TLT - Michael Gayed On Credit Event Phases And The Fed's Unprecedented Moves

2023-11-13 08:00:00 ET

Summary

• Michael Gayed predicts a credit event in the market and warns of longer-term concerns around U.S. debt trajectory.
• He discusses the disconnects in the AI mania and inter-market dynamics.
• Gayed suggests looking internationally for investment opportunities, particularly in dividend-centric sectors.

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

How should investors be thinking about this volatile market? Michael Gayed on credit event phases and the Fed's unprecedented moves (2:00). Longer-term concerns around U.S. debt trajectory (7:30). AI mania disconnects and inter-market dynamics (9:30) Growth value discussion, looking internationally (18:00) Oil, gold and bitcoin (19:30).

Transcript

Rena Sherbill: Michael Gayed, creator of The Lead-Lag Report on Seeking Alpha, welcome back to Investing Experts. It's great to have you on the show again.

Michael Gayed: I appreciate the invite and love everything that Seeking Alpha does. So, kudos to what you guys have done in terms of just building the platform and the kinds of content you put out.

RS : Well, massive appreciation. I think one of our goals here on Investing Experts is to showcase what makes Seeking Alpha uniquely Seeking Alpha and that's analysts like you bringing content that people don't get everywhere else, especially I think these conversations lead to much deeper dives than we read on the site. And I think taking advantage of impressively thought-out analysis is one of my favorite things to do.

So, in that vein, let's get into how you were talking about the markets in July , and then maybe catch investors up, how you're thinking about the markets today. You predicted a crash and maybe talk at some point, and then maybe a melt-up, a credit event as well. Talk about what's transpired in the past few months and how you see it kind of going into 2024?

MG : Yeah, sure. And those that track me on social media in particular, they note that I, through my persona, which I always emphasize is a persona, especially on X, obviously, that I'm very loud and I'm very convinced. And my conviction around things is never around the mile marker. It's always around the conditions, right, that favor something happening.

I always go back to this idea that conditions favor probabilities, they dictate the probabilities, probabilities dictate the outcome.

So, you have to look at the overarching dynamic in the background to, sort of see what is more likely or not, right, from a risk perspective. Now, in July , I was pretty adamant in the idea that the market may have peaked in July as AI mania was at its apex. And I was basing that off of history. So, when you look historically going back to late 1920s, and you look at different months where the S&P peaked for the year, 8.3% of the time, stocks peak for the year in July.

Now, that's not because it's 1 in 12, it just so happens to be one-twelfth. But 8.3% of the time, historically, it's a non-zero probability that historically markets tend to peak in July. 40% of the time, they tend to peak in December for the year. So, it is true that there does tend to be that drift higher into the end of the year. But in July I was saying it could very well be that we're in one of those 8.3% of the times in the calendar because of the lagged effects of the fastest rate hike cycle in history.

Now, I started the year saying, I believe we have a melt-up scenario for equities, but that towards the end of the year, there will be some kind of a credit event on the realization that higher for longer is going to cause significant bankruptcies for a lot of companies that operate on very razor thin margins and that have been living off of zero interest rates for the longest time.

Now, the term credit events is just another way of saying VIX spike. It's just another way of saying significant drop very quickly in risk assets. It turns out the -- what I now call Phase 1 of the credit event has clearly taken place in treasuries. In other words, you saw this tremendous sell-off in long-duration treasuries.

Everyone, including myself by the way, thought that that dynamic was over after what happened last year, instead, it only got worse. And it happened really aggressively. I put a post out in September, saying, treasuries are the credit event Phase 1, and you've seen a lot of disruption from what's gone on in the volatility of the government bond market side.

We have yet to see and I still think that that's coming. It's just a question of when. We've yet to see what I call Phase 2, which is the credit event going from treasuries into corporate credit, into junk debt, into highly levered companies. If that scare happens in junk debt, in high yield issuers, yes, it would make sense that everything would break pretty meaningfully.

