Capital Flows and Asset Markets

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A friend of mine said I should take a look at the most recent Strategy preferred issuance. The headline is that it pays 10% annually, which sounds attractive, but made me think, where is Strategy going to get the cash to pay that dividend? Their Bitcoin holding generates no cash. Looking at the Term Sheet, it seems likely they will never pay any dividends.

The key point here is the dividend deferability. I post it below. Basically, dividends will be paid through the issuance of more securities (never selling Bitcoin).

Dividend Deferability

* In the event that the Issuer fails to declare the dividend by the record date, such failure shall constitute the issuance of a notice of deferral (“Deferral Notice”)

* Subject to the terms of the Issuer’s other securities, upon issuance of a Deferral Notice, the Issuer shall use commercially reasonable efforts over the following 60-day period to sell STRK, STRD, class A common stock and/or other junior securities to raise proceeds in an amount sufficient to cover any deferred dividends plus compounded dividends thereon

* If any dividends are not paid in full the dividend rate per annum applicable to such unpaid amount will increase by 100 basis points following each subsequent dividend period, up to a maximum dividend rate of 18% per annum (the “Compounded Dividend Rate”), until such dividends, together with compounded dividends thereon, is paid in full

This marks a change in strategy for Strategy. Initially, Strategy raised capital through equity issuance and convertibles. The benefit of this was that neither issuance required any further cash flow (ie dividend or coupons).

This made a lot of sense when its market cap traded above its NAV. However this is no longer the case.

Issuing debt makes more sense than issuing equity, and hence the growth in “preferred equity”.

Strategy is explicitly saying that Bitcoin will annualise at faster than 10% going forward, and that it will issue more debt to pay this off when and if needed. It seems unattractive to me - especially compared to the convertible debt. In that case you got the stability of bond, with the upside of bitcoin. In this case you are being offered a high dividend yield, but which the company does not have the cash flow, and will not sell any of it Bitcoin stash to pay. You are hoping that future preferred equity buyers will turn up to help pay your dividend.

Probably the most negative feature of this is that in a prolonged slump in Bitcoin, the debt holdings could start to grow in size at the rate of 18%, causing preferred equity holders to become the dominant owners of the company (it would need to be a very long slump - but then again gold had a 20 year bear market from 1980 to 2000). In such a case, they could theoretically force the sale of the bitcoin holding to get repaid. (This is my reading of the Term Sheet - but I am not a preferred equity investor - please correct me if I am wrong).

In my previous note I wondered if Bitcoin bearishness drove Bitcoin higher. This is more evidence to support this view. Without widespread bearishness, will Bitcoin take a while to recover? I would be more upbeat on Bitcoin if the IBIT (Bitcoin ETF) had seen some selling. As yet, there is none.

I think the biggest problem facing all asset markets is a widespread unease with the expense of assets - and how little trickle down we are seeing. Politically, the winds for asset speculation are turning, and hence Strategy has had to resort to raising yield to raise capital.

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Halloween was last Friday, and my youngest went of trick or treating with his friends, I was left at home all alone. After doling out a mountain of sweets (Halloween is a big thing in my part of London), I decided to go to the local pub in my go to costume - Hannibal Lecter.

As I drank my chianti, chewed my fava beans while I waited for liver to be cooked (I was having a friend for dinner) - I got chatting to an American. I expounded on my Star Trek to Star Wars theory of American politics. They found it interesting, so I am now sharing with you. I know a lot of people find science fiction to be very unserious, but in my experience the best science fiction is merely a tool for the writer to comment on the current world. Dune by Frank Herbert was transparently an analysis of the inevitable outcome of the West exploiting the Middle East for oil. Foundation by Isaac Asimov is a commentary on how to get and maintain power (politics, economics, religion and trade).

So what about Star Wars and Star Trek? I find their differences to be astounding, and reflect very different ideals about how the world should be run. In Star Trek, there is no money. Everyone is assigned a role according to their ability, and all the nations of the world are represented on the original ship, with later versions of Star Trek adding more and more aliens to the mix. Other planets are invited to join the Federation, and Star Fleet is under strict orders not to exploit primitive nations, but to allow them space and time to develop. Meritocracy is a key metric.

In other words, Star Trek represents the post World War II ideal of multilateral cooperation to make the world a better place. All nations big and small have equal rights, and even the most charismatic leader (Captain Kirk) still refers back to Star Fleet Command.

