Market's Worst Sell-Off In A Month, Will It Get Worse? Fund Manager Reveals What's Next

Key Concepts

• Inflation: The rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling.
• Core PCE (Personal Consumption Expenditures): A measure of inflation that excludes volatile food and energy prices, often targeted by the Federal Reserve.
• Max 7 (Magnificent 7): A group of seven large-cap technology stocks that have significantly driven market performance.
• PE Ratio (Price-to-Earnings Ratio): A valuation metric used to compare a company's current share price to its per-share earnings.
• AI Infrastructure: The foundational technology and systems required to support artificial intelligence development and deployment.
• Quantitative Tightening (QT): The process by which a central bank reduces the size of its balance sheet by allowing assets to mature without reinvesting the principal.
• Standing Repo Facility: A facility where eligible counterparties can borrow cash from the Federal Reserve against a portfolio of securities.
• Reverse Repo Facility: A facility where eligible counterparties can deposit cash with the Federal Reserve against securities.
• Credit Spreads: The difference in yield between two debt instruments of similar maturity but different credit quality.
• Investment Grade Corporate Spreads: Credit spreads for bonds rated BBB- or higher by credit rating agencies.
• High Yield Spreads: Credit spreads for bonds rated below BBB-, also known as junk bonds.
• Private Credit: Loans provided by non-bank financial institutions to companies, often characterized by less transparency and more customization.
• Covenants: Conditions or restrictions in a loan agreement that borrowers must adhere to.
• Rehypothecation: The practice of a financial institution re-using collateral that has been pledged by a client to secure its own transactions.
• Value Trap: A stock that appears to be undervalued but continues to underperform due to underlying fundamental issues.
• Soft Landing: A scenario where a central bank raises interest rates to curb inflation without triggering a significant economic downturn.
• Managed Futures Strategy: An investment strategy that uses futures contracts to follow trends in various markets, aiming to profit from both rising and falling prices.
• Dual Mandate (Federal Reserve): The Federal Reserve's objectives of achieving stable prices and maximum employment.

Market Sell-off and Underlying Concerns

The discussion begins by addressing the significant sell-off in equity markets and risk assets on November 13th, noting that this trend has been ongoing for over a week. Despite the government shutdown ending, markets have not reacted positively, suggesting a deeper underlying concern.

Key Points:

• Broad Market Weakness: The sell-off is not confined to stocks but also affects cryptocurrencies and even gold futures.
• Intensifying Tech Sell-off: Large-cap technology stocks, particularly the "Max 7," are experiencing significant declines, dragging down the broader indices.
• Government Reopening Ignored: The end of the government shutdown did not provide a market boost, indicating that investors are focused on other economic factors.

Drivers of the Current Market Volatility

David Bush, co-CIO at Trajan Wealth, attributes the current market volatility to a combination of factors.

Key Points:

• Valuation Concerns: There is growing concern over the high Price-to-Earnings (PE) ratios of large-cap tech stocks (the "Max 7").
• Data Deluge Post-Reopening: With the government reopening, investors anticipate a flood of economic data (inflation, unemployment) that will influence the Federal Reserve's future monetary policy decisions.
• Fed's Data Dependency: The Fed's commitment to being "data dependent" means that upcoming economic indicators will be closely scrutinized for their impact on interest rate decisions.

The "Bubble Bursting" Debate

The conversation touches upon the prevalent discussion of a potential bubble bursting, drawing parallels to the dot-com bust of the early 2000s.

Key Arguments and Perspectives:

• Distinction from Dot-com Bust: Unlike the dot-com era, current large-cap tech companies are characterized by substantial cash reserves and positive earnings, providing a significant tailwind.
• AI Infrastructure Investment: A short-term concern is the substantial capital expenditures required for building out AI infrastructure, which could lead to volatility.
• Long-Term Tech Outlook: Despite short-term concerns, technology is viewed as the "wave of the future."
• Correction vs. Bubble: It remains uncertain whether the current market movement is a full-blown bubble bursting or a significant correction.

Future Outlook and Fed Policy

Looking ahead, David Bush anticipates continued volatility, primarily driven by the Federal Reserve's actions.

Key Points:

• Fed Rate Cuts Uncertainty: The possibility of the Fed cutting interest rates in December is not a foregone conclusion. The Fed's decisions will be heavily influenced by incoming economic data.
• Interest Rates and Valuations: A fundamental principle discussed is that interest rates directly impact valuations: higher rates lead to lower valuations, and lower rates lead to higher valuations.
• Concerns about Fed Dovishness: There is a concern that the Fed may not cut rates as aggressively as the market anticipates.

Quantitative Tightening (QT) and Liquidity

The impact of the end of Quantitative Tightening (QT) on market liquidity is also discussed.

Key Points:

• Reduced Interest Rate Volatility: The end of QT is expected to potentially reduce interest rate volatility, particularly on the longer end of the yield curve, as the Fed's "heavy hand" in the Treasury market diminishes.
• Increased Money Supply: QT's conclusion will add more money supply into the economy, which is theoretically beneficial for equities.
• Bank Borrowing from Fed: A notable observation was banks borrowing a record amount from the Fed's Standing Repo Facility, indicating a potential drying up of liquidity. This, along with the draining of balances at the Reverse Repo Facility, suggests the Fed may have intervened to stabilize money supply.