You would have some kind of a VIX spike, some kind of a crash. And I keep going back to the conditions I'd argue really do favor it because everyone is seemingly not realizing that there's no precedent for what the Fed has done.

RS : And what do you feel like in terms of there not being a precedent for what the Fed has done? Where do you think that leaves the bonds and the treasuries as we move forward into somewhat knowable, but also unknowable terrain with the Fed?

MG : So, I think it's important to distinguish, there's a difference between being bullish on treasuries, to capture yields, right? And being bullish on the flight to safety dynamic, which is the idea that treasuries for a moment in time, counter equity volatility. So, I go back to a credit event means credit spreads are widening, means a VIX spike, means volatility in equities is rising.

So, there's a direct correlation between credit spreads widening default risk getting repriced into the bond market, and stocks acting more violently, generally speaking.

Treasuries are, I keep emphasizing, it's not that they're a hedge to the stock market. Treasuries are a hedge to credit spreads, which means they're a hedge to volatility in the stock market, which is what makes them a hedge to the stock market, which I know that sounds a little Dr. Seuss like, but the transmission mechanism is around corporate credit spreads widening.

So, if you have that Phase 2 dynamic where credit spreads widen the VIX spikes, my expectation would be, and admittedly I'm a little biased in this, would be that, for a moment in time you would see that flight to safety into long duration treasuries, into long duration government debt. The whole concept of that flight to safety is that money goes into treasuries when there's fear, because what is it that investors are fearing in that moment of high volatility?

They're fearing that they won't get their money back that they lent to some highly indebted issuer. So, they go up the quality scale ultimately to treasuries, ultimately to the U.S. government because U.S. government can't default. It's got a money printer. Now that's only a moment in time dynamic. That's a sequence in periods of high volatility. That's what's been missing the last two years.

That's also what's been, unfortunately, missing and hurt my own funds, my Mutual Fund, my ETF, ( RORO ) and ( JOJO ), because they're designed to try to play that dynamic. But I do think it makes sense that, treasuries went from being the source of credit risk to, if I'm right, going full circle to being the beneficiary of the next phase of credit risk, which is default risk rising.

RS : And what are you thinking in terms of the debt levels and how the U.S. is responding to that?

MG : The U.S. seems to love to respond to debt with more debt, which has been really remarkable.

So look, I totally agree with all of the longer-term concerns around trajectory of debt, questioning the ability of us being able to pay it. I mean, I'm sure you've seen the same stats I've seen around interest expense at these higher rates reaching unfathomable levels from what people even thought a couple of years ago.

I don't know what changes that. I do think there's a nuance in the discussion around government debt being inflationary. And this is not going to be a very popular opinion, but if you believe that government spending is inherently inefficient, the implication there would be that the government can spend more, but it doesn't necessarily have to be inflationary because it results in being funneled to only a select number of economic actors, the so-called Cantillon effect, whereby the government keeps on increasing its debt.

It's not going to the vast majority of citizens. It's going to some very wealthy players. Those wealthy players then accumulate the benefits of all that government spending without necessarily themselves spending.

So, even though there is in the mind, I think of most people, the link that more government spending means more inflation, it very much depends on where that money goes. A widening wealth gap is not inflationary. So, it creates other problems, but I don't think necessarily the inflation problem is the one that's at the forefront.

RS : And let me ask you, kind of, I know that I'm switching gears a little bit, but I'm trying to get a sense of how you're thinking of the broad picture. You talked about the AI mania and how we're kind of recovering from that in a sense. What would you describe the state of the AI stocks and how - A, how investors are thinking about that part of the sector , and maybe how they should be thinking about that part of the sector?

MG : So yeah, I've obviously been wrong on Nvidia ( NVDA ) with my colorful way of describing its price movement, but I do think that this is a - the keyword there is mania, right? Because there's a lot of disconnects around the hype around AI and other intermarket dynamics.

So, if AI is supposed to be this game-changing source of efficiency, then why is it that if that's a disinflationary force, long-duration treasury yields keep rising? Why is it that there's still inflation expectations at a fairly elevated level?

