Equities Extremely Complacent; De-lever and Prepare to Buy The Dip

0:00The overriding piece of advice is be unlevered because there are things happening that haven't happened in a long time or ever. And they're happening and they're happening with increasing frequency. And so the Overton window of possibilities in markets, if you will, I think is as wide as I've ever seen it. And I've been doing this 30 plus years. And so it ties back to that prior point of very bearish in the near term, but ultimately very bullish, which is to benefit from what I think is going to happen very bullishly over the next decade. Plus, you've got to survive. You've got to get there. And that to me says, just be unlevered.

0:36I think you want to own some gold. And I think you're going to be real happy with where you are in five years, 10 years for most investors. Welcome to the Master Investor Podcast with me, Wilfred Frost, where we celebrate and learn from the success of the greatest investors, business leaders, and politicians. in the world giving you, our listeners, an edge. The Master Investor Podcast is sponsored by LSEG, Interactive Brokers, the World Gold Council and BNY Investments. Please do remember the views expressed in this podcast are for general information purposes only. Nothing in the podcast constitutes a financial promotion, investment advice or a personal recommendation.

1:21More on that in the show notes. My guest today is Luke Groman, the founder of Forest for the Trees, FFTT, an independent macro research outfit that tries to look where others aren't and identify major long term actionable ideas that most market participants are missing. Luke, it's fabulous to have you with us. Welcome to the podcast. Thanks for having me here, Wilfred. It's great to be here. I think I need to start by saying that I love the name of your firm, but I also, for the Brits that are listening, wanted to point out, of course, that you draw the title from a phrase that is slightly different over here, which is not seeing the wood from the trees as opposed to the forest.

2:06But we get the gist, which is that you're trying to identify big themes that Wall Street is missing. Now, that's exactly what we try to do. We aggregate a large amount of publicly available information in what we think is a unique manner and trying to identify what we call developing economic bottlenecks in different sectors, because it's been my experience over those decades that sectors that are poised or sectors and companies that are poised to benefit from those bottlenecks or be hurt by tend to outperform on a sector basis. I publish two reports a week for 46 weeks a year. So I do a lot of writing, do a lot of thinking.

2:49I think I've got the best job in the world. It's certainly a very stimulating kind of set of topics to cover. And I'm delighted that we're going to get to do that together for the next 45 to 60 minutes. And let's dive right in. I want to talk about the Iran war. I know you've been looking at this a lot and talking about bottlenecks. Obviously, the Strait of Hormuz has been one that's come into focus. And the fact that the war has restarted in the last two weeks, is that something that you think warrants more immediate attention than has been getting? Probably. Probably. And I think as we go back, it's been a topic where we have a saying where, or at least we used to in a former life for me, you can be right for the wrong reason or you can be wrong for the right reason.

3:43and thus far in the Iran war, I've been wrong for the right reason, which is to say we published for clients, I had very high conviction that the war was going to last much longer than expected. If you recall, Wall Street consensus was it's only going to last three to four weeks. Trump was saying it was going to be only three to four weeks. We, from day one, were saying it was going to last a lot longer. So we got that exactly right. As it's ongoing, I think going to accelerate, you know, probably or continue from here for longer than people want to imagine. We also said that Hormuz was going to stay closed longer than expected, which, again, early on was, hey, this is going to be over by April.

4:21We were telling clients, prepare for May, June, even July 4th for it to still be closed. Here we are, it's July 29th. It's essentially still closed. So we got that exactly right. And when we say wrong for the right reason, got the reasons right. And if I would have known for sure that was the case, and I was pretty sure, would have been very negative. And that was right for the month of March. S &P was down whatever it was, 9%, oil up big, rates up big. In the U.S. and around the world, inflation picking up. And then everything changed in early April. And since then, up until recently at least, that's been wrong.

5:04And there have been a couple reasons for that. The most important is I do think underappreciated the ability to adjust by a couple different players, and most particularly China. China's ability to reduce imports by three to four million barrels a day surprised me, surprised a lot of people. I also think there was probably more leakage through the strait than was being let on. But at the end of the day, when you total up the leakage, it was incremental and marginal relative to what China did. And that, I think, is really important as we look forward, which is China has more leverage than we acknowledge right now.