Star Wars which started in the 1970s, has a much darker view of the world. It is definitely world with money, and smugglers and traders. It is a world of hard work, and exploitation. Also in contrast to Star Trek, there is a place for a quasi-religious order, the Jedi, in this world. Power comes from might, as the old republic is over thrown by the Empire. New planets are colonised, and mining settlements are common. Also in contrast to Star Trek, nepotism is a constant. Luke Skywalker is the son of Queen Padme. His father is also somewhat influential in state matters. In later movies his nephew also becomes a substantial leader. Nepobabies of the Universe - unite!

Power comes from pure might. Death Stars, cruisers and guns. Both sides of the conflict claim religious endorsement from their respective branches of the state religion.

Star Wars and Star Trek for me represent the fundamental disconnect in human nature. We all know that we as a species achieve more when we work together, but we also know we get more when we stand out from others. That is we naturally oscillate between cooperation and conflict. As many big thinkers will tell you, human technology and society tends to develop quicker from conflict (Europe conquered the world because they were the best at organised conflict), but ask anyone who lived through the Two World Wars and they will say - yes intercontinental flight is nice, but could be have had that without the 100 million deaths? After 40 years of relative peace (I see 1980 as the peak of the communist threat), we have forgotten the costs of conflict, and we are once again moving to a Star Wars era.

What this means for politics, is we need more Darth Vader style leaders, and less Captain Kirks . Trump is a Darth Vader. Justin Trudeau was a Captain Kirk. Keir Starmer is a Captain Kirk. President Xi is a Darth Vader. Putin may well be a Emperor Palpatine in this analysis. In most elections, I think you should expect the Darth Vader character to win in this era.

But why have we shifted from Star Trek to Star Wars? It I had to guess, Star Trek politics, like the show itself, tends to suffer from stagnation. Even recent Star Trek themes touched on themes of corruption at Star Fleet. And I think the world is tired of stagnation. Change is the political driver - for better or worse. And with that I hope the force is with you, and that you live long and prosper.

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My niece, who now lives in San Francisco, was getting married, so I made a flying five day visit to the Bay Area. Its been nearly 10 years since I spent time on the West Coast of the USA. But it had been nearly 20 years since the last family wedding, which was my own. At that time, my niece must have been 11 and a bridesmaid for us, and now here I was watching her get married. Never have I felt the passing of time so keenly. But what is the point of time passing if not to see young one grow up and become adults in the same way we did?

But my sense of time passing was felt even more keenly as I spoke to my niece and now nephew-in-law (do we say this?) and their friends. They both had STEM degrees from Ivy League schools and had worked at Jane Street. They could have had a table at the wedding for Anthropic employees only. To borrow from Tom Wolffe, I was looking at the new Masters of the Universe. While my own wedding was not as high powered, it certainly had its share of finance and tech people. But this new generation of Masters, contained a very high share of Mistresses as well. Gone was the 6’2 jock finance bro, replaced with the under 6 foot techie bro/sis/other.

Talking to them, I realised that they had no problem understanding this market, as this was part of “their” world, the world they grew up in, and were helping to create. Old school traders had different information sources that they used to make money. Flows, insider information, smart money, economic indicators. The new school used algorithms and scraped the internet. I made good money from 2000 to 2015, because I had spend the 1990s living and studying in Asia, and when it became a China led market, I knew what to do. My niece and her friends had lived and studied tech in the US, and the market had come to them. For them surging semiconductor prices makes sense, as it is obvious to them the benefit of paying up for cutting edge semiconductors based equipment, while I am happy to work on a 10 year old laptop and 2 year old mobile phone.

Perhaps what really ages me is the expectation that technology should be deflationary. I know that it has not been wildly deflationary for 10 years now, but it is hard not to expect productivity increases to drive wildly lower prices for things , which is what we saw from 1980 to 2010 and now something that seems to happen only in China. I wonder if this is an old man habit - of seeing the past repeating itself, even though the world has changed. For me this would be just like the oldies when I started in finance would explain in great detail why bond yields were about to rise even as they began their relentless march lower.

My trip to the West Coast also reminded me of how much China and the US are similar, while in contrast the UK and Japan are much more similar. This sounds odd, as linguistically and culturally UK and US should be similar, and Japan and China should be similar. But what the US and China share is the primacy of money and profits in relationships. As long as their is transfer of money or a promise of money, then all relationships work well. In Japan and the UK, money of course helps, but culturally money is not the only driver. Other concepts are at work, which is why American and Chinese always think the Japanese and British are so polite (“Oh you are doing this without expecting money? Amazing!”). The best possible explanation I have ever heard for this is the continued existence of a royal families in the UK and Japan, who set an example of behaviour that is beyond the grubby drivers of greed. This probably seems crazy to Americans and Chinese, but when you an island nation that faces large rich competitors, setting up a system that breeds loyalty and that does not rely on money is an effective system ((the UK navy found that sailors far from home fought harder for king and country, and the uncertainty of booty (the old meaning of booty)).

