Divestor

This post, in addition to everything else I write here, is not generated by AI.

However, AI is more than happy to scrape whatever it is I write and meld it into its consciousness and is more than happy to regurgitate it and indeed claim it is its own voice!

So you no longer have to read what I write – instead, just ask ChatGPT or the other dozen AI engines out there and I am sure they will be more than happy to tell you what you want to be hearing instead of my lonely voice on an obscure website.

I have taken a hiatus from writing over the past couple months. There was a multitude of reasons why which I won’t get into, but part of it is the value of stepping back and mentally detaching to gain a broader and more strategic perspective on the craziness that is going on. One disadvantage is that similar to the physical example of when you don’t work out for a period of time and your body starts to atrophy, the same applies to writing. It takes quite a bit of effort to finally put pen to paper again.

I have been in a low-risk mode for quite some time, a large part due to my own personal uncertainty and the fact that from around 2023 onwards, I do not think that my ideas and thought process has been very alpha-generating. Most of my ideas since then have not been good, with one notable exception (I’ll just leak it here and say it was Magellan Aerospace – I have not done a write-up on them, but suffice to say, just like any good trade, I wish I had taken a larger position to begin with… and there’s likely to be further upside from here, although the outsized returns are now finished).

Although the tariff tantrums that have caused VIX to spike to 60 have tapered away, we continue to live in a strange world where the narrative that is being created by digital media is the cause of the change of people’s perceptions, but not to the degree that one may think – while perceptions may change, underlying realities, when experienced on the ground, is much different than the digital narrative.

Much of what we perceive in the digital world is completely manufactured for manipulatory purposes – with digitization, it is easier than ever to manufacture stories and push the boundaries as to what can to believed. Originally a photograph was sufficient evidence of potential malfeasance, but now you can even ask the AI to photoshop it into some compromising position. Then a voice recording was a smoking gun – and this can now be faked with AI. I’ve also talked about in the past (a decade or even two ago!) about how video can now be easily faked (see: 1987 movie clip – The Running Man). All of this virtual fakeness is cheaper than ever to manufacture.

While truth is absolute, it is unfortunately very easy to shroud it in a multitude of fictions – and being able to disprove fictions is a much more expensive process because fiction is so damn easy to generate.

In other words, the digital infrastructure is driving us collectively mad – inherently it is the example of a trillion monkeys keying into typewriters and eventually some sort of narrative will ‘stick’ just given our very human susceptibilities to believe in stories. This is the very strange and brave new world that we live in – at least when we stick to using digital media to “inform” us. Just five years ago, we saw a very powerful example of how digital infrastructure can be used to changing the narratives of people in rapid succession (wear a mask and take a vaccine or go to jail because you are killing Grandma) – and this will continue to get worse as long as people continue to believe the digital machine – and they do because it is much easier to listen instead of asking questions!

You can see now why I am going a bit nuts trying to distill everything and figure out where things are going. It can almost justify the valuations we see in the fiction generators of society – the NVidia’s, Facebooks and the like – while the “nuts and bolts” of society (e.g. the CN Rails) trade at much more reasonable price to earnings ratios.

Many years ago, Amazon’s founder bought out the Washington Post – this was not because Bezos decided to be a benevolent news-creator, but rather it was a channel into molding the narrative and public consciousness. Musk bought out Twitter for similar reasons. Facebook has built it up organically, much to their own credit. The value is clearly in creating these networks as a control mechanism to form the narrative that people believe, and this goes beyond dollars and cents and hence a P/E ratio is a meaningless measure of whether there is value or not. How much does one put on the value of an intangible attribute such as trust, for example?

I’m not sure where this is going. In terms of investment options, there is reality and there is virtual reality and the lines between both are getting blurred. Even the macroeconomic environment appears to be precariously positioned – it is quite evident that the infinite money-printing machine is coming to a close (just look at Japan’s long term bond yields which seemingly have a yield again) – US 30-year treasuries aren’t doing that much better either (TLT investors are down about 40-45% from five years ago!) and central banks are on the verge of QE-ing long-term yields into submission once again, which will only have the effect of inflating all asset prices like we’re living in 2009 or 2021. Something will break, but this be asset pricing? Or will the thing that break be future returns by virtue of inflated asset pricing?

One thing that can be taken for certain is that the powerbrokers are the ones controlling the bulk of the assets, and there is a huge vested interest in making sure that control does not get ceded by virtue of collapsing the financial system.

Doing a cursory yield scan of the corporate bond market and the preferred share market, almost nothing is suggesting outsized returns on fixed income. Reliable firms such as TRP or PPL have their preferred shares yielding around 600-700bps on reset, which is hardly a risk premium in light of yields given by corporates. Quite frankly, the environment out there for returns is terrible. Instead, one has to reach for anticipating the psychology of demand and getting that capital appreciation to make those outsized returns. With the TSX at all-time highs and the S&P 500 almost at all-time highs, it could entirely be the case that depreciating currency plus QE will be the vector to propel the markets even higher than anybody expects – keeping the asset values inflated and the speculative mania very much alive.

