Jerome Powell and the Federal Reserve may be in the process of driving the stock market over the edge by spiraling into recession.
That’s one possible scenario envisioned by fund manager Mark Spitznagel, who indeed thinks the Fed will be on the verge of rate hikes soon. He’s not explicitly betting on either outcome, but he’s likely to make headlines again if the tighter one comes true: The last time the U.S. economy contracted, his firm, Universa Investments, earned a whopping 4,000% return. in a few weeks. The time before that, during the financial crisis, he doubled clients’ money even when the value of stocks was cut in half. Between those two downturns, Universa made $1 billion in one day during the “flash crash”.
Individual investors would love to buy the kind of crash protection that Mr. Spitznagel, a protégé of “Black Swan” author Nassim Nicholas Taleb, sells to his sophisticated clients. But they can’t and, in their efforts to recreate it and find peace of mind, they end their returns. Techniques include chronically misguided attempts to read economic tea leaves and mislead the market into using hedged products or investments.
For example, exchange-traded notes that rise in value on down-market days have been some of the most traded instruments on the US stock exchange since the pandemic began. The ProShares UltraPro Short QQQ, which delivers three times the daily inverse return of the high-tech Nasdaq 100 Index, is shining, rising 32% over the past 12 months. But many of its fans don’t realize how terrible it is to own in the long run, having lost 99.9% of its value since its inception in 2010. The timing has also been a bit wrong over the past year, with 45 a day when the price of the note fell by 5% or more and seven days when it fell by at least 10%.
Even the classic 60/40 stock/bond portfolio, meant to iron out returns in choppy markets, has disappointed this year with rising inflation, losing about 16% through Friday — almost as bad as owning total stock market index fund. Gold, a traditional inflation hedge, has lost 9% this year, while “digital gold” bitcoin has fared much worse, falling 57% through Friday.
Risk and reward are traditionally seen as a trade-off – a smoother return means settling for a lower one. Mr. Spitznagel’s book “Safe Haven: Investing for Financial Storms,” published a year ago, argues that it need not be. A leaked copy of his fund’s returns over its first decade through mid-2018, which preceded its pandemic bonanza, also does so. A portfolio with 3.3% in Universa, which uses sophisticated derivatives to profit from extreme market movements, and the rest in an S&P 500 index fund, returned $10,000 to $31,900. One that just owned the index rose to $25,307. Other portfolios with traditional hedges such as gold bonds and Treasuries fared even worse.
In an interview last week, Mr. Spitznagel said that individuals cannot replicate that result. His answer to the next best thing for individual investors is what Warren Buffett would recommend: Buy and hold stocks for the long haul.
This is surprising because Mr. Spitznagel is a pessimist at heart. While his math-driven fund is always swayed by doomsday bets and doesn’t rely on short-term predictions, he sees the Fed backing itself into a corner with long-term consequences. The size of its balance sheet and the increase in debt in the economy as a whole leave it with the choice of continuing to try to push down inflation, which pushes the US into recession, or withdrawing from tightening as it did in December 2018 when it arrived. it brought stocks back from the brink of a bear market.
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Unless the Fed acts wildly out of character and keeps tightening, inflation will stick around and bonds will hide nowhere. A long-term bet on stocks, even if a crash occurs in the near future, is the way to maximize wealth. Universa’s clients rely on its fund to feel comfortable staying invested in risky assets, willing to put up with months or years of small steady losses on that small part of their overall portfolio. California’s giant public employee pension fund lost patience with Universa’s strategy shortly before the pandemic crash and that 4,000% return.
Individual investors who can hold their nerve better than a board of bureaucrats stand the best chance of weathering future financial storms. The strategy is simple, but certainly not easy.
Write to Spencer Jakab at Spencer.Jakab@wsj.com
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