A preface to the newsletter: Apologies for the delayed publishing of last week's newsletter! I ran into some technical difficulties and it took longer than I anticipated to get this edition finalized. Some of the market news is a bit stale as a result, but better late than never.
In this week's newsletter I cover the recent South Korean stock market crash, the U.S. bailout of the Japanese Yen, and the collapse of the hedge fund Situational Awareness. I spend the Personal Finance section on the concept of leverage: what it is, why human beings keep reaching for it, and why it has caused some of the worst financial disasters in history. Bad decisions made with borrowed money is the theme of this week's edition.
Additionally, based on feedback from readers, I've decided to make some changes to the newsletter's format. First, I'll try to shorten it - no one has ever accused me of being a man of few words. Second, I understand that there is some confusion around the Longevity Science Foundation spotlight, so instead of having a dedicated section, I will be including links to their articles at the end of the newsletter. And lastly, the outpouring of kindness and well-wishes for our soon-to-be-born baby boy has been tremendous! I've come to realize that readers want to know more about my life outside of work, so I have created a new section at the end of the newsletter called Life Behind the Scenes dedicated to family, hobbies, and updates on my life.
As always, please don't be shy about sharing feedback and please feel free to forward this on to anyone else who might be interested in reading it.
Have a nice week ahead,
Kevin
Stocks
It was a good week for the stock market. The Dow rose 1.7%, the S&P gained 2.6%, and the Nasdaq was up 3.8% for the week. All three indices flirted with reaching record highs and Amazon crossed $3 trillion in market value for the first time. The July jobs report released Friday showed a less-than-stellar labor market, which counterintuitively caused stocks to rally as investors priced in a lower probability of a Fed rate hike in September.
Bonds
The bond market was flat for the week. Yields pulled back modestly from last week's levels as oil prices fell, reducing near-term inflation fears. However, the U.S. bailout of the Japanese Yen (story discussed below) caused Treasury bond investors to pause and reassess global risks.
Oil
Crude prices fell after President Trump confirmed he had called off a planned military strike on hopes of negotiations advancing again. Iran and Oman are in the midst of hammering out an agreement for the flow of trade through the strait of Hormuz, but Iran has repeatedly stated that they are not in talks with the U.S. A pause in hostilities is a good thing, but I'm cautiously pessimistic - we've been here before and once burned, twice shy.
South Korea's stock market crashed 44% due to excessive leverage (and the same thing could happen here too)
In late May, South Korea launched single-stock leveraged ETFs tracking its two largest chip companies, Samsung and SK Hynix. (A leveraged ETF uses borrowed money to multiply the daily return of a stock or index by two, three, or more times.) The products became immediately popular with retail investors chasing the AI trade and the amount invested in these ETFs tripled in a single month. Then AI sentiment soured briefly, and the cascade began. Samsung fell 32%, SK Hynix fell 40%, and the KOSPI, South Korea's main stock index, fell 44% from its June peak. It was the worst decline since the 2008 financial crisis. Retail investors lost an estimated $39 billion. This is what leverage does in a concentrated market during a momentum reversal: small price declines force selling to payback margin loans, the selling subsequently pushes prices lower, and lower prices force even more selling. South Korea has since banned new listings of single-stock leveraged ETFs.
What concerns me about the U.S. is that assets invested in leveraged ETFs have now reached approximately $218 billion here domestically. U.S. investment in leveraged ETFs is up roughly 60% since March, and more than half of these products are single-stock. We are going down the same path as South Korea.
The US intervened to support Japan's currency
Japan's yen hit its weakest level in 40 years last week, touching nearly 164 yen per dollar. Tokyo sold roughly $59 billion in U.S. dollar reserves to defend it. Then the US Treasury joined the intervention, something we have not done since 2011. Treasury Secretary Scott Bessant used the Exchange Stabilization Fund to sell euros and buy yen alongside Japan, thereby driving up the yen relative to the dollar.
This was more than just an act of goodwill; Japan holds over $1 trillion in US Treasury bonds and is the single largest foreign buyer of American government debt. When Japan defends its currency, its main tool is selling US Treasuries. That selling pushes US bond prices down and yields up, which is exactly the wrong direction for American borrowers right now. The U.S. intervened to reduce the pressure on Japan to dump U.S. Treasury holdings. The most natural fix for Japan (raising its own interest rates) would reduce Japanese investors' incentive to buy U.S. Treasuries, resulting in a weaker demand for American government debt. Treasury yields are already bad enough: the 30-year Treasury yield touched a 19-year high the week before, and concerns over inflationary pressure mean that yields aren't likely to come down any time soon.
