How will the stock market crash and how to prepare for it


There's always a crash coming. Ever since 2013 they've been calling it, just around the corner. I was bearish before the corona crash, but I was wrong. What was I wrong about?

The magnitude of quantitative easing central banks were willing to do.

USD is the global reserve currency - or is it?

The most critical thing the USD as a currency enjoys is trust, and they're about to lose it.

In financially uncertain times, countries and institutions change their assets to safer kinds, which makes a lot of sense. When the markets get fearful, this movement increases demand of those safer assets while people sell anything else. Typically people buy US treasuries. This didn't happen during the COVID crash of 2020. Why?

After the crash of 2008, central banks tried to restart the economy by lowering interest rates - eventually to zero. When that didn't work, they resorted to quantitative easing - first in the billions, now in trillions. QE was supposed to be an emergency measure: something to stop once the market recovered. But it never did.

By quantitative easing, central banks inject more money into the market. They can do this by printing money at a click of a button and exchanging that for securities that are on the market. In the beginning this is typically government treasuries. The treasuries end up in the balance sheet of the central bank and money flows into the market.

The reason central banks do this is because firstly, it lubricates the economy. Having more money in circulation should - in theory - result to increased business activity. Secondly, when banks and institutions own treasuries that are becoming hard to sell due to lowered demand, the value of those treasuries decrease. In the case of the US, if people find treasuries on the market at a discount, why would anyone by any new treasuries the Fed would want to sell? The Fed would have to issue the new treasuries at a higher interest rate for them to be interesting. This is poison.

Letting the interest rates of US treasuries to increase is really, really bad. When interests increase as a result, the value of existing treasuries plummet. This causes massive losses to all entities who have them in their balance sheet; not just the Fed, but everyone else who has invested in them too.

Also, 25% of companies in the S&P 500 index are just barely surviving their loan obligations as it is now. Increased interests mean these zombie companies would all go bankrupt, causing massive unemployment.

What is the likelihood the Fed will do this, let interests rise? Exactly. There's a big risk they won't but instead, they'll try to fight off elevated interests, devouring the unwanted treasuries from the market.



The Fed balance sheet stands at a whopping 7 trillion dollars. The US has only four times that debt, total. In other words, one quarter of their debt, the US owes to itself.

So why did investors not flock to US treasuries at the crash of 2020? Perhaps it's because this pattern cannot go on forever. You cannot print money for yourself forever. It seems that the market is losing faith in the USD continuing to be a safe haven. The market is expecting the USD to weaken due to inflation, caused by the grotesque quantitative easing as well as bottlenecks caused by COVID.

If this happens, the USD would no longer serve as a global reserve and we'd switch to ... what, Renminbi?

A few paths forward

Losing faith to USD as a global reserve would lead to a cataclysmic, fascinating collapse of the monetary system. This can be avoided though, and it probably will, but likely not without some major distress. Why would something like this happen?

What is changing now is that inflation indeed is raising its head. This has the potential to massively change the status quo in unexpected ways.



As you can see, short term inflation expectations have risen rapidly. What comes next is critical - is this going to be a temporary bump in inflation due to bottlenecks in the economy, or will inflation finally jump to elevated levels?

A) Widespread bankruptcies

In November 2020, the Fed changed their inflation target from a simple target to an average inflation target. This suggests already that the Fed will not fight inflation to the death. If inflation keeps rising, so will interest rates. In November 2020, 20% of US companies were on the verge of not being able to pay the interest on their debt. This has now grown to 25%. 

If the Fed chooses not to fight inflation and rising interest rates, the collapse of these Zombie companies will result in a drastic pullback in the economy. The following mass-unemployment would lead to severe poverty, slow growth and rising inequality. Inflation expectations would reverse and we'd go back to interest rates close to zero.

B) Economic growth will fix everything

What the US hopes is economic growth. They're banking on buying enough time for economic growth to re-emerge, which would let them re-start quantitative tightening. See that small dip in the Fed balance sheet from 2018 to 2020? That's what they are looking to do. If economy starts to grow, the Fed can increase rates again, start reducing their balance sheet and return faith to USD as the global reserve.

This is the wishful-thinking answer, since it requires Fed to keep interests low, which in rising inflation might not be possible. If you watch inflation rise, this option does not happen without option A first.

C) Investors flee from USD treasuries

If Fed continues with quantitative easing beyond the point that seems credible, investors could get spooked. How long can you finance your struggling economy by printing the money everyone trusts is the global reserve currency? The US is the only country in the world that has its foreign debt in their own currency. As a last resort, US can just double their money supply and pay off their debt - poof - just like that.