As I travelled around Berkeley and Sonoma, I struggled to understand why the US political system is so turbulent. Compared to UK, population density seems much lower, and yet the President is mobilising the army and national guard to keep immigrants out. But then I remembered, the US is all about money. And the president seems determined to raise earnings of blue collar workers, and the mega wealthy, while leaving the middle class to further decline. There is a political logic to this, but as an old man, who grew up with the political idea that the middle class acted as political ballast to keep a country stable, it strikes me as odd.

But them coming back to technology - perhaps there is no need for a middle class anymore. It is truly remarkable what a single person can do these days, and this is true in markets as in life. (If I went back to the 1990s and told people I write an international read newsletter, while spending my free time making videos, they would assume this would consume all my time - but technology has freed me). Tesla, Meta, Nvidia and Oracle are all companies that are driven and controlled by single minded men. US politics has become the same. Technology has freed the individual to achieve everything it can without the need for institutional support. Trump has come to dominate the Republican party without the initial support of its institutions. SpaceX has clobbered the traditional space institutions of Nasa and Boeing. Social media has destroyed the institutions of newspapers and TV. Crypto is trying to destroy the institution of politically control financial system.

If there is difference between the US and China it is entirely political. The open US political system has allowed a social media, and a totally “modern” President to attain power, which is allowing the new tech powers to become entrenched (forget about antitrust or regulation). While China has remained a closed politically system, where more traditional institutions remain in power. Historically speaking, nations that allow new industrial changes to drive political revolution have prospered (see Industrial Revolution, French Revolution, Meiji Restoration), while countries that have rejected politically modernisation have been subject to revolution and colonisation (see China pre-1945, Russia pre-1915, India pre-1945). The problem is that China DOES seem to have accepted new technology, but has it been able to assimilate modern technology into its political system? Is the Great China Firewall a template for other nations? I don’t know.

In San Francisco, I felt that Americans were at ease with these technological changes. Maybe 15 to 20 years ago, the American economic model of wide income inequality, and the emphasis of individual over society was probably seen as an anachronism, and that slowly by surely America would become like the rest of the west. What I saw in Berkeley, the home of wokeness, is an ease with individual pursuit of happiness even if it degrades society as a whole. And I must say I see similar ease with my own children, despite growing up in the UK.

Technology has freed the individual. But it is destroying the institutions that have existed for most of my life. Do we really need central banks? Or universities? Or governments, when they seem unable to either cut spending or raise taxes from dominant corporates? In San Francisco I saw the techno libertarian future - a society that in market terms would suggest being long equities and short “government” bonds. And this is a trade that continues to work - far beyond anything we have seen in the post World War II period.

Old men pine for a long lost world, while the young seek their place in the new world. In San Francisco, I think I saw that the old world is not coming back.

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I don't really read other macro thinkers. Generally speaking we are looking at the same data - or should be - so I am better off limiting other people's influence of my analysis. However in my 25 years of working there is one guy I will always read, Christopher Woods over at Jefferies. If he wrote a substack I would be a paying subscriber. Sadly he works at a brokerage so you need to be doing business with Jefferies to get access to his work now - which is a very different decision to signing up to a substack. Why is he worth reading? Well he called the top in the Japanese market.

Readers of his newsletter, Greed and Fear, will know he was short Fannie Mae and Freddie Mac into the GFC. And he also was bearish into China devaluation fears.in 2015. Like myself he has come to look at global markets via Asia. In general I like to be similarly positioned to Chris - the only caveat to this is he does take liquidity and drawdown risk on his long portfolios which professional money managers cannot do. I mention Chris as I am going to use some of his charts - which I could make myself - but am too lazy to do. Chris has also picked up on financial stress entering the system. Banks are tapping the Standing Repo Facility and SOFR is rising above Fed Fund Rate.

The obvious problem here is the treasury basis trade - something Chris also sees. And as I have mentioned the Fed has come under political pressure. One thing I had not picked up.was the scale of losses that the Fed now has due to paying interest on bank reserves. I mentioned in a previous post the move to a negative primary income balance was driven by higher interest rates. This is sort of saying the same thing.