5:55I think we're acknowledging they had more leverage in the past, but there's still this view that they don't have the leverage now. And I think what I mean by that is what is China going to do is going to kind of determine. And I think on some level, it is in China's interest to extend this as long as they can keep oil prices and supplies relatively high enough supply, low enough prices for them. Because ultimately, the U.S. getting stuck in another quagmire is good for China. So what's really interesting about that, Luke, is I guess this idea that it'll keep continuing as long as oil prices are obviously elevated from where they started the year, but not over$100 a barrel or above in the way that they were for parts of the early March-April phase of the war.

6:54The thing that has changed, I'd argue, in the last 10 days, though, is even if oil prices haven't got up to that level, bond yields have got to their highs again. How much of that do you think is a factor that will cause equity markets to wake up to the scale of impact that maybe this war should be having? Yeah, I think, you know, you raise a great point, right? We're restarting this thing. And we used to play streetball, right? Cargo buy, game off, game on, right? It feels a little bit like that. And we've got all the same issues, except we're starting from lower global stockpiles of oil and other commodities.

7:37We're starting from a higher baseline inflation. We're starting from higher baseline yields. We're starting from tighter global supply chains, slower U.S. and Western economy relative to, say, three months ago. And so the rates story to me is a big one. I think rates are going to keep moving higher until something breaks. And I don't know if that's going to be in the US. I don't know if that's going to be in Japan. I don't know if that's going to be in the UK, if that's going to be in the EU, Germany, French yield. Western yields are all rising. The only guy whose yields aren't rising is China, of course, right?

8:13When you look at 10-year yields, they're just doing fine. So what will break? I don't know. To me, maybe the most variant perception or one of them that we have is that whenever something breaks in the equity market, probably, I do think you'll get long-term Western yields to drop for a moment, five days, 10 days, maybe even if we're lucky, three weeks. but then they're going to stop going down and they're going to go up even faster as equities fall. And that to me is when the real crisis starts. I think we're still thinking traditional sort of crisis of, hey, yields are rising. That's a problem.

8:54Eventually they're going to break something. Equity prices are going to fall and then bond yields are going to come down. And I see this view over and over and over. And that's not what's going to happen. And it's fascinating to me Because consensus still think that's going to happen, even though what I describe has happened over and over and over since 2020. Right. We have the COVID crisis, 10 year yields down. Then all of a sudden they stop going down. They started going up really fast. 2022, Fed tightens rates. We start to have an issue. Long yields go up. 2023 in the in the S.I.V.B. and Signature Bank.

9:29Yields went up at the long end. fall of 23 yields went up at the long end 2024 even in uh in in liberation day long end yields went up they went down for like two days and then they took off as equity markets fell and even if we go back to when the Iran war started there was an overwhelming view held by many that 10-year yields were going to go down on a flight to safety and it was very vocal you can go find the old ex posts, etc. Like there's no way they're going down. They are going to go a lot higher. And we're up 70 basis points since then. And I think that is the biggest variant perception that is out there.

10:09I guess I have two follow ups to that. One is, what is the sort of level if we use the 10 year that you think would cause Scott Besson and Donald Trump to change what they're doing to back down on whatever market unfriendly actions they're taking at a current moment in time, whether it's tariffs or war. I mean, because I feel like the first phase of the war is like 4.4%. But this time around, it's obviously a bit higher than that where their pain threshold is. But I guess linked to that is, will we get to a point where they can't put the genie back in the bottle again, and yields rise to a damaging level, regardless of if they back down in Iran, for example.

10:53Yeah, my view of the yield pain threshold is about the same as yours from earlier. So 4.4 % for a while, you could see it like clockwork. 4.4, they back off. 4.4, we get a tweet from Trump. And I agree they've allowed that to rise to 4.65, 4.7 for the moment. Historically, over the last several years, anywhere from 4.6 to 4.8, up to 4.9 % on the 10-year has been a problem area. And so I think that is still the case. If only our debt levels are, because our debt levels are higher, you know, Besson's three arrows program is in the toilet. He's going to get none of his three arrows as a result of this war.

11:34And that makes us more sensitive to 10-year yields, not less in terms of the deficit, et cetera. Is there a moment where the genie comes out of the bottle? Look, they can control yields as much as they want. It's just an issue of what's the dollar do. And ultimately, when they choose to either back off, the challenge in backing off enough times is they're eroding their credibility. And I know when you say that, there's a whole slew of a whole chorus of voices that will jump on you in the media and on social media to say, oh, you're anti-American. But that's a fact. Every time they are back down.

