QQQ - The 2-Year Treasury Is A No-Brainer

2023-11-01 09:40:18 ET

Summary

• Stocks rally for a second day, ending October with a third consecutive month of losses.
• Legendary investor Stanley Druckenmiller revealed he holds a massive long position in two-year Treasuries on the basis the Fed will cut rates next year to battle a recession.
• I see a fall in short-term rates as well, but for different reasons.
• Regardless, short-term Treasuries offer an excellent risk-free real rate of return and investment options moving forward as the outlook changes.

Stocks rallied for a second day in a row to finish October with a third consecutive month of losses in what has been the longest losing streak since the pandemic. My sense is that the correction is now behind us, and we can look forward to a year-end recovery during what have historically been the two best performing months of the year. The only thing standing in front of that recovery is Chairman Powell's press conference, which will follow today's rate decision after the Fed's two-day meeting. Investors will parse his every word for clues about whether the Fed is considering one more rate increase at its final meeting of the year in December. I am convinced the rate-hike cycle ended in July.

No matter how obvious that may be, we can expect Powell to talk out of both sides of his mouth. He will acknowledge the progress we have made, but warn that another rate increase is a possibility if that progress is derailed. I think he wants to lean dovish, based on the data, but feels it necessary to balance that with hawkish rhetoric so as to not loosen financial conditions from their current state. Bears have been interpreting this rhetoric as reality in forecasts for rates to stay "higher for longer," but I think that is because they know higher for longer is necessary for a bear market and recession to materialize.

Legendary investor Stanley Druckenmiller is not buying the higher for longer narrative. Last week he revealed he holds a "massive" position with leverage in two-year Treasury notes (US2Y), which are yielding just over 5%. I like that trade a lot, but for different reasons. He thinks the yield curve will normalize next year with 2-year yields falling to 3%, while long-term yields continue to hug 5%, due to the fact the economy will be in recession next year, forcing the Fed to cut rates rapidly. I see a similar normalization, but under the umbrella of a soft landing that allows the Fed to normalize short-term rates to a less restrictive 3.5%. Either way, the two-year note looks like a winner, but stock market performance would be a very different story.

A recession would obviously be very damaging to all stocks, but Druckenmiller was calling for one a year ago and it never happened. He admits that most corporations and households have not been impacted by the rise in interest rates, as he expected, because they refinanced at historically low rates from 2020-2022. He asserts that as higher interest rates take their toll over the coming two years, "you have to be open-minded about something breaking." That may be true, but there are no signs of it today.

There are clear pockets of weakness in the economy, as the rate of economic growth slows under tighter financial conditions, but much of this relates to a return to normal, following the post-pandemic anomalies. For example, those less optimistic are hyping the recent increase in consumer loan delinquency rates as a canary in the coal mine, but the absolute numbers are merely returning to pre-pandemic levels.

When cracks emerge in the expansion that threaten the second year of this bull market, a more defensive posture will be necessary, but a soft landing is still my base case and should result in a resumption of the uptrend that started a year ago. An excellent hedge to that outlook are short-term Treasuries (0-2 years), which pay risk-free rates of more than 5%, because provide a real (inflation-adjusted) return on capital, as well as the optionality to reinvest in other assets over the coming two years as maturities arise and the outlook changes.

I still think the S&P 500 (SP500) will provide better returns than Treasuries over the coming two-year period. The stock market is far less expensive than advertised after the recent correction when we segregate the top 10 names in the S&P 500 from the other 490. Note that the price-to-earnings (P/E) multiple has fallen to 15.6x for the 490 with numerous high-quality names trading at multiples in the single digits.

Peter Lynch's Rule of 20 states that a stock is valued fair when the sum of its forward P/E ratio and the year-over-year change in the Consumer Price Index equals 20. If we take the multiple of 15.6 and add it to the current CPI at an annualized 3.7%, we come to 19.3. That may not be a screaming bargain, but it does not suggest that the S&P 500 is overvalued. This is especially true If the rate of inflation continues to decline, and earnings start to grow again, as I expect. In fact, both are tailwinds for risk assets.

I believe one year from now investors will look back and recognize that today was a very good opportunity to invest in stocks, as corporate profits recover, inflation falls to the Fed's target, and financial conditions loosen. Still, the real risk-free rate on short-term Treasury above 5% provide investors with an excellent compliment to diversified stock portfolios, as well as a hedge to the outlook.

For further details see: