QQQ - More Shades Of 2007

2023-10-04 14:10:37 ET

Summary

• The yield on 10-Year Treasuries broke through the 4.8% mark for the first time since right before the Great Financial Crisis earlier this week.
• In many ways, it is starting to feel like 2007 all over again, especially in the commercial real estate market.
• These developments could have substantial ramifications for the overall equity markets as well as for the economy.
• The reasons why I am banking on at least a 20% pullback in the S&P 500 from peak to trough are detailed in the paragraphs below.

"In practical life we are compelled to follow what is most probable; in speculative thought we are compelled to follow truth. " - Baruch Spinoza

There are plenty of nefarious phrases in the English language. One of my personal favorites for decades has been " I am from the government, and I am here to help you ." A legacy I guess from my late father, who was the libertarian's libertarian.

However, perhaps the most dangerous phrase or canard for investors has to be " It is different this time ." As I highlighted in my article " Shades Of 2007 " in mid-August, we are about to enter a period of more turbulent equity and credit markets. And as Mark Twain famously quipped " History never repeats itself but it rhymes ."

My thesis from that initial article was that 2023 is starting to look like events that played out late in 2007 prior to the Great Financial Crisis that came about in the following year. Back in 2007, collapsing values in the residential housing market triggered a huge increase in delinquencies and defaults at banks. This, in turn, caused these financial institutions to have huge losses, cut back sharply on lending, and also caused huge and unforeseen " counterparty risks" which eventually resulted in the "Lehman Event," causing a massive crash in the markets. This turn of events then forced the country into the worst recession by many measures since the Great Depression, which was triggered initially by the stock market crash of 1929.

Now, I don't see the same such dire scenario playing out this time around, it should be noted. I have the coming pullback in the markets being somewhere between the 2008/2009 meltdown and the taper tantrum of 2013, when the Federal Reserve had to back off of raising rates due to the turmoil in the markets they were starting to cause. However, I am looking for at least a 20% pullback in the S&P 500 (SP500) from peak to trough before things start to stabilize in the markets.

I took out quite a bit of " portfolio insurance" in the form of long-dated, out-of-the-money bear put spreads mainly against the SPDR® S&P 500 ETF Trust ( SPY ) and the Invesco QQQ Trust ETF ( QQQ ) during June and July, when the S&P VIX Index ( VIX ) was trading in the 12-14 range. Thanks to the recent selloff, the VIX is trading just below 20 as of Wednesday morning.

As it happened, my initial article came out right around the same time as the S&P 500 was peaking just above the 4,600 level. As of pre-market Wednesday, the S&P 500 was trading right around 4,280, down just over 7% from its all-time highs set on the last day of July. So, I am one-third the way to my projection coming true.

Now, 2023 is different than 2007 as far as the residential housing market goes. Homeowners are not nearly as leveraged as they were 16 years ago. Most have mortgages at less than four percent, have far more equity in their properties, and housing prices are holding up well, primarily due to the lack of inventory. With average 30-year mortgage rates now north of 7.5% for the first time since the turn of the century, all-cash buyers are dominating what remaining deal volume is happening in the residential housing market.

Now, China looks like it is on the cusp of a massive housing bust that will eventually impact the global economy in ways unknown fully at the moment. However, here in the States, our problems are very likely to come from our commercial real estate or CRE market.

The yield on the 10-Year Treasury (US10Y) moved through the 4.8% mark in trading Tuesday for the first time since late in 2007. This is causing escalating trauma in the CRE space. For instance, real estate investment trusts, or REITs, are now down more than 20% on average from their highs earlier in 2023.

Some $2.5 trillion in CRE loans need to be refinanced at sharply higher rates in the next five years. Approximately 30% of this has to be done around the office sector where values are plummeting thanks to the explosion in the virtual workforce since the Covid pandemic, which has resulted in much less demand for office real estate. Occupancy levels are running at or very near record lows in cities like Los Angeles, Chicago, New York City, and San Francisco.

CRE delinquency rates are already in the process of moving higher at an alarming rate. According to Trepp, Bank CRE mortgage delinquencies rose in the second quarter of this year, with the office sector experiencing a dramatic rise in its delinquency rate, up to 4.9% from 2.7% in the first quarter and just 1.6% at the end of last year. It stood at 5.58% at the end of August.

Kyle Bass, the founder of Hayman Capital Management, who correctly called out the subprime crisis before it happened, recently told Bloomberg TV:

Banks in the US will lose $200, $250 billion in office over time and there's about $2 trillion of equity in the banks so it's like a 10% hit to US banking equity ."

Morgan Stanley sees a 40% wipeout of office property value from peak to trough. Regional banks originate approximately 70% of CRE loans and hold about 30% of overall CRE debt in the office space. Many are also already struggling with large " unrealized losses " on their bond portfolios due to the huge uptick in interest rates since early 2022. This is what helped trigger the bankruptcies of Silicon Valley Bank and a couple of other regional banks earlier this year. This is the key reason I built up a long-dated, out-of-the-money bear put spread position in the SPDR® S&P Regional Banking ETF ( KRE ) in July of this year. I think investors are under-weighting the risks in this space.

Office and retail are the most troubled parts of the CRE space at the moment. A recent survey of market insiders (919 responses) from Bloomberg Markets revealed two-thirds believe a major crash has to happen in office property values before this sector can rebound.

Most also don't see a potential rebound in this market until at least the second half of 2024.

Given the continued deterioration in much of the CRE space and those potential impacts on the overall market, I continue to have my portfolio positioned quite conservatively. Outside of my bear put spreads which make up approximately four percent of my overall portfolio allocation, half of my portfolio is in short-term treasuries yielding 5.5% at this time. 40% is in covered call positions and the rest is in cash.

Not exactly a sexy or aggressive portfolio composition. However, while the S&P 500 fell nearly five percent in September with the NASDAQ (COMP.IND) down just a tad under six percent, my portfolio rose nearly .9% on the month. Discretion remains the better part of valor in the markets right now as well.

"Most areas of intellectual life have discovered the virtues of speculation, and have embraced them wildly. In academia, speculation is usually dignified as theory. " - Michael Crichton

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