12:17They are eroding their credibility a little bit, a little bit, a little bit. And that doesn't matter until it matters. That's going to matter all at once. And so that has implications in the longer term for long-term treasury yields in the United States, because real politic of it is, it's historically, people don't like to admit this, but part of the military's job has been to threaten people into buying treasuries that maybe don't want to buy treasuries. And so to the extent that the threat, the protection racket breaks down because you keep demonstrating that you cannot take pain over 4.6 or 4.7 percent on your 10-year yield, you keep demonstrating that your most powerful Navy in the history of the world, which is true, keeps getting stood off by missiles and drones, which are very cheap and easy to mass produce, you're eroding that underlying first principle dynamic that we've heard so many times in our careers, which is ultimately the U.S.

13:22military backs the treasury market and the dollar. And so you have this backing off. That's sort of a bigger picture, not even threat, but just first principle issue. tactically, they can stop any time they want, and they can cap yields any number of different ways, particularly if their guy at the Fed plays along. It's interesting. If Warsh won't play along, it starts to be much more problematic. And so if Warsh decides this war is not a good idea and decides he wants to run monetary policy in a way that forces the end of this war, he can do that. That'll be really interesting. So that to me, when I think about where can yields go, will it get away from them, yields will only get away from them if Warsh wants them to get away from them, if Besant wants yields to get away from them.

14:19But what's interesting, I guess you're saying, is even in the positive scenario towards yields there, it's kind of negative towards the dollar, which maybe we'll come back to in a moment.

14:33This podcast is sponsored by Interactive Brokers. Building wealth starts with the right broker. And Interactive Brokers helps you reach your goals with powerful tools, global market access, low costs, and unmatched financial strength. That's why the best informed investors choose IBKR. Learn more at ibkr.com forward slash master investor. This episode is brought to you by LSEG, the leading global financial markets, infrastructure, data and analytics provider. To learn more about how LSEG connects businesses, investors and markets worldwide, visit lseg.com. Yeah. Sticking on yields and treasuries, but stepping back long term, I'm just kind of interested to get your take on the extent to which there still is major demand for US treasuries, how that's changed over time, the sort of history almost of who the main holders of them are and the kind of trends you've observed in the last 12 to 24 months of how that's changing.

15:42Yeah, we have seen there's still plenty of demand. The demand has shifted from very patient and nonprofit-oriented creditors, which are the ideal creditor, to basically now extremely fickle, very profit, very short-term-oriented investors in the form of hedge funds based out of the Cayman Islands, et cetera. You go back to 2014, global central banks stopped buying treasuries on a net basis in 2014. Their holdings of treasuries are actually down on a net basis over the last 12 years. So your big patient creditors, they're gone, and they've been gone for a long time. That has been papered over in the ensuing, in the intervening period by regulatory changes such as 2014 U.S.

16:36change so that treasuries were classified as high-quality liquid assets for banks and increased bank regulatory capital requirements to hold treasuries. and banks bought a ton of treasuries. Then in 15 and 16, there were changes to money market fund rules in the United States mandated by the SEC, whereby private money market funds holding non-treasuries, so municipal paper, commercial paper, whatever, they would not get backstopped in a crisis, whereas government money market funds would. Massive shift out of private money market funds into government money market funds. It was effectively a form of QE, if you will.

17:18It raised rates on the private sector. It was a crowding out. The U.S. government crowded out the private sector in short-term money markets to deal with this lack of demand. Then you had in 2018, Trump in his first term changed tax rules to give treasuries more favorable status to U.S. pensions who bought more treasuries. starting around 2018, you saw a significant uptick in the treasury basis trade, the hedge fund base, where you're shorting futures and you're buying spot cash futures as a way of closing an arbitrage that had existed. And you're doing this on massive amounts of leverage. And so you can see that the biggest marginal buyer of treasuries, the biggest marginal foreign buyer of treasuries since 2018, certainly, but really since 2014 has been what we call the ULICs.

