Why do I think so?

Read more

The title of this newsletter issue is not clickbait.

The Federal Reserve has becoming increasingly irrelevant in guiding the economy and this newsletter issue explains why and how.

The Federal Reserve has a dual mandate:

1. Price stability

2. Full employment

To keep the ever-changing economy within the guardrails of the dual mandate, the Fed has many “tools in its toolbox” (as it often likes to say).

These tools are often broad and high level.

The two most important are the ability to set interest rates and the ability to print and delete money.

In this issue, we’ll see how the post-pandemic financial system has become incredibly insensitive to the Fed’s tools.

In lieu of the Fed, the US Treasury now sets the economy’s tempo and is currently marching the US off a debt spiral cliff as it tries to balance getting Big Boss Biden re-elected while bankrolling major foreign wars at the same time.

Why is this important?

It’s important because the financial media is still describing and predicting the market’s behavior with the assumption that the Fed is still in control, and getting it very wrong.

For example, CNBC, The Wall Street Journal, and Bloomberg can’t seem to come up with a coherent explanation for why the S&P 500 is pushing all-time-highs and up 41% since the October 2022 nadir, despite the Fed rapidly raising interest rates from 0% to 5.25% in a year and burning $60 billion of treasuries and $30 billion of mortgage-backed securities a month.

To better understand, and predict, how this new economic environment works, one must view it through the lens of an increasingly irrelevant Federal Reserve and an insatiable US Treasury.

Credits

Big credits to Lyn Alden for coming up with many of the ideas I write about in this newsletter issue. I think she’s spot on with her analyses.

Setting the Stage - Federal Reserve vs the US Treasury

One quick thing to go over is the difference between the Federal Reserve and the US Treasury.

The Federal Reserve is designed to be an independent entity from the elected government.

The US Treasury, on the other hand, reports directly to the elected President.

The Fed has primary control over monetary policy, i.e. controlling the total money supply through broad tools like setting interest rates and printing/deleting money.

The Fed sets the size of the US Dollar Pie, and how viscous the filling is.

The Treasury has primary control over fiscal policy, i.e. choosing how to raise debt, and how to spend money earned through tax revenues and debt raises.

The Treasury determines how the US government earns and spends within the US Dollar Pie.

The Fed takes a long-term view to ensure that the US economy remains in a healthy state. That’s why it’s set up as an independent political entity that isn’t incentivized to buy votes.

The Treasury reports to the President and is incentivized to use fiscal policy to help the President get re-elected.

👋 Hello dear reader, if you’ve enjoyed FinanceTLDR so far, consider sharing the newsletter with friends and family.

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In the past few issues, I’ve written about:

1. How the Federal Reserve responded to President Lyndon B. Johnson demanding more money printing to fund the Vietnam War.

2. How Janet Yellen deftly moved trillions of dollars stored at the Federal Reserve to fund the US government

3. The fascinating economies of Japan and China and how they are both boosting liquidity in the US financial system

I have a lot more content planned and am grateful that you’re keeping up with the newsletter.

Also, if you’d be so inclined, you can financially support the work for a very small amount of $7 a month (or $70 a year for the annual deal). Thank you! 🙇‍♂️

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Setting the Stage - US Government Spending is Soaring

Another thing to go over before we jump into the meat of this newsletter issue: ever since the pandemic, US government spending has been sky-rocketing.

This is partly a result of soaring domestic stimulus spending, soaring war spending, and soaring interest expenses.

Today’s Federal Deficit as a % of GDP is trending like the US is back in World War 2.

At the same time, the government’s interest expenses are soaring. Interest expenses are a direct measure of the solvency of the US government.

Finally, all these trends translate to the Treasury having to incessantly issue a record amount of debt. The Federal Budget is estimated to be $6.9 trillion this year, which is a whopping $1.1 trillion larger than last year.

To fund this year’s massively oversized budget, the Treasury has to issue $1.9 trillion in net new treasuries.

Crazy.

With so much US government debt having flooded or is flooding the market, we come to this idea of Fiscal Dominance.

Fiscal Dominance is when government spending is so high that it drowns out private sector finances and dictates how the economy and market moves.

The US economy is in Fiscal Dominance mode and this can be seen by comparing the fiscal deficit to bank and corporate loans.

We see below that, in the past few years, the fiscal deficit is significantly larger than both.

The economy being in Fiscal Dominance mode is why the Federal Reserve has become a lot less influential in guiding the economy in recent years.

Let’s dive into some of the effects of Fiscal Dominance and how they manifest.

Raising Interest Rates Is Helping The Economy?!

In Fiscal Dominance mode, one of the Fed’s most powerful tools to slow down the economy, the ability to raise interest rates, is a lot less effective.

