We are living through one of the biggest stock bubbles and biggest credit bubbles in history. That is the plain read of markets today, and everything else connects back to it.
Record prices against a wall of bad news
Markets around the world sit at or near all-time highs. Credit spreads are compressed - lenders barely ask for extra yield to buy much weaker credits. That optimism runs straight into a long list of geopolitical problems. The war in Ukraine is widening and may turn into a broader Eastern European war. The war in Iran has stopped being just US-Iran and has become a Middle Eastern war and beyond. China is getting more aggressive toward Taiwan. Political and even military tension between India and China would surprise no one. On top of that come commodity shortages that could shut down part of the industrial economy, which feeds more inflation.
How do you square sky-high prices with all this bad news? The prices are what they are. My reading is that the bad news will eventually produce a break - one of these negative factors, or something else, will crack the bubble.
Spotting a bubble is easy; timing it is not
Federal Reserve officials, starting with Alan Greenspan, said they cannot spot bubbles, so they would not try to pop them - they would wait for a bubble to burst on its own and then clean up the mess. I completely disagree. Nothing is easier than spotting a bubble. Look at a Nikkei chart from 1989, a NASDAQ chart from 1999, or current stock charts. The hard part is knowing when it pops. Bubbles run far longer than expected, and often do.
So is it a bubble? Yes. Will it pop? Yes. Will that be catastrophic for many investors? Yes. But you do not know when. That is why you should not short the S&P 500 index. You can be right about the bubble and the crash and still lose a lot of money in the meantime, because you were early. Being right too early is the most dangerous crash call. The smart response is a portfolio built to survive the pop, not a heroic bet on timing.
The catalyst does not matter
People ask what will pop the bubble. It does not matter, and I am not being glib. It will be something - you can be certain of that, even if you never learn or care exactly what. You could write a list of the usual suspects: war in Iran, war in Ukraine, the credit bubble, circular lending. But it is highly likely the actual trigger is something none of us have thought of. After the fact, everyone claims they saw it coming. The point stands: bubble yes, collapse yes, catalyst unknowable, timing probably sooner than later.
Why crashes fall faster than bubbles rise
A bubble is a dangerous cycle where money pushes prices up, which pulls in more money, which pushes prices higher. The same mechanism runs in reverse. When prices dip, fund managers must sell to raise cash for redemptions, and that selling lowers prices further. The move down is not symmetric - it falls much faster than it climbed. A bubble can inflate for 5 to 10 years but collapse in weeks or months, faster than people can react.
People tell themselves they will simply "buy the dip," or that they are right and the market is wrong, so they hold on as it keeps dropping. Others say they are smart enough to get out at the top. They do not. Human nature is to deny reality, ride it down, and get wiped out. Redemptions force managers to sell no matter their conviction, which punishes investors who believed they could calmly exit later.
Real diversification, not more tickers
My recommendation is to diversify, and everyone rolls their eyes because they think they already do. Someone will say they own 50 stocks across 10 sectors - semiconductors, minerals and mining, consumer goods and so on - and call that diversified. It is not. Fifty stocks in ten sectors is still one asset class. When the market breaks, they all fall together. Owning dozens of stocks creates an illusion of safety while leaving the whole portfolio exposed to one outcome. True diversification means holding assets that behave differently when liquidity dries up, because correlations converge in a panic.
A diversified portfolio looks like this:
- A slice of stocks - you do not have to leave the stock market entirely.
- A slice of US Treasury notes. In a crash, rates fall and those bond prices rise, giving big capital gains.
- A fairly big slice of cash.
- Some real estate - income-producing property and farmland. Farmland in particular. Commercial real estate is probably too soon, but apartment complexes work.
- Some gold, at about 10% of the portfolio, not 50%. Ten percent does the job.
- Minerals and mining.
Within the stock slice, favor defense, medical (for demographic reasons - an aging population), agricultural, and natural resource sectors. Those should do well.
Why the cash holders win
Berkshire Hathaway (BRK.A / BRK.B) holds over a third of a trillion dollars in cash. Why? Because they see the crash coming. When it hits, the one holding cash not only survives - they can go shopping in the wreckage. Cash looks boring until the assets everyone called safe suddenly need buyers.
