NVDA - Credit Event Long Duration Treasuries Utilities And Classifying A Bear Market

2023-08-06 12:30:00 ET

Summary

• Michael Gayed sees a melt-up followed by a potential crash in the stock market this year.
• He warns of a credit event that could impact the bond and stock markets.
• Gayed suggests hedging with long duration treasuries and investing in the utilities sector as a defensive play.

Listen below or on the go on Apple Podcasts and Spotify .

Michael Gayed sees a melt-up and potentially a crash, all in the same year (0:20). Credit event coming (2:10) long duration treasuries as a hedge (4:20) classifying a bull and bear market (6:30) why he likes utilities sector (11:50) developed and emerging markets; value vs. growth (13:20). This is an abridged conversation from Seeking Alpha's recent Investing Experts podcast .

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Transcript

Michael Gayed: After the first week of January, I made the argument that we'll probably see a melt-up and then potentially a crash, all in the same year.

Now, I know that sounds dramatic. But let's look at the historical precedent.

So usually in pre-election years, you end up having a very strong market, you end up having a melt-up. Now all that has pretty much played out so far. You've had a fairly sizable run-in the S&P 500. We know what has happened to the NASDAQ and tech with the AI mania that's run wild. So it's been by all the metrics one of the strongest six months to a year in history, let alone in pre-election years. But I've been warning that in the context of that melt up, there is a credit event that's out there.

Now, in January when I started making that argument, I put the timeframe around the latter part of the year under this idea that you have a large number of loans that are going to be refinanced into higher rates next year, and most crises are refinancing crises. Right?

It's on the rollover of debt where typically there tends to be a problem and higher volatility. If that's going to happen and start in earnest next year, if it's going to be a stress point for the bond market, the stock market and bond market won't respond off of it next year. They'll respond off of it this year, because the markets are supposed to be forward looking mechanisms.

So I always put the time frame around a credit event later in the year. I don't know exactly when, because my bet in the way I think about this is that the stock market and bond market will start to worry about what's going to come in 2024.

Now that seems bizarre and seems fantastical because the trend has been very strong. I'd argue that the fact that the trend has been very strong is exactly why you need to have a credit event to break it.

It's very hard to break momentum in FOMO like what we're seeing this year in the absence of some kind of exogenous shock. And if history is any guide, it seems plausible that, just like everybody fell for the recency bias up last year, with equities going down, people are probably falling for recency bias now this year. The other way around.

Rena Sherbill: And so what does that mean for investors? If they're looking out for -- I understand that you can't predict the timing and such. But what should they be preparing themselves for if you have that in mind?

MG: So, a large part of what I called my hell last year, as somebody who runs rules based funds, a mutual fund, ( ATACX ), ( RORO ) and ( JOJO ), my ETFs, which by the way are totally separate from The Lead-Lag Report investing group.

But in practice, what that means is that I suspect that the thing which was, my hell last year, which was the failure of treasuries to counter equity volatility that treasuries end up doing what they historically do, which just serve as a buffer and counter a stock market correction or credit event, using that terminology.

So from a practical perspective, I know everybody wants to buy and feels tempted to just chase, especially the Nvidias (NVDA) of the world and the high flying names in the stock market.

But maybe the best thing to do is actually start to position a little bit more into long duration treasuries, not because you're trying to play it off of yield in long duration treasuries, but because historically, when you have a credit event, when you have some kind of a shock decline, there's a flight to safety.

Money goes into the pristine asset, which owns all of us through taxation, which is U.S. government debt, at least for a moment in time. I'm not talking from an investment perspective I'm talking about from a, yeah, allocation perspective in the here and now.

So I think that, if you believe that we are, you know, things are strong, but there's still a risk out there. Then I'd argue that the best way to hedge that is long duration of the treasuries unlike last year, because now you have a higher starting yield to actually protect you against falling markets.

RS: And how does that play into, or does it play into how you're thinking about how the Fed is looking at the markets, playing with the markets, however you want to define that terminology there?

MG: It's funny, at the start of the year, I put a tweet saying the Fed actually wants markets to go up. It wants to prove to the stock market that it threaded the needle for the soft landing or even no landing scenario, right?

So, your term playing with the markets I think is interesting because that is - you can argue what they do with their rhetoric.