18:19UK, Luxembourg, Ireland, Caymans, Switzerland. So UK, hedge funds, private sector. Luxembourg, tax haven. Ireland is an American tax haven. That's not really a foreign holder. Those are US corporations. Cayman Islands are primarily U.S. hedge funds. A lot of them engage in this basis trade. And then Switzerland, another tax haven. And so there was a Fed white paper late last year, October of 2025. You can find it online. It showed that since 2022, 37 % of the net issuance of notes and bonds, so the belly of the curve and the long end, everything but bills, was Cayman Islands hedge funds. So it was this, it's the private sector demand for treasuries is still rising.

19:14It's heavily short-term U.S. hedge funds. And that's fine. There is a trade-off to that, though, which ties back into my prior point about whenever yields do get too high and we have a risk off in equities, you're going to get a momentary drop in long-term treasury yields. And then they're going to take off like a scalded cat like they did in 2020, 22, 23, 24, and 25. And we know this. It's a certainty. And the reason it's a certainty is because 40 % nearly of the notes and bonds bought since 2022 have been bought by hedge funds on high, high leverage to some extent because that's what the basis trade is.

19:56What that means in plain English is if you have a pickup in volatility in equities, the first thing the risk managers do with these hedge funds is once vol gets too high in equities, they get flat. They sell everything. They take down vol across the book. Well, if equity vol rises, they've got to get flat across the book. They've got to reduce leverage across the book. Well, they turn sellers of treasuries. The biggest buyer treasuries over the last four years turn sellers as equity comes. And we've seen this over and over. And so in the short run, that drives yields up and a risk off and keeps it going because the higher vol goes, it feeds back on itself.

20:42Higher yields and a risk off. I got to degross equities more. Equities, you know, degross more. Equity vol up. Equity vol up. I got to degross everything more. I got to degross more treasuries. Rates up. And we've seen this playbook happen multiple times. until essentially U.S. regulators, U.S. policymakers cry uncle and inject more dollar liquidity any number of ways. And we've seen that any number of ways. You know, 2020, it was with massive QE,$600 billion a month in the crisis. 2022, it was at the end of it Yellen coming in and weakening the dollar by at a 40 percent annual rate between October of 22 and February, March of 23.

21:21and also later in 23, it was her shifting issuance to the front end and running down the reverse repo, which was effectively just delayed QE that she had control over. Then you saw her do treasury repurchase programs for the first time in this country in 24 years, in the second quarter of 24. Besant criticized the whole thing, became treasury secretary, and promptly doubled the rate of treasury buybacks that she was doing. Again, mostly focused on shift from long end to front end. So you can see all of these. And when I describe this process to my friends in emerging markets or that have traded emerging markets, they're like, this is just an emerging market debt crisis with the American flag pasted on the top.

22:01And that's fine. But that just has implications for asset allocation, inflation, et cetera. I guess what comes to mind to me off hearing you say that is that when we see what sounds like it would be a correlated fall in equities and bond prices together, that it might well be sharp but quite short-lived if one way or another, whether it's Treasury-led or Fed-led or united between them, the base case expectation, which it sounds like, correct me if I'm wrong, is your expectation, that the authorities will step back in again? They have to. We've seen this over and over. Since 2021, I've used a phrase that Jerome Powell coined, which was treasury market functioning.

22:51We're still doing QE with inflation where it is and home prices running like they are because we need to ensure treasury market functioning. That's why we did the big QE. Well, that's the Fed's shadow third mandate. And with debt to GDP at 120%, 6 % deficits, it's the Fed's number one mandate. And consensus is that Warsh will subordinate treasury market functioning to price stability. And there's not a chance. The only question is how long, to your point of your question, how long will he allow treasury market dysfunctioning to occur in his fight for price stability until he has to bend the knee and intervene in treasury markets in order to ensure the stability, the functioning of those treasury markets.

23:44It's as close to a sure thing as you know. You just don't, you know, what is that intervening period of time? It has to be short by definition, just given the leverage in the system and the centrality of treasuries as collateral, etc. Well, I hope you'll come back on and tell our listeners if and when you see that moment as a big buying opportunity. But let's fast forward sort of to that hypothetical anyway. And I wonder if there is going to be moments where even they can't actually put the floor in, so to speak. And what I was going to ask about on that is they're not the only country with the same kind of problem.