The crystal ball after March of 2020 was quite clear. Right now it is foggy, but after taking a small break, I’m getting a better sense as to where the AI dys-reality is taking perception and narrative and areas where it will be potentially clashing against reality. AI is great at taking existing information and meshing it into something that looks new, but my projection is a scenario where, similar to Covid, by necessity things go into original territory once again once there is too much of a distance to reconcile narrative to reality – there needs to be a game changing event to occur.

You’ll probably think I am crazy when I say this, but prepare for an alien invasion.

Clearly I’m not sane. Please consult ChatGPT for more saner advice than what I’m dishing out here.

The VIX index has been wildly dancing around, but as I write this it is roughly at around 50% at the moment.

April 16, 2025 futures (the predicted VIX 6 trading sessions later) has it at about 34%.

(Update: by the time I started penning this draft to when I hit the publish button, the numbers changed to 45% and 32%, respectively)

We are seeing a continuation of policy disruption and the realization that traditional structures that have existed are crumbling before our eyes. With the elevation of risk, prices are dropping and we are also seeing a deleveraging occurring.

It is always instructive to remember that whenever a transaction is performed, that no cash or assets are lost or created in the process – instead, the price of the asset is marked to whatever the transaction price is. The power of double entry accounting ensures that “Newton’s Law of Accounting” is followed at all times – assets equals liabilities plus equity.

Say your personal balance sheet looks like this:

Assets
Cash – $100
Stocks – $900 (10 shares of XYZ @ $90, mark-to-market)

Liabilities + Equity
Debt – $500
Equity – $500

Your own personal balance sheet has a gross debt to equity ratio of 100%, or net 80% with cash. Your loan agreement with the bank is a gross debt ratio of no more than 150% or a net debt ratio of no more than 100%.

Some other market participants decide to panic and take down the trading price of XYZ down to $60 because they want to raise cash.

Now your balance sheet looks like this:

Assets
Cash – $100
Stocks – $600 (10 XYZ @ $60, mark-to-market)

Liabilities + Equity
Debt – $500
Equity – $200

This is a result of a $300 loss in the value of the stock (whether it is ‘realized’ or ‘unrealized’ does not make a difference here). The loss flows directly down to equity. Now your gross debt to equity ratio has ballooned up to 250% (net 200%) and your bank is calling you asking you to normalize your debt ratios. So you sell half your stock:

Assets
Cash – $400
Stocks – $300 (5 XYZ @ $60, mark-to-market)

Liabilities + Equity
Debt – $500
Equity – $200

The transaction is a transfer of 5 XYZ in exchange with $300 cash from another participant. The gross debt to equity ratio is still 250%, but the net is now down to 50%. You then pay off a couple hundred dollars of debt to abide by the gross debt to equity ratio covenant:

Assets
Cash – $200
Stocks – $300 (5 XYZ @ $60, mark-to-market)

Liabilities + Equity
Debt – $300
Equity – $200

Now your gross/net debt to equity is 150% and 50%, respectively, which is within the bank covenant.

No cash or shares of XYZ were created in this equation. Instead, what happened is that your shares went to somebody else’s balance sheet in exchange for them giving you some cash. However, the payment (and extinguishment) of debt reduced the quantity of assets in the overall system – you gave $300 cash to a bank, which had your debt as an asset on its balance sheet – it performed an asset conversion (a loan to you to cash), while your balance sheet experienced a significant reduction.

Effectively this is what is happening – debt ratios get triggered with asset price drops and this forces cash to be raised – the pressure to liquidate further accelerates the asset price drop.

In other words, the anatomy of a margin call.

Fundamentally, asset prices are supported by cash flows provided by such assets, tempered by factors such as risks of business prospects and what one can get as a risk-free alternate. This does create a bit of a speculative outpouring where you get participants saying that assets such as common shares of NVidia will grow their earnings 25% annually for 10 years straight and the like – and when conditions change to thwart those expectations, the asset price corrects accordingly and those that have borrowed to pay for the stock will be forced to reverse course.

The net result is that those that are over-leveraged will have their assets taken away from them in a washout scenario. This applies to traders, but also to financial institutions that make bad loans and have an inability to abide by their regulatory limits.

It goes to show that high debt environments create huge amounts of volatility – Uncle Warren has preached about this for ages in his Berkshire letters. The irony is that those that have the highest amount of debt will have the highest amount of success relative to their equity – until a washout will take them out. This is best described in Greek mythology in Icarus, who was given a great gift of wings that could make him fly, but was cautioned to not fly too close to the sun otherwise they will melt – and indeed he crashed down to earth. High amounts of debt cause similar results.