We can see this with how the S&P 500 is currently pushing all-time-highs and is 13% higher than where it was two years ago when interest rates were at 0% and the Fed just started raising rates.

Two years later, with interest rates at 5% and the S&P 500 is somehow in a raging bull market.

At the same time, GDP growth has also been very hot, significantly beating market expectations all year and ending the year with a 2.5% full-year growth rate.

This is 31% higher than 2022’s full-year growth rate, a year when interest rates were a lot lower!

If high interest rates are meant to slow down the economy, they have clearly not been working.

In fact, I’d go even as far as to say that because of Fiscal Dominance, high interest rates are actually stimulating the economy.

Why?

Because the interest expense of the US government is the interest income of private holders of government debt.

In addition, the US government owns and issues a lot of short-term debt, so when the Fed raises interest rates, the interest income of private government debt holders quickly rise.

We can see this from the rapid rise in the interest incomes of Big Tech companies since the Fed started raising interest rates in early 2022.

You may be wondering, shouldn’t rising interest rates slow down private lending and increase bankruptcies in companies filled with bad debt?

This is true, and a lot of this has happened in the past two years.

The only problem is that the US economy (and its major stock market indices) is dominated by companies that make a sh*t ton of money (think Big Tech) and aren’t reliant on debt.

In fact, they make so much money that they’re net liquidity suppliers to the economy rather than liquidity takers.

As we can see from the charts I’ve shared above, liquidity suppliers tend to benefit from high interest rates rather than be hurt by them.

Finally, even when debt stress does emerge from high interest rates (remember last year’s regional bank crisis?), the Fed will just step in and use public spending to shield the private sector from the damage of high interest rates.

In such an accomodative environment for the private sector, it’s no wonder the S&P 500 is back in a raging bull market, despite high interest rates.

Why Quantitative Tightening Is Also Ineffective

But raising interest rates is not the only tool in the Fed’s tool box to slow down the economy.

The Fed is also stepping on the brakes by reducing the total money supply through Quantitative Tightening.

Specifically, it’s letting $60 billion of US treasuries and $30 billion of mortgage-backed securities roll off its balance sheet on a monthly basis, effectively taking this much money out from circulation each month.

$90 billion removed each month! Shouldn’t this slow down the economy? Why isn’t it working?

The reason is that, as I’ve mentioned several times in past newsletter issues, the Treasury has been issuing a significantly higher amount of short-term treasuries in the past year to tap into a $2.5 trillion pool of funding that’s stored in the Fed’s Overnight Reverse Repo facility.

In other words, even if the Fed is reducing its buying demand for treasuries by $720 billion ($60 billion * 12) a year, the Treasury has found any alternative buyer with $2.5 trillion in funds!

Again, we see here that the US Treasury is in the economy’s driver’s seat, not the Fed.

What’s the End Game?

What’s the end game of Fiscal Dominance?

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So this is a quick follow-up to the Market Pulse Premium issue I sent out on Sunday evening.

In it, I wrote that I expected a bounce this week and I think this bounce has legs until around the mid Bollinger Band line.

These were the probabilities I gave for this move:

What are the probabilities? Here’s what I think:

• Bounce next week (65%) / Selling continues over the next week (35%)

• Bounce in two weeks (85%) / Selling continues over the next two weeks (15%)

The past two days have shown that this was the right call.

Below is the chart I shared in that issue for the S&P 500. This is a daily chart.

Let’s see what this chart looks like now.

Perfect!

So where are we headed to next? Here’s another look at the chart I shared last issue showing how the S&P 500 moved in a down market from late July to late October.

Be prepared to see choppy movement like this, if we’re really in the start of a major downtrend (which I think is likely to be the case).

What are the probabilities of this?

• Major downtrend for the next quarter (80%) / Bull market returns after this bounce (20%)

Why do I think so?

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This is the inaugural Market Pulse Premium newsletter issue.

The goal of this issue is to be straightforward on exactly what I’m thinking about for the markets right now:

1. Sharing predictions, with probabilities (Thinking In Probabilities)

2. How I plan to express these ideas in the market

3. Reviewing past ideas

The first Market Pulse Premium issue is open for everyone but future issues will be for Premium subscribers only.

ℹ️ Aside: Overall Framework

The overall trading framework that this issue is based on can be summarized as:

1. Having a point-of-view, with probabilities, is better than no point-of-view.

2. You cannot predict the future, so you must be okay with making wrong decisions.

3. Lean into the arithmetic mean over the geometric mean through fractionalization of bets.

   1. Each idea gets a small portion of capital dedicated to it. Ideas with more conviction get more capital. Ideas with less conviction get less capital.

   2. Concurrent bets should have minimal correlation so that a single market event doesn’t break several ideas at the same time and significantly hurt the overall portfolio.