"Once you become that large, the street actually identifies you as a target. You effectively become a wounded shark and a feeding frenzy emerges."
- Michael Green, Chief Strategist and Portfolio Manager at Simplify Asset Management, commenting on the implosion of the hedge fund Situational Awareness last week
Michael Green studies market structure and leverage for a living. His comment refers to the collapse of the ironically named Situational Awareness, a hedge fund run by 24-year-old Leopold Aschenbrenner, that went from $45 billion to roughly $10 billion in under a week. The hedge fund was 4x leveraged, meaning that for every $1 invested, it borrowed another $4 (and invested those as well). This strategy worked well when AI stocks were rallying earlier this year, but when they turned south recently Aschenbrenner was forced to liquidate to meet margin calls. Last week he capitulated and sold nearly everything at a discount to Ken Griffin's hedge fund, Citadel, just to payoff lenders.
Green's point is that at sufficient scale, leverage stops being a personal risk and becomes a market event. When Aschenbrenner's aggressive bets began to move against him, other traders could see it happening in real time. Everyone knew he had to sell to reduce his leverage. His initial sales in turn triggered more forced selling as the collateral for his margin loans (his stock portfolio) declined in value, pushing prices lower still. Other traders either sold out ahead of Aschenbrenner to avoid losses from his trades, or piled on shorting the stocks. Eventually this backed him into a corner where he had no choice but to liquidate almost entirely - the market had identified a wounded shark and a feeding frenzy ensued.
The lesson for individual investors is not that leverage is always destructive, it's that leverage removes your ability to wait. A patient investor can sit through a 30% decline and recover. A leveraged investor facing a margin call must sell today, at whatever price the market offers, regardless of the consequences.
Leverage
A tool for both wealth creation and destruction
Simply put, leverage is using borrowed money to make an investment.
Your home mortgage, for example, is a form of leverage. Let's pretend you put $200,000 down on a $1,000,000 house and borrow the rest from a bank. Then the next month the house appreciates 25% to $1,250,000 and you sell it. You pay off the $800,000 mortgage and get to keep the remaining $450,000. Subtract out your initial down payment of $200,000 and you are left with $250,000 in profits. Ergo, your $200,000 has effectively earned a 125% return thanks to leverage.
Leverage amplifies gains, but it also amplifies losses by exactly the same mechanism. If instead that house value were to fall 20% to $800,000 and you sold, then your entire $200,000 down payment is gone and you still owe the bank the $800,000 mortgage.
This is what happened to many home owners in 2008. People borrowed against the equity in their primary home to finance the purchase of a second property with the hopes of selling it for a fast profit. The mortgage payments forced them to sell the second house quickly to stay solvent, which wasn't a problem when home prices were rising every month. But when home prices fell, many investors couldn't break even on the second property and simultaneously became underwater (owing more than the home is worth) on their leveraged primary homes. This meant that they had to do a short sale on one or both homes because they couldn't afford the mortgage payments anymore. The moral of the story is that contrary to what you might hear on TikTok, real estate investing is not always as easy as it looks.
Why investors keep overreaching on leverage
Leverage works spectacularly during bull markets, but people have a tendency to mistake luck for skill and extrapolate recent experience into the future. When you make 400% using 3x leverage, the gains feel like a brilliant strategic decision. The risk feels hypothetical, confidence grows, and leverage grows with it. Confidence and leverage together create a dangerous belief that you can manage the hypothetical risk if (and when) it arrives. Often, you cannot.
When leverage is constructive
Buying a home with a mortgage is one of the best pathways to economic security in history. Most middle-class net worth in the U.S. exists in home equity that simply would not have been possible without the ability to borrow at a fixed rate. Similarly, issuing corporate debt funded the railroads, bridges, and factories that built the American economy. Leverage, when applied to productive assets with long time horizons and in appropriate amounts, creates real value for both the borrower and the lender.
When it has caused catastrophe
When you take out a margin loan, the amount that you are allowed to borrow is based on the value of the investments that you use as collateral. As the price of your investments rise, you are permitted to borrow more, and when the price declines, you must repay a portion of the loan. This is referred to as a margin call, because brokers call their clients to tell them that they need to repay their margin loans (and likely have to sell their investments to do so).
