First Week of October 2023, US Equities Overview & Thoughts on Yield Curve Steepening

Welcome to my weekly financial markets newsletter! I wanted to start by thanking everyone who read my first couple and sent me some very helpful feedback via email. From my perspective, we had several interesting developments outside of US equities, but that always seems like a good place to start.

The S&P 500 is up +10.65% YTD and as I’ve frequently pointed out, the only three segments containing the “Magnificent Seven” FANG+ mega-caps are outperforming the composite average. XLC (Meta, Google, Netflix*); XLK (Apple, Microsoft, NVIDIA); XLY (Tesla & Amazon). No other segment is returning above > 5% YTD and moreover 5 of the 11 are negative on the year.

I’ll try to cover some of my observations in other asset markets, but looking at the weekly performance in the chart below, it’s very clear growth segments are leading defensives and by a considerable distance.

The notion that we’re in a secular bull market in US equities is completely unsupported by how history and intuition tells us we notice the formation of secular bull markets. Secular bull markets in US equities begin with small-caps leading the charge.

We see this both in the S&P 500 and NASDAQ 100 relative to small-caps in the Russell 2000.

From the YTD performance of various US equities indices, we can better assess just how much the US equity market ex-FANG+ has struggled this year. The Russell 2000, equal-weight S&P 500, & Microcaps indices have negative returns YTD.

From a global equity perspective, in 2023 US equities seem to be outpacing just about every major global equity market index.

In fact, when comparing US big tech to Chinese big tech, we can clearly see market participants in Chinese high growth tech equities recognized the deteriorating economic situation was not a positive tailwind for Chinese equity market valuations. Consequently, they’ve been repriced downward and are currently in a staggering -77.21% drawdown.

More light humor than a serious analysis, as I found this interesting while doing research. While FANG+ has undoubtably had an impressive year, the MOEX (Moscow) stock exchange is outperforming the invincible FANG+.

I prepared some additional research on mega-caps I’ll be happy to share, but I would argue that this week was dominated by coverage of soaring long-term yields and an aggressively steepening yield curve. I wanted to briefly touch on those developments because they are concerning, but few (if any) have pointed out the yield curve does not typically steepen in this nature into recession.

To briefly summarize, price pressure on long-term yields can be simplified into the following two elements: short-term yields and term premia. Short-term yields are more straightforward to predict, as they follow movements of the US Fed Funds rate quite closely.

Market participants can think of term premium as the compensation they require for longer-term interest rate uncertainty. With the current macro climate, it seems appropriate for market participants to be looking for more of a premium for longer-term government bond yields, given the US debt crisis, inflation re-emerging, a “higher for longer” rates environment, and a pessimistic longer-term economic outlook. The term premium on 10YR US Treasury has now increased roughly +125bps in three months and climbing.

Here we can see as the term premium on the 10YR US Treasury recently spiked upward and with it the 10YR US Treasury yield has risen accordingly.

This has result in the 10YR-2YR benchmark yield curve aggressively steepening, which is what a lot of the financial media coverage is looking at right now. The 10YR-2YR yield curve steepened from a max inversion of -106% to just -30% now.

But does that necessarily mean the yield curve is telling us we’re on the cusp of “something breaking”? My take is: maybe. As illustrated below, the dynamic of this recent steepening isn’t exactly what we expect when we see an inverted yield curve steepen into a recession. The below chart confirms that in the past four cycles – from my research much longer than that as well – we typically either see the Fed cutting into recession, causing both short & long-term yields to fall, or we experience a credit event like SVB collapsing and if you’ll recall in the immediate aftermath, we had both short & longer-term yields falling on the short & long end. For full context, the dynamic described above would represent an easing of financial conditions. This looks very different; we have the 10YR and 2YR US Treasury yields both soaring, partially due to the aggressive nature of this US Fed hiking cycle and partially due to market participants demanding more yield to compensate for enhanced uncertainty. While it may be counterintuitive, when the yield curve steepens into recession, it should generally be because yields have blown out.

The reality is a systemic financial collapse could occur at any point from here on out. There are a lot of red flags out there that consensus is missing (again). While the macro theory does suggest broad deterioration in the US labor market leading to recession, that could also occur from a credit event. Look at what happened in the most recent cycles – discounting C19 as it was an exogenous event – in 2008 we had a “credit crisis” and during the 2000s tech bust, we had a collapse in private equity/venture capital funding leading to insolvency in start-up tech that would up igniting into a widespread US equity market collapse in the tech sector. The below reconfirms no matter what ultimately instigates a US economic recession, the key US labor market metrics follow the same path into recession.

With rapidly rising term premium and global 10YR government yields soaring in advanced economies, at bare minimum we should not rule out a credit event. Therefore the next especially germane question I see is whether financial assets are priced for potential disappointment. I don’t see that as even close to accurate, certainly not risk assets in US equities. It may surprise you, but the highest growth areas of the US equity market are even more expensive, on a relative basis, than what some would consider the ultimate risk assets: Bitcoin & cryptocurrency. ?

Furthermore, during the post-2008 GC secular bull market, even in a zero-rates decade we observed longer-term US Treasuries outperforming the NASDAQ 100 on a relative basis. The same can’t be said about today.

Same dynamic with the LQD – a proxy for investment grade credit bonds – and the S&P 500. As you’ll observe in the chart, investment grade bond prices quite intuitively fall during economic contraction or financial instability. Even if “if it’s different this time” and all this credit market stress, as well as other LEIs (Leading Economic Indicators) are wrong, US equities are still drastically overpriced relative to their bond market proxies in the current environment.

Closing with a topic I’ve been quite perplexed by all year: FANG+ mega-caps. There are a lot of different way to think about FANG+ and many different metrics one can use in an attempt to assess what might happen, especially if we observe economic disappointment or a credit event blind-sighting market participants. I’ll get to why, but I think this is one of the more pragmatic way to assess drawdown potential. Not to say we should expect to see a repeat of the 2000s tech bust – no two bear markets are ever identical and this is proving no exception – but there are parallels I wanted to share with market participants.

Considering mega-caps are considered long duration, “safe” assets in US equities, we should expect some considerable length of time for valuations to reconnect with the economic reality. Given the volume of capital in the US equity market that increased very considerably, a substantial drawdown for FANG+ could have broader ramifications. Apple topped off above $3T in market cap this year, which seems to be more than the cumulative market cap of the ten largest TMT mega-caps entering the 2000s tech bust. Primarily due to the capital market participants stand to lose if they are wrong on either FANG+ or the US economy is largely unprecedented, yet market participants don’t seem to have interest in downward protection.

We also have two very curious bearish “double top” technical formations relating to today’s environment versus the 2000s tech bust. The NASDAQ 100 / Russell 2000 ratio forms the same double top as XLK (S&P 500 Information Technology) / SPY (S&P 500 Composite). ?

US equity market participant favorites NYSE FANG+ index and the SOXX Semiconductor ETF have both formed bearish “double tops” as well.

The below chart is the ratio between the NASDAQ 100 / S&P 500 equal weight index. I primarily used it to articulate the post-C19 part to describe what I found to be quite counterintuitive regarding price action in US equities this year versus even last year.

A couple more related points. I wanted to share my findings on VIX as it relates to shorter-term VIX options (1DAY & 9DAY VIX). As the demand for shorter-term volatility protection in the S&P 500 rises, we may observe VIX getting pushed down a little more than “natural”, due to the availability of shorter VIX options intervals.

It’s also been suggested over the last year numerous times that the market trades on the VIX expected volatility index. Looking at the chart below where VIX is inverted relative to the S&P 500, the correlation seems to suggest it’s at least a possibility. Note VIX inverted means in the chart when VIX is falling, in the chart it looks like it’s rising alongside the S&P 500 price.

Last two mini-points I wanted to comment on as I’ve read some comments on this. When it comes to a hard landing for FANG+, there have been some individuals who have pointed out there’s still enough liquidity in the US & global central banks to keep risk asset valuations somewhat “artificially” high. Or at least market participants can strategically trade up on unreachable earnings targets. My sense is this late into the US Fed’s most aggressive hiking campaign in US history, the lag at which contractionary monetary policy operates is almost here on the shorter-end of historic ETA’s, and with credit market prospects are seemingly shaky, it’s a (very) big risk if you’ve been following this market from a macro perspective. In reality, when a credit event does come, just like with Lehman, SVB, & others, we will find out about it at that time. Unfortunately, it’s not something consensus will be able to provide any helpful direction on. To close the loop on liquidity, while this isn’t the best metric it makes for an interesting chart illustrating the underlying point. The ratio of the S&P 500 / US M2 money supply forms a very interesting – or completely coincidental – “trend line”.

Another comments I’ve seen mostly in financial media was comparing today’s environment that caused the US equity market to selloff quite substantially in 2015. The two could not be more dissimilar, in my view. From my knowledge, there were three primary reasons for investor fear and the subsequent selloff in 2015: a) China’s economic growth seemed to be materially slowing, b) global oil prices took a considerable hit, and c) the US Fed began gingerly hiking again by +25bps. I find the first two points particularly interesting because from my perspective, we have both of those in today’s macro climate and both are viewed as positives. China is arguably our biggest global economic competitor, so their suffering post C19 should only benefit the US, assuming it stays that way. Falling oil and energy prices are now commonly known as a positive tailwind for US equities.

With respect to the US Fed hiking, I do agree that may be a potential catalyst to selloff in the US equity market out of fears of an upcoming recession. But trying to be objective, we started very slowly and carefully trying to come out of the now infamous zero-rate decade. As displayed in the chart above, the nature of the hiking cycle was not even in the same conversation as the aggressiveness observed today, where we went up +525 bps in about a year and a half. My sense is the combination of financial market and economic threats is more straightforward today and not somewhat abstract like arguably 2015 was, especially with the benefit of hindsight.

I thought I’d end with one interesting idea, for those who don’t know Warren Buffett recently invested almost $1B in three homebuilder stocks. At first I couldn’t quite understand it and to boot real estate is currently the third worst performing segment in the S&P 500 down -7.21% YTD. However with valuations extremely low and at least the current pricing & other dynamics in real estate markets suggest Americans would benefit greatly from more new homes being built. I don’t consider this segment to get any serious attention in the near to mid-term, just sharing an idea for perspective.

Hope you enjoyed the weekly read! Please feel free to email me with any questions, comments, feedback, or concerns to:

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Thank you very much again for taking the time to read this and I hope it was somewhat useful to some. Best of luck to all market participants in this upcoming week.

Disclaimer: The information and publications are not meant to be, and do not constitute, financial, investment, trading, or similar advice. The material supplied is not intended to be used in making decisions to buy or sell securities, or financial products of any kind. We highly encourage you to do your own research before investing.