Credit Spreads and Private Credit Risks

David Bush, with his fixed income background, provides insights into credit spreads and the emerging risks in the private credit market.

Key Observations:

• Tightening Investment Grade and High Yield Spreads: Investment grade corporate spreads and even high yield spreads have continued to tighten, suggesting investors perceive these as good credit risks.
• Private Credit as a "Canary in the Coal Mine": A significant concern is the widening of spreads within the private credit space, which could be an early warning sign of broader credit issues.
• Lack of Transparency in Private Credit: The difficulty in obtaining clear optics into private credit loans, their performance, and collateral is a major concern.
• "Covenant-Lite" Loans: The prevalence of "covenant-lite" loans in private credit, where fewer restrictions are placed on borrowers compared to traditional bank loans, increases risk.
• Rehypothecation Risk: The practice of rehypothecating collateral, where the same collateral is assigned to multiple loans, poses a significant risk, as seen in recent regional bank issues and BlackRock losses.

The Role of Fixed Income in the Current Environment

The discussion shifts to the attractiveness of the bond market and the role of fixed income as an investment.

Key Points:

• Highest Yields in 15 Years: Current bond yields are at their highest levels in approximately 15 years, offering attractive income generation opportunities.
• Dampening Volatility: Bonds can serve as a valuable tool to dampen portfolio volatility, especially given the historically low correlation between stocks and bonds.
• Focus on Credit Quality: Investors are advised to maintain high credit quality and avoid chasing yields.
• Intermediate Term Focus: For retail clients, a focus on the intermediate part of the yield curve (3-5 years) is recommended.

Systemic Risk in the Regional Banking Sector

The conversation addresses the potential for systemic risk within the regional banking sector, referencing comments from Jamie Dimon.

Key Arguments and Perspectives:

• Idiosyncratic vs. Systemic Risk: Currently, the issues in the regional banking sector appear to be idiosyncratic (company-specific) rather than systemic.
• "One Cockroach" Analogy: Jamie Dimon's comment, "when you see one cockroach, there's probably more," highlights the concern that problems in one institution could signal broader issues.
• Lack of Market Pricing: The broader market is not yet fully pricing in systemic risk in the regional banking sector.
• Optics and Performance Data: The lack of transparency into private credit and the performance of loans makes it difficult to gauge the true extent of the risk.

Consumer Sentiment and Delinquencies

The health of the US consumer is examined as a key indicator of economic performance.

Key Observations:

• Rising Delinquencies: Credit card, auto loan, and personal loan delinquencies and defaults have been rising.
• Consumer Stretch: Consumers are "stretched way too thin" due to persistent inflation on essential goods and services.
• Impact of Consumer Pullback: With consumers representing approximately 70% of the US economy, any pullback in their spending will have a ripple effect across various sectors.
• Flat Credit Card Delinquencies (St. Louis Fed): While some measures, like the St. Louis Fed's credit card delinquency rates, show stabilization, the overall trend for other loan types is upward.

Managing Volatility and Concentration Risk

The highly concentrated nature of the current market, particularly the dominance of tech stocks, is a significant concern for managing volatility.

Key Points:

• Concentration Risk: The S&P 500 is market-cap weighted, meaning the top 10 companies (largely tech) represent a substantial portion of the index. A sell-off in these names can significantly impact the entire index.
• Diversification is Key: Investors are urged to be thoughtful, tactical, and remain diversified to mitigate concentration risk.
• Pairing Growth with Value: A strategy to manage volatility involves pairing large-cap growth stocks with large-cap value stocks, particularly dividend payers, which provide steady cash flow and can dampen volatility.
• Value's Potential Outperformance: Historically, value stocks tend to perform better than growth stocks during market sell-offs.
• Fixed Income for Softening Volatility: Adding a layer of fixed income is recommended to further soften portfolio volatility.

Examples of Large-Cap Growth and Value Stocks

To illustrate the concepts of growth and value investing, specific examples are provided.

Examples:

• Large-Cap Growth: Tech names like Tesla, Meta, and Nvidia.
• Large-Cap Value: Companies in sectors like financials (Citigroup, JPMorgan Chase), energy producers, utilities, construction, and manufacturing. These are typically established businesses with proven cyclical performance and reasonable valuations (PE ratios around 15-25).

Valuation Metrics and "Value Traps"

The discussion touches on how fund managers assess valuations and the risk of "value traps."

Key Points:

• Trading Personality: A key piece of advice is to "trade your personality," implying that investment decisions should align with an individual's risk tolerance and investment style.
• Tesla's Valuation: Tesla's trailing PE ratio of 320 is considered extraordinarily high, even among its peers.
• Nvidia's Valuation: Nvidia's PE of 55.6 is also noted as being on the higher side.
• Apple's Cash Position: Apple's substantial cash reserves on its balance sheet are seen as a buffer against market downturns.
• Avoiding Value Traps: Investors must be cautious of stocks with very low PE ratios, as these might indicate underlying fundamental issues and limited earnings growth potential.