When there is a race for cash, participants try to unload whatever is liquid – stocks, bonds and other alternatives. We see on a day like today that Gold is down 2%, and the two main cryptocurrencies (Bitcoin and Ethereum) are down about 6% and 13%, respectively. However, the world’s leading liquid cash substitute, US treasury bonds, typically a safe haven during equity market declines, have their futures down about 2.5% at present. Presumptively, today can be characterized as a race for cash. The race for cash provides opportunity for those that do not have to raise it – and timed well, can result in outstanding returns.

It is still far from the 2008-2009 days where I remember seeing corporate debt securities of credible and stable entities (e.g. telecom firms) trading at 15-20% yields. 2016 was also another ripe environment for fixed income (I remember the preferred share market was ripe with credible double-digit yields at the time). Perhaps my expectations are still too lofty for these types of returns in a 2025 environment that has been bathed in liquidity – if we receive a continued contraction in liquidity, there might be enough forced selling out there to make it happen. We will see.

It is psychologically damaging to see the equity component of the portfolio flailing so badly in this spiral (should I have gone 75% cash instead of 50%?), but I can only imagine how it would be if the portfolio was leveraged long – the financial stress would be considerable. I took a lot of chips off the table a couple years ago for this reason. I would only want to put those chips back on the table when it would seem to be crazy to do it – and believe it or not, it doesn’t seem like that yet, despite the fact that we live in crazy times (the causes of the increasing mental insanity can be the subject of another future post).

Things are starting to get interesting. The S&P 500 is down over 10% now from the mid-February peak and I am sure participants are getting a little skittish about asset pricing.

When things go crazy, it always helps to distill things to fundamental finance and economics and try to pick winners and losers.

One is that assets with higher risk are priced lower.

If your cash flows are 10, 10, 10, … to perpetuity, in a 10% rate environment, the asset will be worth 100. If the cash flows instead are 8, 12, 3, 17, -4, 16, etc., but still averaging 10, all things being equal that asset will be worth less than 100. One operational reason is that if a bank wanted to loan you money for your operation, there might be a chance you would blow a covenant. At the very least, you could take less leverage than the first “stable” operation.

Second, higher returns come from lower pricing.

Using the above example, if you managed to obtain the first asset at a price of 80 instead of 100, you would be sitting on a 12.5% return forever. If you bought it for 120, your return would be 8.3% instead.

Third is that a trade tariff is taxation.

Money that otherwise would go into the input is diverted to government. Governments, not known to being the most productive entities with capital, will likely reduce the overall efficiency of the economic engine.

Fourth – concepts of price elasticity

There are some items of trade that are crucial and have no substitutes. For these inelastic products, an increase in price will have no subsequent diminution in demand. Typically gasoline has been one of these products, but even then there is substitution effects with electric vehicles, or taking public transit, or just driving less. An even less elastic market would be basic food consumption – people need to eat to survive. The most elastic products would be semi-luxury products such as designer clothing and other completely discretionary purchases.

The seemingly “on again, off again” nature of the US administration has rapidly increased the perception of risk, hence lower prices (for financial assets). For price-elastic industries (which are most of them) this is going to have a marked decrease in overall demand due to increasing prices (of the consumable). As the aggregate demand drops, this will also have to corresponding boomerang impact of suppressing prices and create a negatively reinforcing loop. Despite revenues and profits decreasing, the amount of leverage employed to support decreasing profitability will result in a deleveraging shift.

Essentially this might be the start of the unwinding until central banks decide to employ the “plunge protection team” when opening up the monetary spigots once again. We are nowhere close to the conditions where the central banks will go full-blown QE, but you can be sure they are watching in regards to the stability of the financial system if we start hearing rumours of firms going under.

In Canada, we have the short-term rate likely to drop to 2.5% on their April 16 policy meeting. The yield curve has been a shallow “U” shape for some time, a change from the persistent inversion seen a couple years back. However, the introduction of quantitative easing is slowly back on the radar, both in Canada and in the USA – Canada has stopped their tightening, while the USA has slowed down theirs. This has been more gracefully implemented than what happened in 2009 and 2020.

Unlike what happened with Covid-19, I do not have a good radar as to where the opportunity is. I still continue to remain very defensively positioned with a high magnitude of cash, but many of my selections that I have taken small positions I have faced losses with.

The timing is going to be tricky. In bear markets, the bull rallies are usually quite monstrous in magnitude but very short-lived. Valuation-wise, we still have a lot of the S&P 100 in nosebleed territory and the perpetual EPS growth estimates are likely going to be tapered down significantly, which completely busts the rationale for high P/E valuations.

If I am using the year 2000 playbook, this has yet to still play out on the downside. There will be sharp rallies luring participants back in, thinking the worst is over. Cash is a defense – out of all the stupid decisions I made over the past couple years, I do not regret this one.