At the peak of the stock market in 1929 right before the great crash, investors had leveraged roughly 90 cents of every dollar of stock they owned on margin. Meaning that investors were borrowing against the value of their stock portfolios at a rate of $9 for every $1 they owned, and using those loans to buy more stocks. When prices fell, margin calls forced selling, which pushed prices lower, triggering more selling. The snowballing cascade helped tip the US into the Great Depression.
In 1998, Long-Term Capital Management (a hedge fund run by the all-stars of the financial world, including two Nobel laureates in economics) was operating at 25 to 30x leverage when Russia defaulted. The Fed had to organize a bailout because the fund had grown so interconnected with major banks that uncontrolled liquidation threatened the global financial system. LTCM was the first investment company ever deemed "too-big-to-fail".
In 2008, the housing market became a leveraged bet stacked on leveraged bets using mortgage-backed derivatives. When prices fell, the entire chain unwound simultaneously and we all know how that story ended.
In 2021, Bill Hwang's Archegos fund used leverage to hold $100 billion in concentrated positions on $20 billion of equity. Several stocks fell 50% or more within a few days when the forced selling began. And this week, we saw the same thing happen again when Aschenbrenner's Situational Awareness turned $45 billion into $10 billion in under a week.
Every one of these stories follows the same structure: initial investment gains build confidence, confidence builds leverage, leverage builds fragility, and a single shock triggers a cascade that no conviction or intelligence can stop. It's the financial equivalent of playing Jenga.
What to do
Rarely, if ever, do I recommend leveraged ETFs or margin loans to my clients. But leverage is broader than that; a mortgage, a home equity line of credit, any borrowed money used as an investment qualifies as leverage. The question worth asking yourself is this: under what conditions would I be forced to sell? If the answer is never, then you are in a strong position. If the answer is a specific scenario, then you should know exactly what that scenario looks like and how to protect against it.
Leverage is a tool. Like a hammer, in the right situation and the right hands, it is constructive. It builds homes, companies, and generational wealth. But in the wrong situation or the wrong hands, it is destructive. And that damage usually arrives faster than most people have time to react. Know which situation you are in before you pick up the hammer.
The bull market and the fragility underneath it are running in parallel right now. For a long-term diversified investor with no margin debt and a plan for when the market doesn't cooperate, this past week's news was just noise. For anyone in a concentrated portfolio carrying significant leverage though, the alarm bells should be ringing. The South Korean market crash and Situational Awareness' fund collapse are cautionary tales - heed them, or risk succumbing to the same fate.
Longevity Science Foundation article of the week:
Female Fertility & NAD+ Levels: A Deeper Look
Family, hobbies, and other updates on my life
Two of my favorite hobbies are gardening and cooking, and fortunately they go hand-in-hand together. Building financial plans and following the markets for a living means that I spend most of my waking hours in front of a computer screen (usually three screens at time). So when I get a chance to step away from work, I prefer to do something that is just as intellectually stimulating but also gets me outdoors in the fresh air. Gardening is very similar to investing: you make decisions based on forecasts of how an environment will change, anticipate risks and take steps to mitigate them, and if you do it well, you get to benefit from the results of diligence and patience over a long period of time. Cooking doesn't have quite as many parallels to finance, but I love to eat and cooking is generally a prerequisite to that, which is enough of a reason for me to be interested.
This past weekend my wife Mikaela and I made Chicken Enchiladas with fresh, homemade Green Chili using Anaheim Chiles, San Marzano Tomatoes, and Pinto Beans from our garden. We also harvested some Eggplant and made a simple side dish by slicing and frying them up, and dipping in teriyaki sauce. The Eggplant dish was something quick and easy to nosh on while we spent the afternoon roasting tomatoes and peppers for the Green Chili and baking the Enchiladas. I also made a little bowl of Salsa Verde using Purple Tomatillos and Serrano Peppers from the garden. I like the heat from the Serranos but Mikaela doesn't, so I made it separately rather than mixing them into the Green Chile.
Here are some similar versions of the recipes if you want to make these dishes yourself (we generally don't follow recipes too closely, we prefer to cook like we are playing jazz and make it up as we go along).
Have a nice week ahead!
Kevin