If all this AI down the pipeline is supposed to increase efficiency, it should increase profit margins for the vast majority of companies which are highly indebted. Well, then why is it that small caps have done so terribly year to date?

So, I do think that there is this dynamic where investors have viewed anything that's AI-related, part of the Magnificent 7 Bucket as a, "Safe Haven", because everyone else views it as a Safe Haven, right? And nobody wants to touch treasuries as a Safe Haven, at least for now. And I use the word "Safe Haven" in quotes, right? Air quotes. This has been a very deceptive year because I do think that this AI momentum has made people think that we are in some new bull market.

In a pre-election year, typically stocks tend to have the best performance. There's a lot of studies around pre-election years in the presidential cycle being the best year of the four years. But again, I go back to the vast majority of stocks that are negative on an after-inflation adjusted basis and small cash are not participating, retailers are not participating, European stocks are not participating, emerging market stocks are not participating.

So everyone's being fooled by the idiosyncratic aspect of these AI names driving the large half averages, the S&P and Nasdaq. And by the way, pushing their valuations to levels that don't make sense for companies that are this large. So, as is always the case, mania's do end.

That's not to say that AI won't inevitably be such a game-changing dynamic and the next industrial revolution for the economy, but there's a price for everything. And if there is a price for everything, it should be fairly consistent in terms of how AI changes the world, not just focused on changing Nvidia's valuation higher.

RS : Speaking of changing the world, there's a lot of discussion these days about how fast the world is changing. I think in terms of AI, I think in terms of energy, I mean, you could name a sector and pick it apart in terms of what's about to disrupt it, how quickly it's going to be disrupted, and how investors can best benefit from that. What kind of sectors are you looking at that peaks your interest the most or maybe that you think investors aren't looking at it in maybe the exactly right way?

MG : I think broadly speaking, we're going to go back to an era of dividends focus. Whether it's through REITs or the utility sector or consumer staples or healthcare, at some point, tech AI relative momentum ends. At some point, you have to believe, and always a question of when, investors get back to their senses and start saying, you know what, we can't just keep on pricing things at a price to earnings of 30, when you can get a very inexpensive company yielding, from a dividend perspective, 4% or 5% or even 6%.

So, I think you are going to see a pendulum shift away from capital appreciation back to the dividend, which means any sector which is dividend-centric probably does start to see flows. Now, I do think this gets to be interesting in particular when it comes to healthcare in that to the extent that investors and asset allocators still want to buy into the growth style.

Growth style is primarily tech, but the next biggest sector typically is healthcare as far as that growth style of investing. So, for healthcare to work, I'd argue it has to be funded from sales on the tech side because it's the next major bucket that can absorb inflows and absorb capital.

So, I just think in general the hatred of dividend names , that's probably pretty exhausted at this point. And if I'm right on that, yeah, there will be some really good opportunities for, going back to traditional blue chip, dividend-type investing as opposed to speculative PE expansion trading.

RS : So, how would you best articulate, I mean, you've articulated a lot of it up until now, but synthesizing how investors can look at these next, I don't know month or two leading up into the new year and how traders can look at it?

MG : We're talking on November the 9th, right? And everyone got excited from the best week of the year that happened last week when I thought actually was going to be a very vulnerable week and it ended up being the exact opposite, but conditions really haven't changed all that much. I don't buy the seasonality argument this year. I tend to believe in seasonality in general.

I mentioned before, again, stocks tend to peak for the year historically 40% of the time in December on average. But I think there's a lot of other dynamics at play here, which make that a bit of a challenge dynamic. So, I do suspect that into the end of the year, we're probably going to see a lot more volatility than people would expect.

If the consumer numbers around Black Friday, around the holidays end up being weak, I think that'll shock a lot of investors into positioning more defensively into 2024, which again would favor the dividend sectors, utility staples, healthcare.