4. Lean into asymmetrical risk-rewards.

   1. In other words, the pay-off for being right should be significantly larger than the loss for being wrong.

   2. If you’re only 10% better at coming up with right ideas than wrong ideas, with reasonable bet sizing and asymmetrical risk-rewards, you can generate significant returns.

   3. Options is an example of an asset with asymmetrical risk-rewards. When an idea is expressed as an options position, it can pay off tremendously if you’re right (Keith Gill turned $53,000 to $50 million in two years) while if you’re wrong, you’ll at most only lost 1x.

5. Iterate fast.

   1. Iterate fast on idea generation and trade execution. Fail fast, succeed fast, and review results often.

For more details, check out these two prior newsletter issues:

1. Two Key Principles of Effective Investing

2. Thinking In Probabilities

For premium subscribers, I elaborated on this framework in the document “Retail Multi-Strat Hedge Fund Emulation” that I’ve shared in the Premium Subscribers spreadsheet.

ℹ️ Aside: Determining Probabilities

I will share a series of probabilities below. You may be wondering how I came up with them.

They represent quick and rough point-of-views based on the qualitative aspects of the market’s recent historical behaviors.

One should interpret them as, “this is more likely to happen, here’s why”, instead of, “here’s a mathematical framework to show why the probability for this happening should be exactly X”.

Every new market environment is different from past environments with many unknown unknowns, so any process to quantify exact probabilities could itself be wildly wrong.

In the face of many unknown unknowns, I find it often better to rely on intuition (Daoism) rather than complicated and time-consuming processes to determine event probabilities.

However, I’m not saying that one should entirely eschew complicated and time-consuming processes. They have their place and I’ll use them when I feel that they’re appropriate.

As Charles de Gaulle observed in his meditation on leadership, The Edge of the Sword (1932), the artist ‘does not renounce the use of his intelligence’ – which is, after all, the source of ‘lessons, methods, and knowledge’. Instead, the artist adds to these foundations ‘a certain instinctive faculty which we call inspiration’, which alone can provide the ‘direct contact with nature from which the vital spark must leap’."

📉 We’re likely at the start of a new major downtrend

The S&P 500 sold off sharply last week.

6 red daily candles in a row, each pushing the bottom Bollinger Band (a 2 standard deviation negative move, with respect to the last 20 days).

At the same time, RSI collapsed from 65 to almost 30 after hanging above 60 for almost 5 months (since early November).

This was an extreme downside move that we haven’t seen for many months.

Typically, after such large downside moves, the market is liable to bounce and hit the mid Bollinger Band line, before selling off again.

Quick Bollinger Band TLDR: the middle BB line, as seen below in orange, plots a 20-period Simple Moving Average (SMA). The blue lines above and below are 2 standard deviation moves from the 20 SMA.

For example, below is how the S&P 500 traded last year from the start of Q3 (August) to the end of October. Lots of selling, a big bounce to the mid Bollinger Band line, more selling, another big bounce, and then even more selling.

In the past few years, S&P 500 has often exhibited this bouncy downtrend pattern during prolonged sell-offs.

💡 As such, I think that the market will more likely than not make one of these big bounces after last week’s significant selling.

What are the probabilities? Here’s what I think:

• Bounce next week (65%) / Selling continues over the next week (35%)

• Bounce in two weeks (85%) / Selling continues over the next two weeks (15%)

ℹ️ Aside: RSI and Bollinger Bands

Price indicators are derivatives of price movements.

Investors use indicators to have a better sense of short-term price action.

Why?

One principle is that short-term price movements are very probabilistic.

For example, the longer price has been pushing the 2 standard deviation line below the 20 simple moving average, the more likely it is to bounce in the short-term.

RSI and Bollinger Bands are very simple and popular indicators that, in my opinion, present the simplest view of short-term probabilities.

Don’t take it from me. These two indicators, especially Bollinger Bands, are very popular among options analysts, and options analysts are the best probability traders in the market.

📉 Shorting the short-term bounce

If the S&P 500 bounces within the next two weeks, the probabilities start to skew toward more selling when it touches or crosses the mid Bollinger Band line.

💡 At that point, I’m going to start looking to short the market.

What are the probabilities?

If a bounce to the mid Bollinger Band line happens within the next two weeks, the probabilities of the next move are:

• Selling continues after the bounce (70%) / The market bounces or levels off (25%)

📈 Start preparing early for a long-term bounce

Although it’s very early to start thinking about a long-term bounce (assuming this is the start of a period of prolonged selling), it doesn’t hurt to keep the next long-term bounce in mind.

When the bounce comes, it’ll likely be large and very profitable, even if you don’t time the entry perfectly.

