🗞 Buffett's Warning to You

WHILE YOU POUR THE JOE… ☕️
Meta Flop

Shares of Meta were down after the company reported earnings, and we entertained the possibility of a short in this name a couple of posts ago. 📉 

More specifically, we gave you a short position in the ARK innovation fund ahead of this mess. We just pulled out of both, at a hefty gain for each, to get our weekend started early.

Anyway, hope you enjoyed Halloween. If you’re in Florida, Halloween Horror Nights at Universal was even better this year.

Speaking of scary news, let’s get on with today’s email 📧…

GOING DOWN WITH THE SHIP
Buffett’s Timeless Wisdom

Back in 1999, Warren Buffett went on a live CNN interview to talk about the stock market, and a couple of posts ago, he didn't sound too optimistic for the decade that was coming.

He said that the stock market's next 17 years would be nothing like the past 17 years, pointing to two main factors driving his flattish outlook.

We have to agree with him here, on top of all the other factors and indicators we've posted about in the past, the next decade for the S&P 500 is going to be a trader's paradise, and an investor's nightmare. 📉 

So, here's what concerned Buffett in 1999 and what should (unless he lost his touch) concern him today as well.

The ten-year bond yields are rising rapidly, and in case you forgot, this is the yield that drives most investor expectations and benchmarks in the rest of the market. 📈 

In English, investors will expect a minimum return of 4.3% from the S&P 500 because they can get that same return with zero stress and minimal risk through buying bonds.

That’s going to be hard to achieve for the market, especially at today’s valuations, which are at all-time highs. Particularly the Buffett indicator (Stock market / GDP) ratio, which tells us that the S&P 500 is at its most expensive level today.

That’s the same concern Buffett had in the 1999 letter and interview, where the stock market was at an all-time high valuation relative to GDP, and bond yields were too high to give stocks any room to breathe.

Right after, you would have had an entire decade of lost returns unless you knew how to trade the ranging market in a mean-reversion fashion.

His second concern came from corporate earnings (EPS) relative to GDP, which is a good predictor of their future growth potential.

Here’s the record for the US GDP and corporate earnings (blue area) from 1985. You’ll notice three things that aren’t too clear on the chart:

1. 2000: Earnings were 6.3% of GDP, then flat market

2. 2007: Earnings were 8.3% of GDP, then flat market

3. Today: Earnings are 11.5% of GDP, then…?

Over history, it makes sense to see earnings as roughly 4-5% of US GDP. Whenever we get too high past this norm, it means the economy might be too indebted and leveraged and that the S&P 500 might run into what’s known as a “lost decade.”

Non-surprisingly, a lot of media outlets are calling for this same scenario to play out again, which is also why Buffett:

• Sold out of Apple, banks, and some consumer names

• Bought into overseas stocks and is now holding the largest cash pile in history

What will you do when the market crashes?

It doesn’t necessarily have to crash, but look, this is what the S&P 500 did from 2000 to 2011.

2% annualized returns, that’s it. You would have done much better by being an active trader (mean reversion specifically) or just simply investing in bonds.

The next 10 years could look like these, so buckle up. 🫰 

 TRADE OF THE WEEK
Curve Ball

This is the infamous yield curve, which is measured by taking the yield from the 10-year bond minus the yield of the 2-year bond.

The curve measures the liquidity and credit cycle of the economy for reasons that could turn into a whole post in itself. So, today, just worry about these two generalizations:

1. If the curve goes up, it’s typically deleveraging and tightening credit for the economy

2. If the curve goes down, it’s a leveraging cycle where there’s rising liquidity and credit

Now, when the curve inverts 📉 (goes negative), it means the pendulum of credit and liquidity has swung too far in one direction, and the consequences will be bad.

That’s why it always calls recessions accurately, like 100% of the time.

So, knowing that Buffett’s warning from 1999 is as valid today as it was then, we feel it’s appropriate to consider a long yield curve trade here.

To make this happen, we need two ETFs.

Through the $IEF, you’ll have access to the ten-year bond and its price action mostly. Now remember, yields move opposite to bond prices.

With this in mind, a rising yield curve means ten-year yields go up faster than 2-year yields, meaning $IEF prices are set to go down faster than other bond ETFs.

Got it? Right, so we’re going to short this one. 📉 

Now, going back to the curve, the 2-year yields will also rise, but they will rise slower than the 10-year or not even rise at all.

This is why buying the $SHY ETF makes sense: if we’re wrong, we make money; if we’re right, we make even more money.

Gotta love these sort of setups. Simple, not much analysis needed, done for you.

Don’t get used to it; next week, we’re back to our good old deep dives. 👀 

NOW GO AND MAKE IT HAPPEN
Business School? No Thanks

Do you want to sit for hours and listen to someone deadbeat tell you about business when that person has never run a business in his entire life? Or, would you rather learn from who once was the wealthiest man in the world?

Today’s book recommendation 📖 is a collection of shareholder letters from Warren Buffett. Reading them would lead to the same conclusions about the market we landed on today and much more.

To your success,

G. 🥃