But I guess the broader point here is, everybody, from that I talk to, and I talk to a lot of financial advisors, they're itchy to want to buy small caps as a way of playing catch up to large caps because they've done so poorly. But the reality is, as long as rates stay elevated, that is going to be a major headwind. And every time it looks like small caps want to run, they get hit pretty badly.

So, I think it's more of the same of whipsaw risk around everything outside of large caps. And then at some point, large caps themselves, "the generals," they fall to the soldiers when it comes to market dynamics.

RS : Where do you figure in the Fed in terms of rate hikes? How do you see it developing? Do you see any changes? And are you pretty much in agreement with the consensus out there?

MG : Look, the Fed only responds when credit spreads widen. I mean, the whole reason - the Fed doesn't really care about the stock market. The Fed cares about default risk rising because that's what impacts the real economy. And to the extent that credit spreads stay tight, then the Fed is going to stay tight with its monetary policy. I do think that they have probably backed themselves a little bit into a communication wall in that by constantly saying hire for longer.

What if there is some kind of exogenous tail events where, as I keep mentioning, Japan might end up being a source of global volatility and risk through the reversal of the carry trade concept? And then what if the Fed has to respond? Well, it seems like they might end up breaking their own credibility if they keep on saying higher for longer than suddenly have to do an emergency rate cut.

My point is they've left themselves very little wiggle room in terms of their ability to be flexible when they keep using that terminology. Now, they're going to do what they need to do at the end of the day, right? From their perspective. But if a lot of this is ultimately around Fed credibility, their ability to fight inflation, well then if there's a concern around suddenly a deflation pulse or a deflation scare, now their credibility is going to be questioned on that end, right, too.

So, as far as what the Fed does next, my crystal ball is as murky as everybody else's, but I suspect that history will prove to be right in the future, which is to say that the Fed follows, the Fed often is late both ways to raising rates and to cutting rates, and this time is not different.

RS : And you've written a bit about this recently, the international picture and speaking to Japan and there's obviously a lot of global focus these days. What are your thoughts in terms of investors looking outside of the U.S.?

MG : Yeah, I mean, so let's go back to the growth value discussion. I mean, the reason international has done poorly is because most international doesn't have tech, doesn't have Magnificent Seven type names. The valuations are unequivocally attractive. I mean, I think it's hard to argue otherwise when it comes to the international side. So, I do favor it from a longer-term perspective and I recognize that international has done poorly for well over a decade. I mean, we've been in a lost decade for most international stock markets, emerging markets, not India obviously, but developed markets on Europe.

That's not necessarily a bad thing, because if you believe in 7 years of famine, at some point you have 7 years of feasts. There's still cycles, I think, that play out. But for international to work, you have to have an end to U.S. large-cap momentum just to have money shift and look elsewhere rather than be focused on just a select number of names. So, I think there's some really good opportunities on that end. The ECB Europe is much more likely to cut rates before the Federal Reserve, the U.S. does.

In the initial stage of that, it's probably not going to be good, but at some point, that easier liquidity would probably benefit the Eurozone broadly. So, I think, yes, in general, Europe - International makes sense. Just to me, a bet on international is inherently a bet against tech, which is not necessarily a bad thing to do at this point.

RS : And just given where we are these days, what are your thoughts on oil and gold is in terms of how investors should be thinking about those as kind of big topics in this kind of volatile market?

MG : Yeah. And it's, you know, everyone thought that obviously the Israel-Hamas war would cause a spike in oil and we've seen a pretty aggressive sell-off here. And just because the point that it's always much more complex , but typically oil does drop pretty hard prior to recessions and prior to major tail events, prior to major credit events.

So, I'd actually argue that the movement of oil here should have persist, gets to be really complicated, the higher-for-longer argument in the sense that the demand pull side of inflation is waning because consumers are tapped out. And you can see that in the behavior of retailer stocks. The cost push side on commodity and primarily through oil is now breaking. So, you've now suddenly, your two main drivers of inflation have just essentially cratered out of nowhere.