Now, unpopular opinion, but this is the fact, the Fed doesn't control the long end of the curve. Long duration treasuries, yes, there is a correlation with Fed policy, but it's not 1 for 1. So the Fed can keep on raising rates as they have on the short end, but long duration treasuries can still do well and be in their own world.

If you notice, for example, the ( TLT ) 20+ year treasury ETF it’s not made new lows, while the Fed keeps on hiking rates. So, there's one thing to hear a narrative and another thing is to look at the reality.

The reality is that the Fed is a follower of the bond market. I've used that line a lot many times before. The Fed does not own the bond market. The bond market owns the Fed. So treasuries are going to be the thing that ultimately dictate what the Fed is going to do later down the line with a lag.

Now, if you have a credit event, default risk increases, credit spreads widen, that probably marks the end of the bear market, which by the way, I still think we're in. I know this sounds bizarre. We can touch on that maybe in a bit here.

But that will be consistent with what you see in highly volatile risk off periods. You would see treasuries move first and then the Fed respond after.

RS: Get into the bear market a little bit. I'm interested to hear what you think about that.

MG: I put a piece out and I've been trying to stress this as much as I can because it's not just sort of a function of playing with words here, but you know, like the media typically says, you're in a new bull market when the market is up 20% off of a low.

Okay, that to me has always been strange because it's not, you’re entering a new bull market. You technically have been in a bull market, right? If you're going to think of it that way, because you've already gone off 20%. It's in the process of going up 20% when you're in a bull market.

But even that to me is not really a proper way to think about the classification what's a bull and a bear.

To me, a bull market is only known with hindsight after you've taken out the prior inflation adjusted high. Inflation adjusted high for the stock market. So if the S&P 500 were to break new highs this year, which by the way is possible. I said that back in January in an interview. I said it's possible that the S&P breaks nominal highs, but it won't necessarily get back to the real after inflation adjusted highs. If you think of it from that perspective, we're still in a bear market, because you're still in a drawdown. Right? You haven't taken out the prior high.

Okay, that doesn't have anything to do with portfolio construction. That's more just about the framework from getting overly excited around how much to allocate, right, to equities.

Now, if – one of the dynamics that was unusual about last year was, there's this saying that markets follow a staircase up and then elevator down. And that typically bear markets end with capitulation. The kind of moment where everybody just sells, and you have a very nasty decline. And that typically is what marks the end of that cycle, VIX spikes to very high levels.

You didn't have any of that last year. So if last year, if October was the end of the bear market last year, it would be historically abnormal given the sequence and given the way volatility itself played out at that bottom.

Now, if we're still in a bear market, a credit event would confirm the end of the bear market because what would a credit event mean? It would mean the VIX spikes , it would mean a very significant sharp decline, maybe slightly breaking the lows of October last year, and again treasuries countering this time around unlike what we saw in 2022.

So, it's more than just semantics. I always go back to, you have to define things properly. Is it a bull market? Maybe, but you don't know until you've taken out the prior high. Until then, to me it still looks like it's a bear market.

You can have a melt-up in a bear market. Bear markets have plenty of very vicious aggressive moves. I hear the argument from people that say, you've never had a bear market rally last this many number of months, I don't disagree. You also never had the fastest rate hike cycle in history like we saw last year.

So my point is, it is more about perspective. We don't know where we are in the cycle just yet, because a lot of things arguably are off. All I know is that when I see the sentiment so one-sided, when I see put-call ratios as low as they are, when I see everybody screaming melt-up when none of these people were around back in October of last year when I tweeted that out the end of the world's bull case, when you have so many people being this adamant, markets do what they do, which is they tend to throw everybody off.

So, I think this is just going to be one of those environments where people do have to be careful with narratives and have to be careful with how much they over-allocate to equities because if this is going to be somewhat fleeting, it can be quite painful to chase a high right before a tail event happens.

RS: Yeah, it seems to me to your point about - also that you know you need to have perspective in order to define things, that seems true of the stock markets and economy - I mean, broader life stuff as well. But I think pointing to both terms like recession when people are screaming up and down that we're in one, a lot of times it seems to me that you don't know that you're in one, until you've been in one. And it takes some hindsight to recognize that.