Imagine the horror, if there are any signs that investors are getting concerned about the US ability to pay back its debt, which would lead to the above scenario. The magnitude of USD money supply is so massive, there are no real alternatives. Where can that money go? The only fiat that has a larger money supply than USD is Chinese Renmibi.

No, crypto currencies are not yet mature or large enough for money to flow there, although it's extremely likely that in this scenario, cryptos would see a massive price increase, too.

It's much more likely that money will flow even more so into the global stock market, further inflating the appreciation levels. If you own Google, you own Google, no matter what USD is worth.

D) Infinite Quantitative Easing is the new norm

We'll keep going forever in this new norm. Just like in Japan, prolonged quantitative easing halts the US growth into a crawl.

The reason I don't believe in this scenario that much is that US has its foreign debt in USD, which means they can at any point just print the money.

This of course is stealing from investors, but if push came to shove, they would do it instead of decades of non-growth.

Waiting for the music to stop

What can you, as a private investor, do to prepare yourself?

First you need to ask yourself these questions

  1. Will inflation rise for longer?
  2. Will Fed save Zombie companies from bankruptcy to avoid unemployment?
  3. Will markets lose to trust US paying back its debt without massive money printing?

If you are like me and answer Yes! to all of the questions above then here are some ideas you could consider (no advice though!).

Value stocks instead of growth stocks

If long-term inflation expectations rise, and consequently interest rates, growth stocks will take a beating. In the turbulent period that follows, it will be difficult to secure funding for some growth stocks to survive over it. Thus, holding a large bag of growth stocks is risky. It makes sense to consider value stocks instead.

By definition, value stocks have more margin of safety as they are conservatively priced. They are usually the most un-sexy thing out there: sewage treatment, cardboard, plumbing and such. They are tough to find, so I try to learn from people wiser than me. I've mentioned a few times ValueSignals, which has a stellar newsletter. Every month they find a under-the-radar value stocks that this year have already yielded +19% comparing to euro stoxx 600 only +12%. For someone seriously wanting to get into value stocks others don't know of yet, ValueSignals is a great service.

Short term consumer loans

Long treasuries will take a beating when inflation pushes interests up. However, short term loans do not have the same issue, as you can always wait them out to maturity. Some services such as RoboCash and Swaper offer even 30 day loans that yield 10-12% p.a. Services such as Mintos and PeerBerry have loans from 12 months and up, which could still be acceptable

Real estate typically absorbs inflation

Typically, inflation is seen also in real estate prices. Therefore, owning real estate could be a good way of hedging yourself from inflation. You can do this through REITs such as $REI or $O. They have dividend yields of 4%-5% and give a steady dividend. I own both in my portfolio.

You could also buy a property to rent out. If you can finance that with a fixed mortgage, like they have in Finland, you could see inflation eat away your debt while your property produces steady income. This is a play I'm very seriously considering.

You can also turn to real estate platforms such as Estateguru or Reinvest24 and get the most bang for the buck with least effort. I especially like Estateguru, as they seem to have the most sophisticated processes, provide intricate details on each project, keep investors absolutely updated and continue to have an unparalled track record. I am invested on both platforms too.

Crypto play

If USD loses its place as the global reserve currency, I will be shocked if cryptos don't at least double. When media stories break out about the "collapse of the dollar", what is the narrative that people have heard over and over for the past five years? That cryptos will replace gold as the safe asset.

At least private investors won't think of Renmibi, while Euro might come to mind. But it only requires a small jump in Bitcoin and FOMO will drive the rest of the herd to buying BTC with their USD.

One smart way of HODLing your cryptos is Nexo, which pays interest to your asset value. Storing BTC for example will give you a 6% interest. Compared to your cold wallet, that's 6% more. Then again, you need to trust Nexo will keep them safe.

Companies with pricing power

Although I much prefer value stocks in general, some sectors are more resilient to inflation than others. And that makes a lot of sense. People need water, electricity, internet, healthcare, and so on. Industries need micro chips, raw materials and such. A good defensive play against inflation is to buy companies that have a solid foundation even when zombies roam the streets.

Afterwords

Obviously no-one knows what will happen. This is at best an educated guess, but as such, I believe it's a good one. There are longitudinal examples of quantitative easing, the best of them being Japan. While that one hasn't lead into an implosion, it has stalled the economic growth into a standstill - not great either. We are still quite far from the Japan example, if measured by central bank balance sheet as a percentage of GDP, but markets will likely predict the play much sooner than the Japan levels.

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