If that holds, then relative to where the Fed is, that means the Fed is way too tight, right? Relative to the other forces of inflation against where interest rates are here. So, I think that oil is going to be important because it would suggest even more that we're out of the inflationary phase and the Fed is late again to recognizing that.

Now, that does translate into gold in the sense that if the Fed did indeed over-tighten, as I suspect they have, and if we are still in a prolonged bear market, which I suspect we are, and if other institutional investors start to see that and believe that, they're going to start allocating to diversifiers. And gold, in truth, as a long-only product, is one of the few real diversifiers when it comes to correlation. So, I suspect gold probably can make new highs fairly soon.

I've said it's possible in November this month. Could be totally wrong. But I can easily see a setup where there's some momentum in gold as bigger institutional players start to say, you know what, we need less correlation to beta. And there aren't that many options other than gold to do that with.

RS : Thoughts on Bitcoin?

MG : Yeah, Bitcoin acted like gold in October as far as just seemingly acting like a hedge, but now obviously it's gone with all the other cryptocurrencies vertical on all this ETF hype. So, I don't know how long-lasting that is. I know there's a lot of excitement around it. I always go back to whenever there's been some kind of innovation as far as ways of accessing Bitcoin, when those products are live, it tends to be more of a sell than use type of dynamic, meaning, you know, when you look at when Bitcoin futures came out, that was around the top of Bitcoin.

When the Bitcoin futures ETF thing came out, same deal around the top of Bitcoin. I suspect it's going to be probably a similar dynamic. That's not to say you can't rally because, obviously, it'll take some time for an ETF to actually spot ETF to actually come to market. But that speculative behavior that you're seeing pricing-wise and not just Bitcoin, but other cryptocurrencies around it, I'd argue that's not healthy. That's not something necessarily that you'd want to chase.

That's the wrong kind of reasoning. I think for an institutional player to go into Bitcoin, if it's just FOMO around ease of access, that seems to me not like the proper due diligence to consider allocating to it.

RS : I appreciate you touching on all these different kind of threads within one major fabric. Curious what you think retail investors, let's say we talk again at the beginning of the year, how do you think retail investors should be set up for not just the next couple of months, but looking into 2024?

MG : I think the - there's two things. One is, most retail investors should not be investing unless they have zero credit card balances. No, and I'm actually very interested when I say that. I say that very purposely.

RS : No, I laugh, but you're totally right. Yeah.

MG : I say that very purposely because it's like, all right, so at least if you pay off your credit card debt , you have a guaranteed rate of return that you're not paying in the form of net interest for revolving credit. And that number now is high as far as average credit card interest. So, I get it, people want to speculate and YOLO and make more money and get a higher percentage, but like one's a guaranteed thing and one is not, right.

So from that perspective, number one thing, I think retail should do is, instead of worrying about trading and investing, pay down your liabilities as much as possible, especially the high interest liabilities. As far as trading and investing, and admittedly this is against my own interest because I run funds, so I want to see people consider my funds hopefully when the flight to safety trade comes back in ( RORO ) and ( JOJO ), my ETFs as a PM, as a portfolio manager, the simplest answer is the right one for most individuals.

And the simplest answer is, just do treasury bills, just lock it in, get that 4.5%, 5%, use some CDs. Time will take care of whatever risks are out there, but why even deal with the anxiety around could recession happen next year, could or not? Could stocks melt-up or collapse?

We went through, we know we're now in November in the pre-election year, which again is among the strongest of the four-year presidential cycle, why even bother? At least you're getting some income, right? So, I think from that, it's not really interesting or exciting, but I fail to understand why more retail doesn't just see that and say, you know what, let me do that and just kind of enjoy my life.

RS : Do you think it's just because of the thrill of the game?

MG : Oh, 100%. I mean, which is unfortunate, because it does distort the signaling nature of markets when you have no barriers to entry and you have what I would argue is uneducated speculation, especially leveraged uneducated speculation through option trading by people that are not caring about earnings or the fundamentals of a company or the economic backdrop, but are doing things based on, gamma squeezes and based on dealer positioning, where it's - when you get to a point where you're gaining the legal ownership of a company that has all kinds of very nasty implications on the way the system works.