Fixed Income as a Hedge and Correlation Dynamics

The role of fixed income as a hedge against equities and the correlation between yields and stocks are explored.

Key Points:

• Fed Intervention Scenario: If the Fed were to aggressively cut interest rates in response to an economic shock, bonds would likely perform well, with falling yields leading to rising bond values, thus offsetting equity price risk.
• US 10-Year Treasury Performance: The US 10-year Treasury had a relatively range-bound year, not significantly underperforming despite the S&P 500's gains.
• Components of Treasury Yields: Treasury yields are influenced by two main factors: compensation for time risk (term risk) and inflation expectations.
• Impact of Inflation Expectations: Falling inflation expectations tend to lower bond yields, while rising inflation expectations can cause yields to jump.
• Tariffs and Bond Market: Tariffs are viewed as taxes that can initially be inflationary but become deflationary in the long term due to reduced consumer demand.

Correlation Between Stocks and Long-Term Yields

The varying correlation between stock market movements and long-term Treasury yields is analyzed.

Key Interpretations:

• Stocks as "Risk On," Bonds as "Risk Off": Generally, stocks are considered "risk on" assets, while bonds are "risk off." When investor sentiment is positive, money flows into stocks; when it's negative, investors seek the safety of bonds.
• Divergent Movements: When stocks rise and yields fall, it can indicate that the stock market is running ahead of economic reality, or the bond market is anticipating risks that equity investors are overlooking.
• Inflation Expectations Driving Bonds: In the Treasury market, price movements are largely driven by inflation expectations.
• Current Environment: The current environment of falling yields while stocks have been rising (until the recent sell-off) suggests that inflation expectations are coming down, while equity markets have been driven by strong investor sentiment and a desire not to miss out on the performance of large-cap tech.

Scenario Analysis: Inflation and Sector Performance

The potential impact of different inflation scenarios on sector performance is discussed.

Scenarios:

• Higher Inflation: This would lead to an increase in the inflation premium in the Treasury market, causing yields to rise. Consequently, stock valuations would likely decline, leading to a sell-off in both bonds and stocks.
• Cooling Inflation: This would result in compressing yields and would be supportive of equity valuations.
• Higher Inflation and Growth: This scenario, though less common, could be driven by significant infrastructure build-outs, such as those required for AI. In such a case, sectors supporting this infrastructure (construction, manufacturing, energy production) could benefit.

Investing in AI Infrastructure and Domestic Manufacturing

The potential for investment in businesses supporting AI infrastructure and the outlook for domestic manufacturing are explored.

Key Points:

• Beyond Chip Manufacturers: Investment opportunities extend beyond chip manufacturers to businesses involved in construction, manufacturing, equipment rentals, and energy production needed to power data centers.
• Energy Production: Companies involved in natural gas, uranium mining, and rare earth minerals are highlighted as potential beneficiaries.
• Challenges of Onshoring Manufacturing: Onshoring manufacturing in the near term is seen as difficult due to the high cost and time required to build new plants.
• Impact of Tariffs on Manufacturing: Tariffs are expected to increase the cost of goods manufactured overseas and imported into the US, potentially slowing down the momentum needed for AI infrastructure development.

Hedging Against Volatility

Various strategies for hedging against market volatility are discussed.

Approaches:

• Defensive Sectors: Investing in consumer staples, healthcare, and utilities.
• Fixed Income: As previously mentioned, fixed income can help dampen volatility.
• Alternative Assets: Exploring assets with low or inverse correlation to the stock market.
• Managed Futures Strategy: This trend-following strategy can go long or short, aiming to profit in both rising and falling markets. It utilizes futures contracts across various sectors like interest rates and commodities and is considered an uncorrelated asset class that can dampen portfolio volatility.

Cryptocurrency as an Asset Class

The increasing accessibility of cryptocurrencies, particularly through ETFs and 401(k)s, is noted.

Key Points:

• Speculative Asset Class: Cryptocurrencies are viewed as a speculative asset class.
• Downside Risk Mitigation: Funds are being developed that aim to participate in the upside of cryptocurrencies while limiting downside risk through derivatives.
• ETF Accessibility: The availability of ETFs makes it easier for individual investors to gain exposure to digital currencies without needing to purchase entire coins.

Key Economic Events to Monitor

The discussion concludes by highlighting the crucial economic indicators investors should follow.

The "Big Three":

1. Core Inflation: Persistent inflation above the Fed's 2% target remains a key concern.
2. Unemployment: Cracks are beginning to appear in the labor market, with layoff announcements and furloughs suggesting a potential rise in the unemployment rate.
3. GDP (Gross Domestic Product): Economic growth is a critical factor in assessing the overall health of the economy.

Federal Reserve's Reaction: The Fed's response to these indicators will be crucial, especially in navigating its dual mandate of stable prices and maximum employment, which are currently moving in opposite directions.

Conclusion and Where to Learn More

The conversation emphasizes the need for investors to be thoughtful, tactical, and diversified in the current market environment. David Bush's firm, Trajan Wealth, can be found at trajanwealth.com and on social media platforms.