A Minsky moment resembles a snake attack: a sudden and violent destructive move, much like a stock market crash. It originates in a slow psychological process according to economist Hyman Minsky, namely a gradual weakening of the financial system through mounting debts in periods of irrational euphoria.

Can we verify this hypothesis? And is the Minsky moment actually unpredictable?

Like in Sergio Leone’s film, the story of the S&P 500 is played out with three characters:

In March 2021, we warned the Speculator of the likely end of the Price-Earnings ratio expansion cycle. In June, we warned the Moderate investor that the game was no longer worth the candle. Today, we address the Rentier: The S&P 500 earnings yield is now offset by inflation.

For 50 years, when the Rentier expressed dissatisfaction, it was a message for his two fellow investors to take shelter.

Are there laws in economics as well as in physics? We say yes, absolutely. Just like gravitation, classical mechanics, thermodynamics, and even quantum mechanics.

To understand this phenomenon requires a bit of imagination. In particular, a new status of law, which does not find its foundation in an external Platonic world but rather the self-organization of individuals. Here, we state a new scientific law governing a living society: rats in a cage, or «The Law of Diving Rats.”

This example introduces Econophysics.

Does China today play the role of the leaking seal at the origin of the 1986 Challenger Shuttle explosion? Chinese authorities are stiffening up against their own capitalism deemed too “Western,” be they in the tech, food-delivery, real-estate, or tutoring industries.

Here, we focus on the risk of propagation, from Chinese equity markets to world equity markets.

Managing portfolio risks has nothing to do with massaging the average volatility; it is all about not being caught in violent market bifurcations. There are ways not to time bifurcations, but time the risk of bifurcations. Why? Because like nature, financial markets exhibit measurable fractal forms for the better, and for the worse.

This letter introduces fractality for two reasons:

Information technology changed the world from knowledge transmission bottlenecks to instantaneous access and worldwide diffusion of non-events. Does this drastic change help investors decide between buying equities or bonds?

Well, look to our Youngsters!

In a series of three publications in February 2021, we explained how accelerating inflation – not simply high inflation – had been awfully bad news for equities for 140 years. Some of our readers argued that rather than inflation, interest rate was the key driver of equity behavior. If central banks continued using their purchasing power to cap government bond rates at low levels, equity markets should be fine.

Here, we refocus our analysis on interest rates, and our conclusion remains the same: last round for equities!

Benjamin Franklin believed in free trade. “No nation was ever ruined by trade,” he said, adding, “even seemingly the most disadvantageous.”

Now fast forward to equity markets today; world trade in volume is one of the seven macro rules embedded in the artificial brain of TrackMacro, Gavekal-IS’ software providing real-time investment portfolios.

Last month, TrackMacro issued a “strong” signal on trade. World trade is anticipated to boom.

Does this mean equities should rally?

Some forty years ago, Charles Gave introduced the “Four Quadrants” concept, used by generations of investors to drive asset allocation in global investment portfolios. The concept crosses inflation and growth to cluster four macroeconomic situations: inflationary boom, inflationary bust, disinflationary boom, and disinflationary bust.

Here we revisit the concept with a scientific eye, applied to ecosystems. We focus on the second derivative of economic production or asset prices, i.e. the acceleration or deceleration of growth and inflation, intentionally ignoring the levels of inflation and growth. A new “Four Quadrants” is born, bridging macroeconomy and simple mathematics. It massively amplifies Charles’ discovery decades ago.

What is it telling us? That the US game on equity price-earnings’ expansion is over.

Equity holders are brave investors who abandon their capital forever (unless they find a third party in the marketplace to replace them, which is never guaranteed) against a flow of uncertain future dividends. Companies, therefore, must distribute dividends, and they can only do so in two ways: they either pay dividends on capital if earnings are sufficient, or they pay dividends off capital.

The worse of the two is the latter and leads to capital destruction. So, who is responsible? The most influential macro factor on portfolio construction for long-term investors, today on the verge of resurfacing: inflation.

Inflation kills equity returns. This has been the case for more than a century in the US, and nearly all countries in the last twenty years, as evidenced in this letter.
So, are we in – or about to enter – the dangerous territory, turning the equity dream into an equity nightmare?

Our previous publication, The Mason’s Strategy, underlined the longstanding and intriguing forecasting power of behavioral finance. Today, our masons go back to the university to study macroeconomic sciences and specifically where stock markets go. This time, they want to know in a purely objective manner.

Will they succeed?