How To Prepare For What's To Come in the Markets | Larry McDonald and Jimmy Connor

Key Concepts

• Seismic Market Shift: A fundamental change in global financial markets, moving capital from financial assets to hard assets.
• Financial Repression: Government policies that keep interest rates artificially low, often below the rate of inflation, to reduce debt burdens.
• Private Credit Crisis: A looming crisis in the private lending sector, characterized by defaults and fraud, particularly in corporate and consumer loans.
• Vendor Financing: A practice where a company provides financing to its customers to purchase its products, often seen in bull markets and potentially leading to circular revenue schemes.
• Aggressive Accounting: Practices that stretch accounting rules, such as extending depreciation cycles, to inflate reported earnings.
• Business Development Companies (BDCs): Publicly traded companies that invest in small and mid-sized businesses, often through debt, and are seen as indicators of private credit health.
• Gold-Silver Ratio, Gold-Copper Ratio, Gold-Oil Ratio: Relative valuation metrics used to identify potential shifts in commodity preferences.
• 50-Day Moving Average: A technical indicator used to identify short-term trends and potential buying opportunities in a bull market.
• Reshoring: The practice of bringing manufacturing and jobs back to a country from overseas, contributing to higher inflation.
• Hubris in Washington: Overconfidence in US foreign policy, particularly regarding sanctions, which drives central banks to diversify into gold.

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Introduction: Book Overview & Market Thesis

Larry's book, "How to Listen When Markets Speak," published in Q1 2023, argues that seismic shifts are underway in global financial markets. The core message is that capital will flow from financial assets (equities and bonds) into hard assets such as gold, silver, and other commodities in the coming years. The book's latter half, a publisher-demanded addition, focuses on portfolio construction for this "new era" or "new regime." Larry, a former Lehman trader, views this book as a continuation of his previous New York Times bestseller on the Lehman crisis.

Drivers of Seismic Market Shift

Monetary & Fiscal Policy: The primary catalyst for this shift is the unprecedented level of money printing and irresponsible government spending. The fiscal and monetary response to the 2008 Great Financial Crisis was approximately $4 trillion over four years. In stark contrast, the response to COVID-19, the 2023 regional bank crisis, and pre-election spending amounted to roughly $16 trillion in four years. This massive increase in liquidity, four times the previous crisis response, is seen as "too much money printing" and "irresponsible spending" not only in Washington but also in global capitals like Paris, Tokyo, and London, pushing money towards hard assets.

Tightening Liquidity & Emerging Credit Crisis: Despite asset values reaching new highs, underlying liquidity is starting to recede. Indicators include:

• Repo Market Tightening: Short-term financing is becoming more constrained.
• Fed Funds Rate: The effective Fed funds rate traded above its upper bound twice in the last month, signaling liquidity issues.
• Tertiary Asset Underperformance: "Garbage coins" (e.g., Solana vs. Bitcoin) are dramatically underperforming, indicating tightening liquidity.
• Private Credit Crisis: A "massive crisis" is brewing in private credit. Examples include large defaults by Tricolor and First Brands in the loan space, two significant frauds in private credit, and two more recent frauds in commercial real estate involving Western Alliance Bank and Zion Bank. These incidents are reminiscent of the small Bear Stearns funds that collapsed in 2007, signaling the "truth bleeding out one drop at a time."
• Subprime Crisis: A "big kind of subprime crisis" is emerging, affecting companies that lend to the bottom 60% of consumers, such as "buy now pay later" firms (Affirm, Upstart) and auto loan companies. This mirrors the 2007 New Century bankruptcy, which occurred during full employment, demonstrating that a subprime crisis can happen even when people are working.

AI Spending & "Vendor Financing" Parallels: The current market rally is heavily driven by "never-ending spending" associated with AI, data centers, and GPUs. Nvidia's commitment of over $100 billion to OpenAI (in return for GPU purchases) and similar deals with CoreWeave and ARM Holdings are cited as examples of "circular vendor financing." This practice is compared to the early 2000s dot-com bubble, where companies like Nortel, Lucent, and Cisco sold equipment to now-defunct entities like Global Crossing and WorldCom, creating an unsustainable "testosterone arms race" in Silicon Valley.

Aggressive Accounting Practices: Tech giants like Meta and Microsoft, once "cash cows," are now engaging in aggressive accounting practices, particularly by "extending depreciation" cycles for their AI-related assets. This allows them to inflate reported earnings, but it is expected to "blow up probably in the next 6 months" as institutional investors become more bearish. Sophisticated accounting experts suggest many companies are pushing the envelope dangerously due to competitive pressures in the AI arms race.

Pervasive Fraud & Lack of Business Cycle: The long bull market and aggressive lending have fostered an environment where "pervasive bad actors" thrive. Larry quotes his book, stating that "when you don't allow the business cycle to function over longer and longer and longer periods of time, you're creating really you were putting Bernie Madoffs on street corners around the United States." The lack of a natural business cycle, which typically "outs the bad guys," has led to widespread fraud, as highlighted by Harry Markopolos (who outed Bernie Madoff), who sees parallels with the accounting scandals of 2000-2003 (Tyco, Adelphia, Enron, Sunbeam).

Investment Implications & Portfolio Construction

Shift to Hard Assets: The overarching recommendation is to shift capital from overvalued financial assets to undervalued hard assets. This is driven by persistent inflation, financial repression, and the need for real assets in a new economic regime.

