A Gambling Mood on Wall Street
Investors are in a gambling mood after rushing in to buy the dip at high prices despite an extreme set of risks. Most acutely, the U.S.-Iran conflict is at a critical juncture. If a diplomatic settlement is not reached by midnight on Tuesday, the conflict risks a catastrophic escalation.
The S&P 500 set three consecutive record highs last week on an 11‑day run that marked the fastest rally to a new all‑time high following a correction of at least 8% in the past 50 years. Bonds edged higher last week. Commodities were down. Gold and bitcoin were up.
In the U.S.-Iran war, political gamesmanship is clashing with strategic reality.
Social media is here to stay, but war is always won and lost on the battlefield. I suppose a Zoom negotiation could end a war… That’s not the point! The news that matters is that Iran maintains military control of the Strait of Hormuz and is maintaining a hardline stance in brokered negotiations.
Iran has said that the Strait will remain closed until the U.S. Naval blockade of its ports is lifted. Over the weekend, several oil tankers attempted to exit the Strait and were forced by the Iranian military to turn around. Control of the Strait is one of several key strategic advantages for Iran but importantly, it's a matter of national pride.
Iran will never surrender to the United States and they’ve just re-supplied their rocket and drone launchers. So far, they’ve said “no thanks” to a second round of negotiations. It’s time for the U.S. to face strategic reality. They have a few options—none of them are too attractive and they’re all unlikely to achieve the key objectives.
The first and best option is a diplomatic agreement, which, at this point, would be largely on Iran’s terms. The hope is that U.S. officials could find a way to credibly move the goal posts and declare victory. The second best option is an extended ceasefire—and more social media threats—but that can’t go on forever. The third option is more largely ineffective bombing. The last two options—bombing civilian infrastructure and/or some sort of ground invasion—do offer the U.S. government a chance to win but would cost many lives and economic disaster for millions in the Middle East and around the world.
The damage to global supply chains will be felt soon.
The closure of the Strait poses a systemic threat to the global economy, but the financial markets seem blind to it. Pre-war shipments have masked the crisis due to long ocean transit times, but the damage has already been done. Impacts to global supply chains around the world have largely been ignored by U.S. media but are in fact having major impacts in other counties.
Consumers and businesses in the United States may not see many supply shortages, but they will see price increases. Americans pay higher gas prices not because gas is in short supply here, but because those in emerging and developing markets are willing to pay a higher price. The market for oil is a global competition where the highest bidder gets the supply. More price increases are coming as pressures across thousands of global supply chains begin to take hold.
Most critically for third world and emerging markets, critical fertilizers and petrochemicals threaten crop yields. Massive agricultural disruptions are coming and food prices will be higher, especially later this year.
Higher prices will drag on corporate profit margins and consumers’ balance sheets. Even if a deal is reached today, the structural damage to these critical supply chains ensures the global economy will suffer inflationary and contractionary ripples for months, if not years, to come.
Investors are in a gambling mood with many on “winner’s tilt.”
The CAPE Ratio, which stands for Cyclically Adjusted Price-to-Earnings Ratio, is a widely used valuation metric in the stock market. Also known as the Shiller PE Ratio, named after Robert Shiller, the Yale economist who popularized it, the CAPE Ratio is a gauge that indicates whether the stock market is overvalued, undervalued, or fairly valued compared to historical averages.
The current S&P 500 CAPE Ratio is now over 40–above 99% of historical valuations—well above its 1929 peak, not far below its 1999 dot-com bubble peak.
FOMO, another acronym, stands for Fear of Missing Out, is the go-to explanation for why investors are piling into the stock market at times when prices and risks are both near all-time highs. There's undoubtedly plenty of FOMO in today’s stock market, but I think there may be a more nuanced explanation: “winner’s tilt.”
A winning poker play is an expert at straddling the line between risk and ruin. He’s able to pick and choose his spots applying just the right amount of aggression without falling into his opponents traps. Poker pros must keep their wits about them at all times, maintaining their focus, similar to a professional athlete.
In poker circles the term “tilt” describes a player who, due to a losing streak or a run of bad cards, gets frustrated, lets his emotions get the better of him and, as a result, loses his focus and his edge and his money. A player on tilt can easily slide into a death spiral where he’s bleeding money, fast.
Winner’s tilt happens when a poker player goes on a big winning streak. The cards are falling his way. He’s winning almost every pot and the game feels easy. He can’t miss. A winning streak—just like a losing streak—can throw a player off his edge. Over-confidence can be fatal, not just in poker, but in life and investing is certainly no exception.
Benjamin Graham, the father of value investing famously said, "The investor’s chief problem—and even his worst enemy—is likely to be himself."
Over-confidence is an expensive lesson learned by every seasoned investor. Today’s markets are filled with unseasoned investors who have no idea that winner’s tilt is real.
How am I positioning clients’ portfolios today?
The danger of extreme valuations is not that they predict an immediate market crash, but rather that they dictate the mathematical reality of long-term returns. Historically, the valuation metrics we see today have a near-perfect negative correlation with subsequent 10-to-12-year market performance. At current levels, the math suggests that passive investors in cap-weighted indices like the S&P 500 are locking in expectations of near-zero or even negative average annual total returns for the next decade. The passive buy-and-hold strategy that worked effortlessly during the era of easy money is now priced for a lost decade.
More immediately, these valuations create severe, asymmetric downside risk. A simple, run-of-the-mill reversion to historical valuation norms—not a worst-case scenario, but just a return to the long-term average—would imply a 30% to 40% decline in the S&P 500 over the completion of this market cycle.
In this environment, recognizing the unprecedented risks embedded in today's market prices is the first step in protecting your wealth. My clients’ portfolios are focused on managing risk and alternative asset classes. We’ve implemented a relative value trade where our short position in U.S. stocks is balanced by an allocation to foreign small-cap stocks and positions in infrastructure, energy security, and natural resources. Earnings growth is moving to companies with tangible assets and pricing power.
To see how we’re invested and why, download our Q2 Investment Outlook: The End of Easy Money.
THE ALPHA ROCK DIFFERENCE - Our investment strategies are a compelling alternative to traditional buy-and-hold investing. By focusing on liquid alternative investments and active risk-management, we target absolute returns, not benchmarks. To see how we’re invested and why, download our most recent Quarterly Investment Outlook, The End of Easy Money.
REVIEW YOUR INVESTMENTS - When market volatility increases, it’s a good time to review your investments, especially if you’re using a passive, buy-and-hold strategy. Please schedule a call or meeting)
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