Julio López (Attitude Gestión SGIIC) | Beyond other considerations, two extremely dangerous trends or thoughts are converging in the market. On one hand, there is the plan of all the politicians and demagogues who are sprouting like mushrooms, believing that everything can be solved by resorting to debt (which belongs to no one). They promise endless tax cuts and public spending without ever explaining what they will do about the public deficit that is being generated and how they will address the long-term problem of the debt stock. This is a recurring theme in my letters, and sometimes I get bored of it myself, and today I won’t elaborate further, although I will just give you the latest data: the American fiscal deficit for August was 30% higher than the already enormous expected deficit, not only due to increased spending but also due to lower revenues, showing a total lack of control.

On the other hand, there is the addiction to risk that is being created, especially among the average American investor, who thinks that if things get complicated, someone will always come to save them, whether by sending them envelopes with money as was done during COVID, or through asset purchases by Central Banks. After all, this is what they have seen over the last 16 years, much like Bertrand Russell’s turkey, which does not know what Thanksgiving represents for someone who has been methodically fattened every day at the same time. This addiction does not only encompass financial markets; we see it every day in sports betting that generates prices for everything, whether it’s the number of yellow cards in a match or combinations of corner kicks in the matches of the 14th league round. Most governments seem to be tearing their hair out and are taking actions to limit gambling, whether by avoiding advertisers on football shirts, warning minors, or limiting the attraction of local establishments on the street. In any case, these actions have totally null effects. In the United States, six years ago, the Supreme Court overturned a federal ban on the activity, and by the end of last year, the sports betting market generated $120 billion. I don’t consider myself very puritanical about gambling and recognize its entertainment value when playing occasionally, but the risk of addiction is getting out of hand. There are even reports quantifying the substitution effect in the stock market as a 14% reduction in flows every year.

How does the market react? By creating perfectly substitutable products such as one-day options or leveraged ETFs based on a single stock. These are products that have an immediate effect on the rest of the market due to indexed funds that are forced to make moves in the same market direction, causing real avalanches in stock prices. For now, due to the positive “mood” of the market, they do not seem to pose much danger, but let’s see what happens when the fishing rods turn into spears. For example, consider the Direxion Daily TSLA Bull 2X Shares ETF. This ETF allows you to double the potential gains generated by Tesla’s stock… and double the risk of losses. If you look at an equivalent ETF for Nvidia, we see absolutely explosive volumes. These are not funds that multiply the long-term appreciation of a company. They only multiply the appreciation of the stock in a single day; your position resets every morning. Someone might think that despite everything, they can always control the maximum loss, but the math can lead you out of your error after a couple of days. Let’s look at a simple example of how it works:

Let’s suppose we buy the 2X Tesla ETF with the stock at $200. That day, bad sales figures are published in a neighborhood in northern Kathmandu, and the stock falls by 10% to $180. The ETF doubles the loss, so it is worth $160. The next day, a municipality in northern Lesotho approves self-driving cars, and the stock welcomes this news with great optimism, rising by 10%. By the end of that day, the stock has risen by $18 to $198, and the ETF gains 20%, rising to $192. In two days, the stock has actually fallen by 1%, but surprisingly, we have not lost 2%, but rather we have lost 4%… every time there is a drop in the stock, the effect multiplies. This strategy in extreme cases can lead to stocks that rise by the end of a year having taken down many investors.

In this situation, we find ourselves every day in the market. Erratic movements completely influence the behavior of investors beyond fundamental news about the performance of companies. The movements are marginal in volume, but they have a significant impact on the overall market valuation, which we see moving in terms of trillions of dollars in daily capitalization. I have the feeling that we have entered bubble mode in the North American market, and this makes any measures we take of little use, as the extent of the movements may be greater than we initially estimate. The level of market capitalization in terms of GDP has once again matched the figures we saw at the end of 2021, which led to the sharp declines of 2022. We might think that bubbles could be concentrated in everything related to stocks associated with Artificial Intelligence (one in three American investors owns stocks related to this topic), but when we look at the astronomical valuations at which huge companies that have nothing to do with it and might seem defensive, like Walmart or Costco, are trading, it makes it difficult to pinpoint where the arrows might come from.

The general idea among investors is that interest rate cuts by central banks will help prevent a recession or contribute to a soft landing for the economy and will benefit the stock markets. If we look at the abrupt rate cuts of 2001 or 2008, we see that these cuts were actually the signal for stock market corrections. It is often said that the stock markets anticipate economic data, but this is not the case, and significant drops in stocks occur during a recession. If we don’t want to look to the past, let’s turn our gaze to the East and see what has happened to Chinese stocks after more than a year of rate cuts. If we trust in the predictive effect of stock behavior, it’s worth noting that the stock that has fallen the most in the last month and a half in the Russell 1000 is Trump Media. Watching Jerome Powell’s explanation of the rate cut last week was cringeworthy, especially considering his track record over the past four years, and we must attribute it to a political and personal reason. The only way for him to renew his position is through a victory for the Democratic Party. It would be so easy to just put a microphone in front of Donald Trump.