RS : Yeah. Let me ask you this as long as we're on the topic in terms of retail investors. I mean, I know that this might be like a very easy volley, but I feel like you are intellectually astute enough to answer it fully.

What do you think is the key thing that retail investors should be looking at when they're looking to analysts to provide them a service? Is it just the fact that they connect with their type of strategy that it makes the most sense to them? Is there something that a retail investor should be looking out for that you could articulate?

MG : So, I say two things. One is make sure whoever a retail investor is following has skin in the game and has legitimate back tested research. I find that, and I see this on the social media side all the time, there are a lot of people that have large followers that you can't validate anything they say, yet people track what they're trading, not even knowing if they're being fooled by randomness, to use a term from Nassim Taleb's original book, right? In Fooled by Randomness.

So one is you got to make sure that it's real and they're skin in the game, right, and recognize their cycles. So just because somebody who has skin in the game isn't doing well doesn't mean their approach is invalid. It just means the cycle doesn't favor it.

The other part of this is, I think, - and it's hard I think for a lot of people to think like this is, you probably want to follow and read research from people that have a very different view of the way the world works than you do, and probably it has a different conclusion than you do.

The problem that I think everybody is faced with, not just in financial markets, but just in general as a people is, we all get stuck in these echo chambers and we all get stuck into confirmation bias. We're seeking out information that agrees with our view. And algorithms love that, right? Because, of course, you want to see what other - somebody else says that agrees with how you think about things.

The problem with that from an investing trading perspective is that it results in too much concentration risk because the more convinced you are of a viewpoint, because you're seeing others say the exact same viewpoint, the more likely you are to overweight and take on more risk than you should.

And also I'd argue the more likely you are to be wrong in terms of timing, when to actually reduce or sell. So, my point is that, I know it's a big ask, right, but the best thing most people can do is follow and track respectfully those that have totally different conclusions to them.

The only way you learn is by taking different viewpoints. The only way you grow is by going beyond your own right of the equal sign and look to somebody else's left of the equal sign.

RS : Yeah, so true. I was reading today something to the effect of, if you're talking to somebody with a different who disagrees with you, the best compliment that they could give you is instead of saying, oh yeah, you're right, that they changed their opinion is to say, "Oh, you really made me think about that." And I think the best that we can do is, nobody's right, with capital R-I-G-H-T, I mean, everybody has some version of a truth. And I think all of us together get closer and closer. And until we unpack it and chew it up, I think there's no way.

So, yeah, I appreciate that. That's a, I think very good way of putting it. Anything else, Michael? I really appreciate you coming on. Anything else that you think that we would be wise to share with investors?

MG : No, I think the main thing is, I would just caution investors in terms of how they think about different people that are in the industry. I always go back to that line, there are no gurus, only cycles.

And I speak from experience when I say that, right, because I've gone through all kinds of cycles in my career as a researcher, analyst, and then obviously as a portfolio manager of rules-based funds that would run the exact same way if I died tomorrow. And unfortunately, that I've gone through a nasty cycle because in my case, my funds are designed to be in treasuries when in risk-off mode.

So, the last two years have been brutal, right, from that perspective. Your signal can be right, but your opportunity to set an expression on that signal doesn't matter because the cycle is not in your favor. I think if you have respect for cycle dynamics, it just puts into perspective how you view other people's success and failures for a moment in time. And the results, I think, are just broader, more respectful debate, discussion, learning, than if you just said, "Oh, this guy is not performing right now. Why should I listen to this guy?" That may be exactly why you have to listen to that guy.

RS : Yeah. Yeah. Good stuff, Michael. Michael Gayed runs The Lead-Lag Report on Seeking Alpha. He writes on Twitter a lot. Look out for him there. He runs his own portfolio. A lot of nuance and insight to be gained from Michael . Really appreciate you joining us again, Michael. Looking forward to the next time.

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