Gold & Silver Outlook:

• Gold: Larry is bullish on gold, despite recent weakness and extended short-term technicals. He projects gold could reach $4,200 to $4,400 within the next year to year and a half. The current rally is seen as the "first, second, maybe third inning" of a larger bull market, with little retail participation yet. Central banks are aggressively buying gold due to "hubris in Washington" regarding sanctions and confiscation of capital (e.g., Russian assets), coupled with unsustainable US deficits.
• Silver: Larry is "much more favorable to silver than gold," noting the gold-silver ratio is around 80 but should be in the 60s. Silver, like gold, is significantly under-owned by households (below 1% of household wealth, compared to 3% in the 80s/90s).
• Platinum & Palladium: These "tertiary metals" offer diversification, with a total market value of only $400 billion, significantly smaller than Bitcoin ($2 trillion) or gold ($24 trillion).

Natural Gas & Coal Equities: Larry identifies natural gas equities (e.g., FCG ETF, Range Resources RRC) as the "sexiest trade on the board" for the coming year. These stocks are trading with "12 to 14% free cash flow yields" and are aggressively buying back stock. Natural gas is deemed "the only way to the green meadow" for energy transition, especially with AI's increasing power demands. He predicts natural gas and coal names will "absolutely destroy Nvidia" in performance over the next 24-36 months. Coal stocks are also highlighted as an overlooked sector.

Copper & Oil:

• Copper: Copper names are strong, and the "gold-copper ratio is still below COVID level," suggesting investors should "be taking down your gold exposure to buy copper right now."
• Oil: While oil prices are under pressure (below $60/barrel for West Texas), oil stocks are "very, very cheap." Shale regions are being depleted, and the ability of the US to pump more oil is declining. The low valuation of oil equities (2-3% of S&P 500 market cap vs. 50% for S&P technologies) makes them attractive as money rotates out of tech. This is exemplified by Warren Buffett selling Apple and buying Occidental Petroleum, and David Einhorn adding to oil service names (Weatherford, Schlumberger, OIH). The current low oil price is partly attributed to geopolitical efforts by the Trump administration and Saudi Arabia to pressure Russia and allies buying Russian energy, similar to James Baker's strategy in the 1980s Cold War.

US Dollar Outlook: The US dollar is currently oversold and experiencing a bounce, but it is in a bear market. The developing private credit crisis and a slowing economy are expected to lead to a "much weaker dollar" as the Fed will likely cut rates to support the economy. The dollar's peak was in November 2022, and lower highs are expected for the next 1.5-2 years, further supporting hard assets.

Persistent Inflation: Inflation is expected to remain "persistent" at 2.5-4%, rather than returning to the old regime of 1-2%. This is due to continued deficit spending (even by Republicans and Democrats), the difficulty of "killing" inflation once it's out of the bottle (as noted by Andreas Stefz), and the "reshoring" of manufacturing jobs back to the US. The reshoring trend, a reversal from decades of offshoring, creates a "foundation for a higher level of inflation."

Global Conflict & Geopolitics: An increase in global conflict is anticipated. Larry discusses the US's aggressive stance in the Western Hemisphere, particularly regarding Venezuela and Colombia, potentially leading to invasions or regime change. He notes a significant military buildup in Puerto Rico, suggesting preparations for a "new war," driven by a desire to protect the hemisphere against initiatives like China's Belt and Road.

Investment Strategy & Risk Management

Lessons from Market History:

• Charlie Munger's Wisdom: "Testosterone is your greatest enemy in investing as a young man" and "The big money is all in the waiting." This advises against chasing speculative rallies.
• JP Morgan (1907): "There's nothing in this world which will so violently distort a man's judgment more than the sight of his neighbor getting rich." This highlights the psychological trap of FOMO (Fear Of Missing Out).
• Dot-Com Bubble Parallels: The current market exhibits similarities to the early 2000s, with high speculation, vendor financing, and aggressive accounting, which ultimately led to a 78% decline in the NASDAQ.

Managing Speculation & Leverage: The current market shows "unprecedented" levels of speculation, far exceeding the 1990s. Examples include 250 funds filing for 5x leverage ETFs (e.g., GDX) and Bitcoin perpetual futures offering 50-100x leverage. This indicates a "blowoff top" scenario where the market might go up another 10-20% before a significant downturn. Investors are advised to "raise cash and be there for when the opportunities really come."

Buying Strategy for Hard Assets: For those who feel they've missed the initial rally in gold, Larry suggests a staggered buying approach:

1. Buy a quarter position now.
2. Buy another quarter position near the 50-day moving average (a key technical level in a new bull market).
3. Buy a third quarter position near the 100-day moving average. This strategy helps average down the cost. He also advises diversifying into "tertiary metals" like silver, platinum, and palladium.

Conclusion & Main Takeaways

The global financial landscape is undergoing a profound transformation, driven by excessive money printing, irresponsible government spending, and an impending credit crisis. This environment fosters persistent inflation and widespread fraud, making traditional financial assets vulnerable. The smart money, exemplified by investors like Warren Buffett, is rotating out of overvalued tech stocks and into hard assets. Investors should re-evaluate their portfolios, reducing exposure to speculative growth stocks and increasing allocations to commodities like gold, silver, natural gas, coal, copper, and oil, which are still in the early to middle innings of a major bull market. The US dollar is expected to weaken, further supporting hard assets. The key is to be patient, avoid speculative excesses, and strategically accumulate undervalued real assets on pullbacks.

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Larry's intelligence gathering from institutional investors is shared through [email protected] and on Twitter @convertbond.