For Chris the above means the end of quantitive tightening and the beginning of balance sheet expansion and hence a bullish view - at least on gold. I think he is probably also implying a bullish view on equities. I look at gold v SPX and wonder if that's correct?

If Chris is right about loosening and I am right about semiconductors as the new oil then tech should fly higher. As I write this, Korean semiconductor company SK Hynix is approaching an all time high. Long time Asia watchers should be as surprised as I am.

What I read from Chris would be probably bullish gold AND tech. As I have pointed out bullish tech seems to be an inflation trade so that makes sense. What I also read is that inflation is going to start surprising to the upside again very soon. That is maybe Gold/Spx is not turning now - but another sell off in treasuries is over due. 30 year US treasuries at 4.6% looks wrong. My target remains 10%.

What I like about the Treasury short here is that it should work in a bear market driven by the unwinding of the basis trade AND in a Chris Wood predicted dovish turn in the Fed. Maybe this is what is needed to get back to 1980 levels on gold/treasuries.

To me the connection between semis and tech and inflation is becoming more and more obvious. Chris is probably right that the Fed will come to realise it too late and despite surging semiconductor pricing will cut interest rates. Certainly, a bullish view on stocks and gold has been the right view this year.

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I have thought the world is moving to a 1970s style stagnation. What this means is rising wages would create inflation and higher interest rates. This would lead to asset markets stagnating. I thought the best way to trade this was long GLD short TLT. It has been a good trade - even with the reversal this week.

I also thought equities, and particularly the S&P 500 would be a big flat nothing, with swings up and down like the 1970s.

That has not been the case. I just got an 11 hour flight to San Francisco which has given me time to think. The problem for markets in the 1970s was the repricing higher of a key input- namely oil. And the emergence of OPEC as a price setter. Today, we see the repricing of a key input - semiconductors. If Aramco was listed in 70s - then its share price would have looked like Nvidia - and ever fund would be forced to own it.

I resisted the idea of semis as the new oil for two very good reasons. Unlike oil wells, semiconductor productivity increases over time so supply is always growing. And secondly, there is no real reason why semiconductors cannot be built anywhere - its just a matter of capital and effort. Japan has a semiconductor driven boom in the 1980s that turned to bust. And Asia had the same in the 1990s. But both of these busts were driven by free trade. US developed semiconductors first, then Japan, then Asia. And I assumed China would follow suit. Obviously efforts to slow China has worked and the SOX index has been like owning oil in the 1970s.

I will file this under “the market is always right”. So for me the interesting question is why is gold and precious metals doing so well? Oil prices are still in the dumps, so they are not moving with energy inflation.

I think the simple reason is that semiconductor and tech inflation is taking over from oil as the driver of inflation. Electricity CPI is NOT being driven by energy prices - but by AI capex.

Even though I have been sceptical of AI, many of my “non-tech” stock picks have been influenced by the rise and rise of semiconductor and computing as the driving force of growth. When I think.back to the commodity super cycle from 2000 to 2010 - this was driven by China catching up to the old oil centric economic model, something the western world did in 1960s to 80s. The China boom was like a big franchise sequel - made mainly for old people (industries) and totally derivative. China car sales are a good example. The US and Japan were ex-growth auto markets in the 1980s.

Lack of semiconductor supply is driven by politics and economics, just as lack of oil supply in the 1970s was driven by politics and economics. When I think about the world in this way - you can still see that GLD/TLT will do well. Unless central banks tighten - AI growth will drive more inflation. The other option would be allow China to bring on semiconductor supply - but that is a political non-starter at the moment. This means equities continue to outperform bonds - a changed relationship that really caught me out a few years ago.

The dot com bust ended as Asian supply came online, China was accepted into trading markets and fiscal and monetary policy was tight. This time China supply is rejected and fiscal and monetary policy is loose. The trillion dollar question is when does politics move decisively against inflation as it did in the late 70s? Here it gets tricky. China tends to be reticent about its semiconductor developments, and companies like Google and Microsoft are aware of their dependency on Nvidia so are spending heavy on R&D. I would be lying if I said I had inside knowledge of what is happening in China and in US big tech (and so would anyone else). What I will say is that gold/SPX is hinting at change, just as it did at the beginning of the 70s and the end of 70s.

I wonder if this well be another episode of “the market is always right “?

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We have had quite the precious metal frenzy in recent weeks, but with some chunky weakness today. First of all, even though gold has had quite the move, it is only double from its previous peak in 2011, still nothing compared to equities.

That being said, on my very long term chart of gold versus treasuries, it has now had a fairly serious move. Still far from the extremes reached in the 1970s - but the pace of the move recently is substantial.

