The BlackSummit Team

The Wooden Nickel is a collection of roughly a handful of recent topics that have caught our attention. Here you’ll find current, open-ended thoughts. We wish to use this piece as a way to think out loud in public rather than formal proclamations or projections.

1.     Chart Crimes

“There’s nothing like price to change sentiment.”

It really is amazing to see what the whiff of any sort of volatility can do, not only to people’s predilection to risk assets but also to invoking mass hysteria. Take the chart in Figure 1. Some form of it was making its way across newspapers, business magazines, “research”, and other forms of media. 

Figure 1: Black Monday All Over Again

The chart’s recurrence and proliferation within a short period of time was comical. When someone asked me what I thought of it I replied, “I have seen this chart so much recently that at this point such an event is almost guaranteed to not happen.” Since the publication of this specific chart above, the S&P 500 is, on net, up 2.5% and the vaunted drawdown that everyone should fear was a pedestrian -3%. Congratulations on avoiding the great crash of 2023!

More seriously, the problem with lazy and sensationalistic observations like this is that they do not seek out disconfirming evidence. It goes back to basic statistical and scientific testing. Something cannot be objectively true and causal unless its repeatable but also holds up in antithetical environments as well. Take the chart in Figure 2. It also was promulgated irresponsibly about one year ago by a major investment firm.

Figure 2: GFC 2.0 Failed


The correlation is far stronger even if the date range has been cherry-picked to engineer a stronger relationship. And yet we know how the market has behaved from the fall of 2022 until today. Of course, no one took accountability and responsibility for the reckless insinuation last year but why didn’t anyone in the present iteration ask if similar patterns occurred with the opposite results, i.e., has the market pattern correlated with a dismal ending gone on to actually perform well?

And if you want the polar opposite of 1987 just look at the next two charts with the Nasdaq YTD in blue, and then in white over the same exact 9-month frame but in a different year.
Figure 3: Same Start, Different Finish



The second is 1999. Overlaying charts without a thesis and strategy doesn’t make for an investment process or any sort of rigor. It doesn’t tell you if you should brace for a 25% decline or a rally of 45% over the next two months, which is what the Nasdaq did in 1999.

2.     Black Swan Hedging

Related to section 1, if you had wanted to hedge your portfolio on an imminent Black Monday-style crash at some specific point in time, what could you do? To that, I think two practical points stand out. First, if you are so worried about some sort of imminent calamity affecting your portfolio then you’ve probably gotten the first step in portfolio construction wrong. The whole point of diversification across asset classes is to reduce risk concentration and correlation. If someone doesn’t start with that holistic view in mind then preservation of capital is jeopardized. Second, the only way to protect against a spontaneous, cascading, and deep market selloff like the one experienced on Black Monday is to do it continuously – meaning literally at every point in time – burning premiums, paying fees, sacrificing capital day after day, month after month, year after year, and decade after decade in the hopes that something historic is around the corner and that the position you’ve structured will be profitable and protective of a substantial portion of a portfolio. Because what good does it to allocate 1% or 5% or even 10% of your portfolio to an instrument that may double or triple in value if the other 99%, 95%, or 90% gets cut by a third? You’re still down 20% even in those extreme scenarios. And that doesn’t even consider the opportunity costs of this kind of positioning. That’s why the front-end work on asset allocation matters so much. 

Finally, if someone is so arrogant as to believe that they not only know without a doubt where the market will go but also how far it will go up or down on a given day or week, then they haven’t spent much time in markets before. 

3.     Higher for Longer

The notion of interest rates, especially longer-term ones like the 10-year and 30-year, remaining “higher for longer” has become an increasingly popular notion with more and more investors citing it as their expectation and the topic is getting regular press attention. It’s not an unreasonable perspective at all, even if it becomes or is on its way to becoming a consensus view. Between rising debt usance, especially on the long end, some reshoring efforts, tightness in labor supply, and other factors, it’s plausible to hold the view that there’s a floor in the interest rate markets that didn’t exist in the last 15 years. If that’s the case, then what level does the 10-year settle at in the occurrence of a recession? It’s an ongoing discussion we’ve been having for several months in our office and it’s not an easy one to answer for a variety of reasons.

But another angle to the debate materialized this week with the comments of Stanley Druckenmiller at an investments conference. Druckenmiller is on the short-list of people who would go on the Mount Rushmore of investing, especially in the hedge fund world (for a glimpse of why see here and here). His trade, going long the 2-year and short the long end (what I’m assuming is the 10-year but could be further out), is banking on the de-inversion of the curve. It’s an occurrence we’ve written about earlier this year and happens before the onset of recessions; the short end of the curve, namely the 2-year yield, smells rate cuts are needed because of a recession and falls further than the outer portions of the curve.