24:23And these things often kind of snowball in a way you can't control. When you look at other nations, which ones stand out to you as flashing red with similar problems or worse problems? Yeah, it is. It's the old in the land of the blind, the one-eyed man is king problem, right? Yeah. Look, I think the UK, Japan, Germany, France. No, I think what's really interesting is these are all our allies historically. Right. You know, you know who isn't having a problem? You know, who's not flashing red? China. You know, since 2008 to now, China's gone from the highest of all those yields at the 10 year level to the lowest.

25:05Their yields are below Japan now. And so it's kind of interesting when you hear some people say, well, we're doing this Iran war. There's a greater 5D chess play here. We're going to close down the strait. We're going to choke off China. Yeah, but you're going to choke off your own allies way first because their bond markets are going to break first. Yeah, but that's okay because we want the Europeans to sort of get on board with China. You understand that the UK and Japan, Japan and UK respectively, are the number one and number two foreign creditors of the United States now. The UK, which is an astonishing statement in and of itself, right?

25:38The private holdings of treasuries in the UK are higher than Saudi, higher than China, higher than Russia, higher than Germany, higher than all these. And I say it's astonishing because the UK is the only other developed twin deficit nation. They are in at least as bad a fiscal problem as ours. The financial center is buying a lot of our bonds, which is fine until UK bond yields rise. Because then you can see, if you call up a 10-year or five-year chart of 10-year UK gilts and you run it against 10-year US treasury yields, if you want to know where 10-year US treasury yields are going to trade, just look at where UK gilts are today.

26:21They just lockstep. They're tied at the hip, which makes perfect sense. And so that to me leads me to the conclusion of, I don't know where it's going to break first, but once one of them breaks, they're all going a break in very short order, again, for that exact reason. When two of the three biggest creditors have at least as big a debt problem as you, and you're the biggest debtor, you're going to hit the wall a millisecond after them. So Luke, with that all in mind, how complacent do you think equity markets are, even if a pullback will be short-lived, but how complacent do you think they are at the moment?

27:09I think I'm going to answer that on a dual timeframe. In the very short run, I think they're extremely complacent because ultimately big tech, AI, et cetera, has become very debt financed, very cash negative debt financed. And when you have a segment that is valued extremely highly in equity in terms of equity valuations, that is a very large portion of the equity indices in the biggest equity market in the world, in the United States, they can't have anything go wrong. And yet they need to keep borrowing more and more money. And the underlying rate is rising on them, is going to keep rising on them.

27:56And that is a very bad combination. So I don't know when that creates a problem. But that is in the very short term tactical. I think equities are extraordinarily complacent to what I was describing is occurring secularly and tactically in sovereign bond markets, Western sovereign bond markets in particular. If we take a step back, I think equities are pretty rational in dollar terms. if we look at if we say hey this is just an emerging market debt problem with u.s and uk and german and japanese characteristics uh look for several years if extremes inform the means for several years the number one percentage performing equity index in the world was Venezuela, as the currency was just getting destroyed.

28:51And in that same way, again, I don't think the U.S. or any of those Western nations are going to hyperinflate. That's not my point. But my point is, is that equities rising the way they are and being so resilient are in some manner telling us what is happening, which is it's the currency. It's not, it's, that's driving it. And we can see it a couple of different ways. Number one, if you look at a chart of the S &P 500 over, say the TLT, long bond US ETF, it is exponential. There's just money going out of bonds into stocks. And we can see that both on a price basis, we can see that on a flow basis.

29:29The other way you can look at it is equities are in, if you price them in gold, which is, you know, when the great, in the great depression, when the Dow fell 85, 90 % from 29 to 33, us was on a gold standard. That was the Dow falling in gold terms. That wasn't the Dow falling in dollar terms. And in that same light, equities priced in gold are still down 40 % since January 2000 dot-com highs. Equities priced in gold are down 8 % since the fourth quarter of 2018. And this is the S &P total return. So this includes dividends. S &P is down 8 % in gold terms since 4Q18. um s &p is down into s &p total returns down 21 since january 22 when the fed started hiking rates even with this recent gold sell-off year to date and the rally in s &p since since april so i think the the equity markets on a structural secular basis away from sort of the very tactical near term that we described are acting perfectly rationally which is if you see the debt situation the way it is, and you know that the Fed has proven five times in six years that their number one mandate is not price stability, it is treasury market functioning, and you see the U.S.