MG: Right, and I think it's difficult because like now the narrative is, well, everyone was wrong about the recession. So we have to -- everyone has to now admit that they were wrong about recession. Okay, well, isn't that also a prediction that we're not in a recession if you're poking fun at other people that have said we're in a recession or having a recession?

So if the narrative by the crowd was wrong about the recession a year ago, which again you only know with hindsight, then couldn't the narrative be wrong now that the recession has been actually pushed out? Like, this is my point. The things that people often will argue against, inherently means that they're making a prediction which itself probably ends up being wrong too, right?

So again I go back to the perspective -- again, all that means from a portfolio construction perspective is, I don't know if it makes sense to get overly excited and think about going into, again, Nvidia is my kind of favorite stock to point to, I don't think it makes sense to consider Nvidia a store of value , right, or something that you do put your savings in.

A lot of people make a lot of money and don't get me wrong, but you know, if the bear market isn't over and if we're in a manic phase, you can make a lot of manias, the question is can you keep it. That I think is where I think a lot of people are going to get tripped up on if I'm right about what comes next.

RS: Are there specific sectors that you like more than others at this point?

MG: The most boring sector of all, which is utilities. So, I just put this tweet out today, but – so utilities are the most unique sector of the stock market in the sense that they don't suffer from seasonality. Some may go away, dynamics not there.

Utilities are the most bond like sector of the stock market, and utilities have done terribly on a relative basis. If you look at the relationship of utilities against the S&P 500 , you're pretty much at the November 2021 level, meaning utilities have gone a round trip in terms of their outperformance last year. November 2021 is when most people would argue the large cap bear market started.

So, I think, if I'm right that we're in this kind of mania phase and that there's a credit of it out there, and you're going to be long only equities, the sector to be in is the most defensive sector of all which has the highest yields and most boring characteristics which is basically utility companies.

So, you know, I think a rotation out of tech into defensiveness is going to be coming at some point. Utilities are the least weighted sector of most large cap averages. So, at the margin, big players can't really do too much to allocate there, but if you're nimble and a discretionary trader, that could actually be your best equity play.

RS: You're somebody who covers, I mean really a wealth of different parts of the market . One of the things that I wanted to touch on, because not everybody covers the international side of things. How do you talk about the internationals? I mean, I'll let you kind of choose which path if you want to focus on a certain area, if you want to focus on certain ETFs, however, you want to talk about sort of allocation to an international section of the market, let's say.

MG: Yeah, so I think it's important to keep in mind that when you think about internationally, you have to make two distinctions, right? So, one is developed international or emerging. But then on top of that is value versus growth.

So, emerging markets have been dead money for over a decade. I mean, it's -- and I've been very wrong, hoping as -- hoping purposely because my mutual fund tries to play emerging market momentum, it just doesn't want to stick, hoping that emerging markets would lead. And the reality is it's been a game purely of U.S. and not only U.S. but large cap momentum.

So, yeah, the last decade plus has not -- obviously not been good for anything international. Now if you believe in cycles, at some point you have to assume, I think, that there's going to be momentum outside of the U.S.

For momentum outside of the U.S. to take place in emerging markets , you have to kill off the tech trade. You have to break the technology momentum because a lot of the emerging market indices and ETFs have a value tilt.

In other words, the sector composition for a lot of emerging markets are heavily weighted towards financials, materials, energy, less so tech, which is what's driving them as they can, and the S&P 500 in the U.S. So, if you have a shift away from growth into value, I suspect you will have a shift away from U.S. into international, and in particular, emerging markets.

Now on the developed side, whole different animal, because demographics are horrible when it comes to Europe. They're less flexible, obviously, in terms of -- and less dynamic in terms of their economies. I'm, in general, not a fan of trying to diversify in Europe for a lot of structural reasons. And that value growth story is not as clear as it is with emerging markets as sort of the beneficiary of value tilt.

But I very much do think that we're going to be entering a cycle that should favor emerging markets more than anything else but it's going to be violent and volatile. Part of that thesis relates to commodities, which haven't really done all that much this year, but if you believe in the argument that these are structurally underinvested parts of the investment landscape, emerging markets tend to correlate nicely with commodity momentum and strength.

So a bet on commodities is also a bet on emerging markets, which is also a bet on value. And all that basically can be summed up into a bet on anything outside of the U.S. where you could have big gains is ultimately a bet against technology as the leader in the US.

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