The market in the past few years has consistently and strongly trended upwards after a period of prolonged selling.

Just look at the non-stop buying from last November to the end of March. You don’t need precise timing to profit from such strong long-term upwards moves.

💡 When does this long-term bounce happen?

If I were to guess, I think the market sells off during the summer and bounces in early H2 (second half of the year). Perhaps at the end of July.

What are the probabilities of this happening? My rough guess is:

• Long-term bounce starts in early H2 (80%) / Selling continues into the election (20%).

Why?

For one, stocks tend to rally hard in the few months before a Presidential election. The US Treasury, which works for the incumbent President, will work hard to add liquidity to the market to increase the chances of their boss winning.

In a Fiscally Dominant financial environment, the US Treasury has a lot of power to set the market’s tempo.

Another reason is that prior periods of prolonged market sell-offs in the past 4 years have not lasted for more than a quarter or two. It’s unlikely for this current sell-off, assuming it’s another big one, to be different from the others.

How could this idea go wrong? More war and more inflation later this year.

ℹ️ Interest Rates and Big Tech

One idea I’ve been thinking about for a while now is how high interest rates actually benefit, rather than hurt, Big Tech companies.

Big Tech companies make so much money that they’re effectively liquidity suppliers for the rest of the market and don’t need to borrow money to sustain or grow the business. As such, they’re largely unaffected by high borrowing costs and instead will earn a lot more money lending out their constantly refilling or overflowing corporate treasuries at high interest rates.

Below are three charts showing how, as the Federal Reserve rapidly hiked interest rates over the past two years, Big Tech interest income has soared alongside rising interest rates.

Reviewing New And Existing Ideas

1. Short TQQQ (technology sector)

   1. Ongoing idea. Working very well. Started the position on April 11th and I should’ve doubled down last week but made the mistake of obsessing over a perfect entry.

2. Short TLT (long-term US treasuries)

   1. Ongoing idea. Working very well. A summer of hot inflation means greater expectations for higher interest rates. When interest rates rise, bond prices fall and vice versa.

3. Long ITA (defense sector)

   1. Ongoing idea. ITA hasn’t moved much since I expressed the idea but the US House just passed a $95 billion foreign defense aid bill (Ukraine, Israel, and Taiwan) and this should be a big boost for the US defense sector (the Democrat-majority Senate is likely to ratify the House’s decision).

4. Long Z (Zillow)

   1. With hot inflation, which means higher interest rates, the Z idea is not doing well. However, it’s a long-term idea (one year) and I see it as just being a bit early. Z has materially out-performed the real estate industry in the past year and I think it will continue to do so.

   2. On the off chance that inflation does fall in the summer for whatever unforeseen reason, the Z idea will start working early.

   3. In a way, the Z idea is a hedge against interest rates falling more than expected, even though my opinion started to shift towards higher inflation throughout the summer and thus higher interest rates.

5. Long INTC (Intel)

   1. I still think Intel is a great hedge against TSMC troubles if China-Taiwan tensions worsen.

   2. I was expecting the new CHIPS Act grants to be very positive for the stock, but didn’t expect fab costs to be so high, pulling the stock down overall (The Register headline: Intel's effort to build a foundry biz is costing far more – and taking longer – than expected).

   3. I think most of the bad news for Intel is out of the way now. This idea is also a long-term idea (one year) and still has a lot of time to play out.

6. Long NKLA (Nikola)

   1. I remain very bullish for Nikola.

   2. This idea played out very nicely in the short-term, with the stock rising from $0.60 to almost $1.20 in the last week of March.

   3. A broad market sell-off coupled with a large stock dilution proposal with little communication from the company sunk the stock afterwards. I don’t see a stock dilution plan as a significant problem. Authorized shares != issued shares and Nikola’s modus operandi has always been to secure enough funding for operations for the next year.

   4. The company’s fundamentals, as it pertains to the build-out of hydrogen fueling infrastructure and sales of hydrogen and battery truck have never been better and the company continues to execute vigorously and successfully towards both.

   5. With the recent large rise in oil prices, alternative fuel sources become more and more valuable. Geopolitical tensions near some of the world’s largest oil-producing regions are very high right now are very high right now and I won’t be surprised if oil continues to climb over the next few months.

   6. Nikola’s achievements

      1. IMC, the largest marine drayage firm in the US, expands its hydrogen trucks order from 10 trucks to 50.

      2. Edmonton, Alberta hydrogen fueling station complete. This came shortly after the completion of the Ontario, California hydrogen fueling station.

      3. Loblaw Companies, a major Canadian supermarket conglomerate, is rumored to be testing Nikola trucks.

      4. Sold 40 hydrogen trucks in Q1, significantly outperforming analyst expectations of 30 trucks.