Is "cash is king" dead because of inflation?
Many say cash is unattractive now because inflation eats it, and that those days will not return. The answer is that cash can be very attractive even under inflation, because you can earn strong yields.
Consider the early 1980s. A first mortgage in 1980 carried a 13% rate, which felt shocking next to a 1950s mortgage around 2.5%. But inflation then ran about 15%, so the real rate was about -2%. In a 50% tax bracket with deductible mortgage interest, another six points came back through the tax deduction, making the after-tax real rate roughly -8%. The bank was effectively paying you to borrow. At the same time, you could buy a 30-year US Treasury bond in 1981, maturing in 2011, yielding 14% for the whole 30 years - a Treasury security, highly liquid if you needed to sell.
The lesson: even in high inflation there are cash strategies that beat it - short-term Treasury bills, bank CDs, and gold, which performs well too. Bank CDs pay near nothing now, but in the environment we are heading toward they will pay around 10%. I am not pro-inflation, but it is naive to think inflation is not coming. The strongest cash signal may appear when inflation is high, not low. Investors who automatically dump cash could miss an unusually valuable defensive position.
Inflation is the only real exit for governments
Do the math on debt-to-GDP ratios, annual budget deficits, and trends, and separate nominal GDP from real GDP, and you quickly reach one conclusion: the only solution is inflation. No government will admit it. It is not tomorrow, but that is the direction.
Cash carries hidden optionality
Cash has a benefit most people do not appreciate: embedded optionality. Imagine buying an at-the-money call option on every asset class in the world - that sounds valuable. Cash is exactly that. Holding cash gives you the option to buy anything once prices are knocked down enough, and that option has real value. It is invisible, but if you understand option theory, cash lets you be the buyer when everyone else is a forced seller. You add that option value to what cash is worth in a portfolio. In a crash, cash becomes the right to choose when everyone else has lost the ability to choose - you can buy distressed assets without borrowing or selling something else first.
The first warning signal: the yen carry trade unwinds
Asked for the early sign of a liquidity crisis - the one sophisticated investors should catch before the obvious signals - the answer just got easier, because it is happening: the unwind of the yen carry trade. This is the biggest financial story in the world, bigger than everything else discussed, and all of it is related, since one thing can trigger the next into a cascade.
The yen carry trade is the backbone of global finance, and the idea is simple. Say you are a high-quality borrower - a major corporation, an asset fund, a hedge fund speculator, an investment bank doing M&A, or a private equity firm doing a rollup or takeover - and you want to borrow to do a deal in US dollars. Your dollar cost of funds is around 6% or 7%, higher than Treasury notes but not by much if your credit is good.
The cost of funds in Japanese yen, until very recently, was zero. It has been zero or negative for over 30 years.
So instead of borrowing dollars at 7%, you borrow in yen at 0% - from any bank with a yen lending facility, not necessarily a Japanese bank. You convert the yen to dollars on the spot market, take the dollars, and invest them in your deal. Right away you save 700 basis points on financing.
Now add leverage. A hedge fund might run 3:1; a private equity rollup might run 10:1. At 10:1 you are not saving 7 points, you are saving about 70 points, because the saving is leveraged - between 21 and 70 points depending on the ratio. That is a huge saving on financing alone, before any gain on the deal itself, and it can add roughly a 70% return on equity just from lowering the financing cost. You borrow yen, swap into dollars, invest on leverage, earn big returns, and pay zero interest.
That trade is the engine of everything - it even finances direct foreign investment in China. It looks almost risk-free while the yen stays cheap. But leverage turns that convenience into a systemic fault line. Cheap yen supports positions far beyond Japan, so a funding shock can force global deleveraging, which makes currency moves more important than their headlines suggest. Borrowing cheaply is only half the equation: if the yen rises, that financing advantage can vanish fast and force liquidation. Investors watching only equity indexes will see the warning after the selling has already spread.
The bottom line
Get your diversification right, hold a meaningful slice of cash for its yield and its optionality, and stand by, because the storm is coming.