However, as most people know, duration rises the further out along the curve one moves, all else equal. And duration provides leverage to a fixed income investor, meaning that for a given change in rates, the further out you are on the curve the more price appreciation you get. Put simply, a decline of 100 basis points in both the 2-year rate and 10-year rate sees a greater price appreciation on the latter bond. That is why during recessions, you not only see people flocking from risky assets to fixed income, but you also see them reach for duration to pick up greater price appreciation.

What’s of interest about Druckenmiller’s specific bet is the angle at which he is shorting the long end. He is indeed betting on higher for longer. But the duration differences between a 10-year bond and a 2-year note are quite large. For example, a 2-year note maturing in October 2025 has a duration of 1.878 while a 10-year bond maturing in August 2033 has a duration of 7.9 (this is as of October 31st when this analysis was done). So even if yields on the 2-year completely collapse, it wouldn’t take much of a fall in the 10-year yield (and they virtually always fall during recessions) to go underwater on the trade.

We thought it would be a fund exercise to use some rough, back of the envelope type math to see what kind of sensitivity such a trade would have and what it would mean for where rates would settle.
Figure 4: Breakeven Points in Long 2s Short 10s

The table in Figure 4 presents many scenarios using some rough math. It calculates, for a given change in rates for the 2-year and 10-year, what is the difference in price appreciation of going long the 2-year note and short the 10-year bond. As an example, and picking an extreme scenario, if the 2-year yield goes from ~5% to 0% while the 10-year rate only falls 25 basis points, then this long-short pairing would provide a 7.4% return. The areas shaded green show the scenarios in which the trade is profitable. As is evident, based on this very rough math, the trade doesn’t work if the 10-year falls by 125 bps to 3.60% as of Oct 31st.

Now, one can believe in higher for longer and believe that the 10-year goes lower than 3.6%; those two things are not mutually exclusive. But this exercise was one (out of many) way to triangulate around a level to answer the question of where the 10-year goes in a recession if indeed we stay higher for longer.

As a sanity check we thought we’d calculate the spread between the 2-year and 10-year in these scenarios and compare them to history. 


Again, the green-shaded figures represent changes in yield moves and bond prices that denote a profitable long/short trade. In the extreme scenarios, the spread between 2s and 10s goes anywhere from 400-600 basis points. Those are historical outliers. But the rest of the scenarios are totally plausible and consistent with a historical range of 50-300 basis points (in non inversion scenarios).

Figure 5: The Historic Range for 2s10s Spread is 50-300 Basis Points

Again, this narrows the field of potential options for higher for longer during a recession to somewhere in the mid to high 3s. Of course that’s assuming historical trends hold and long-term rates fall during a recession. If they don’t, we’ll be worrying about much more than just a fun academic exercise.

4.     Two Bets in One

Speaking of pair trades, one thing that a person investing in a “disruptive” company often neglects is that they’re really making two bets in one. It’s a pair trade embedded within a single security. And oftentimes, investors do not realize it. They think in broad strokes and narratives and don’t realize that in order to win the distribution of future scenarios, it is narrower and more specific.

Take the automotive market where we’ve been told that a massive transition and disruption was going to come for over a decade and was accelerating before our eyes during the COVID years. Embedded within investing in a Tesla, Rivian, Vinfast, or other electric darling is a series of multiple bets. The first is the most obvious: a decline in the dominant position of the internal combustion engine. But the second wager is much, much more difficult to get correct because it is several wagers in one. And that is what specific technology, or configuration of technologies will replace it, will the execution of the disruption occur within a reasonably expected time frame at the forecasted economics, and at an entry price that will allow for quality returns?

Investors in the electric vehicle and “clean” energy complex are learning of these multiple, embedded wagers the hard way, especially over the last few months. Stocks of automakers, “clean” energy players, and their derivative plays have been decimated, especially recently regardless of the quality of their business. The reasons are numerous: from price wars to capital investments being postponed and canceled, to the inability to generate profits, overestimations in demand, deflating mythologies, and a growing realization that the future of moving away from ICE vehicles is multivariate in paths with wide uncertainties in probabilities and their economic viability. Are we sure the future of vehicles is fully electric? What if hybrids dominate? And if so, what kind of hybrids? Are we sure we know the chemistry of batteries that will go into those vehicles? It seems more and more likely that without moving away from the current lithium-ion complex, will we even get to a point where the net-energy claims match the hype and total supply chain costs bear some fruit. And it is more likely that all of the above is not going to happen in a matter of years, but rather a matter of decades.

Could current OEMs and supply chain partners pivot once all this is discovered? Of course, but along the way they will have burned billions in capital and that’s what needs to be considered before thinking about making an investment in a “disruptor.”

5.     Recommended Reads and Listens

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