But in terms of gold versus the S&P 500, we are only just beginning to move.

Putting it all together, gold does not look cheap, but its seems cheaper than both treasuries and the S&P 500, which is exactly what I have been thinking for awhile now. On a shorter time frame, gold/SPX could correct a bit. The 200MDA looks like a good technical support, and was where we got a bounce after the surge earlier this year. We are 11% away from that, but with a rapidly rising 200MDA ( assuming no crash in S&P 500)

GLD/TLT which has been following the 100MDA would also suggest a quick 12% sell off is also possible.

That being said, I suspect a sell off in other precious metals is probably likely here. Precious metal mining stocks have been on a tear. SIL US, Global X Silver Miners ETF has surged. But as the long term graph should suggest, silver miners (like gold miners) are terrible businesses.

Shares outstanding in SIL tends to surge whenever the silver price surges, and then a new generation learns that precious metal mining is a terrible business.

I find it easy to see silver falling back to its 200MDA of 36 USD for me, which should lead to heavy falls in silver miners.

Surely a weak silver price is bad for gold? I think that relationship ended a long time ago. As I put in a recent post, as long as the US runs a current account deficit, then Asian Central Banks will be forced to put money into something other than treasuries - and gold seems the most likely beneficiary. And the only thing that I think causes the US to balance its current account is much higher interest rates. As far as I know, central banks do not stockpile silver. So what do I see? Silver could get hammered, but gold looks like a corrective to me. Politics is still way to supportive of gold.

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I have dabbled in Bitcoin. When Donald Trump was reelected, I purchase some IBIT, which did okay, but I was a bit late to the trade as my custodian made me wait a day or two. Compared to both equities and gold, Bitcoin has disappointed this year.

Why is this? I used to have theory that you should watch Tether market cap to see if liquidity was coming into or out of the crypto space to drive bullishness of bearishness on crypto. Tether market cap continues to surge.

I have been surprised by this surge to be honest. Tether pays no interest, nor does it offer capital appreciation. Why leave your money in Tether when interest rates are not zero? Perhaps its capital controls, or perhaps people leave money in tether when bearish on crypto? I don’t know, but I find it odd. As we can see from gold and silver, people are happy so speculate on zero yielding assets, so what is wrong with Bitcoin? Well I saw an interesting article in the FT postulating that Bitcoin treasury companies like Strategy (aka Microstrategy), were actually incentivise to issue stock to buy Bitcoin, as their market caps traded above NAV. Generally speaking, Strategy Market Capitalisation has been above it NAV, until recently.

And it has been increasing its stash of Bitcoin dramatically.

And we have seen a huge increase in the issue of shares from Strategy.

If you are mindlessly bullish, there is no problem here. You would think the market was rewarding the vision of Michael Saylor with a superior market cap, and he took full advantage. Personally, I think its a variation of the CDO trade we saw from the Big Short. Big hedge fund wanted to short CDOs, so CDOs needed to be created to be shorted. Bearishness created its own demand. Investors were bearish on Strategy, so short interest as share of outstanding surged from 2021 to 2024. I do not short popular shorts, because when a hedge fund shorts a stock, it is locking up those shares. They can not be sold, until they are bought back. Bearishness on Strategy, probably drove its premium to NAV, which in turn drove its purchases of Bitcoin - market circularity at its fineness.

There are a number of Bitcoin treasury companies - one of the most interesting is Japanese listed Metaplanet Inc. It apparently holds 30,000 Bitcoin.

Like Strategy it was keen on issuing equity.

It currently has an EV of 3.2bn USD, which matches its NAV of its Bitcoin holding. That is the market is not incentivising buying of Bitcoin anymore, at least not through the issuing of equity at least.

The other negative for Bitcoin has been the success of the Ishares Bitcoin ETF. Shares outstanding have surged. It would have similar holding of Bitcoin to Strategy.

The problem with ETFs, is that unlike Strategy or MetaPlanet, they can also see redemptions that make them sell Bitcoin. I have always been a bit cautious of ETFs with surging shares outstanding. Even if the underlying story is good, you are at risk of profit taking, which can then spiral into a much large sell off.

So what is wrong with Bitcoin? Positioning has become long, as has positioning in Bitcoin treasury stocks. There is no “structural” buying be central banks either (not yet anyway). As mentioned in other posts, China’s surging trade surplus probably drives gold buying, just at Strategy premium to NAV drove Bitcoin buying. Weirdly, Bitcoin needs the market to get bearish again before it can move.

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