You Call That Easy Money, Huh? (Part 2)
This is part 2 of a 3-part series on where markets and the economy stand as we launch into the second half of 2023. We’ve talked about interest rates (part 1), this one is about the stock market generally speaking (part 2), and we’ll then look at the economic tapestry for it all (part 3).
Last time we talked about the fact that interest rates have risen lot over the last year or so, as the Fed responded to the post-Covid spike in inflation by ratcheting up the Fed Funds rate over and over again. As a result, US Treasury bills now yield about 5.25% (with the added benefit of not paying state or local taxes) and inflation-protected bonds (which are called TIPS) yield about 2% on top of whatever inflation turns out to be in the future. This is a brave new world — ok, fine, the return to a long-forgotten old world — and a much better environment for savers and investors than the zero-interest world we’ve just escaped (The escape left us bruised and scratched up, I will grant you). It now looks like inflation is coming down, though whether we return to the pre-Covid low inflation world is TBD. Oil prices are rising, residential housing is showing signs of turning around after last year’s “micro-dip” and labor deals like the UPS-Teamsters one all suggest inflation could easily claw its way out of its shallow grave despite the many stakes the Fed has driven through its heart. Not a prediction, but certainly a scenario worth contemplating.
Upside-Down “Slam Dunk”
Given the Fed’s fight against inflation and its presumed sledgehammer effect on the economy, the stock market declined a lot in 2022 (And because higher interest rates make future cash flows worth less today, “growth” stocks like tech stocks got wacked extra hard last year). And because of the Fed’s sledgehammer, educated students of the economy and markets were preparing for a recession and a decline in corporate earnings in 2023, never mind the fact that human psychology is such that people hate losing money, so that declines tend to create panic, which creates more selling and more declines, and so on and so forth. At the risk of mis-quoting former public servant George Tenet, the “slam-dunk call” was for tough markets and a tough economy in 2023.
Then around the end of 2022, the stock market started climbing and it just kept going. By the way, the Fed working hard to “cool the economy” (which is a euphemism for making households and companies spend less, hire less, and do everything else less) was among the least traumatic things that happened over the last six months. We’ve had large American and European banks fail (See SVB, First Republic, and Credit Suisse) and China not doing “post-Covid” very well, just to mention two major headlines that made everyone in the worrying business lose a lot of sleep over what could happen next. Anyway, all of that was some version of 20 percentage points ago for the stock market…
They Had to Rebalance the NASDAQ
OK, so the economy has been resilient (shocking so) and corporate earnings have been relatively strong. I would file all of that under “good news.” And, as it should be, a wave of unexpected good news has caused some of the rally that we’ve just experienced. We can have an honest conversation about whether all the good news is now “priced in” but that part seems like regular course-of-business stuff.
What seems a little more out of the regular course of business is the extraordinary rally that we’ve seen in Tech, and specifically AI-related (Artificial Intelligence) companies. As a first approximation, the “Magnificent Seven” or “Enormous Eight” (think Nvidia, Meta, Tesla, Amazon, Apple, Microsoft, etc.) have powered nearly all the gains in broad stock market indices this year while the remaining companies in the S&P 500 have been a rounding error at best. This has been so extreme that the NASDAQ had to go through an extraordinary “rebalancing” (where amounts of stocks are forced to be sold and bought to make the index work according to its own rules).
Now, it’s not like they shot the Archduke Franz Ferdinand or something, but this one is worth filing under “not a‘pposed to be ‘appening,” as my kids would say in the face of confusion when they were toddlers. What do I mean? The whole point of “investing in the market” is that you trust the wisdom of investors and the prices they set for assets and that the resulting portfolio reasonably approximates the world around you without having to get into the tricky business of trading stocks. And let me be very clear, I am a big fan of rebalancing, but this extraordinary step is telling you that “the market” may be getting so far ahead of itself that it is not reflective of, well, what a healthy market should (and the economy does) look like.
It’s not all bad out there. There are cheaper segments of the equity market, both in the US and internationally, but as far as the largest US stocks are concerned, our friendly gatekeepers for the NASDAQ and the S&P 500 are telling us that these are not usual times. In fact, people with big job titles at S&P Dow Jones are saying things like, “if something can’t go on forever, it will stop.” In the meantime, very smart and very well-incentivized people said the same about six months ago, and now they have to make statements like “we were wrong” very publicly, which is admirable in intellectual honesty and the humility of which should rub off on anyone trying to make market predictions.
A Little Good-Guy Wizardry
For those of us with a healthy tendency to worry about things, the above is an added argument for risk management, diversification, and looking at the valuation of assets. That’s a good place to start across the board, even though it still leaves you exposed the risk that stocks do go down as well as up, including those that seemed cheap and attractive to start. But here is a more structured way to manage risk, and one that has sprung back to life after years of “not working” under the old zero-interest-rates regime.
I’ll use Matt Levine’s words and numbers, just to keep things simple. What if I told you that mid-2023 markets are offering an opportunity to gain from stocks if they rise further without being exposed to the downside of the stock market? Wizardry, you say? Kind of, but not for option theorists. With interest rates as high as they are now, here is the way Matt spells it out, all for illustration purposes only, and nothing exact here:
“You give me $100 today, I can invest $91 of it in two-year Treasury notes paying 4.75% interest, and in two years I will have $100. And I can invest the other $9 in two-year at-the-money call options on the S&P 500 stock index, options that gain value if the S&P goes up over those two years. Those options cost, let’s say, 13% of the price of the S&P today, so spending $9 on options will get me an option on about $70 worth of the index. And so I can offer you the following trade:
You give me $100 today.
In two years, I give you back (1) $100, no matter what, plus (2) 70% of the return on the S&P 500 index, if it’s up.
If stocks go up, you get the gains (well, 70% of them). If stocks go down, you don’t get the losses.”
Matt rightly notes that this is not a free lunch (You give up the gains from your Treasuries to pay for the option, etc.), but as an educator and forever an options theorist, I think it’s kind of cool that we are back to a world where these things aren’t just “not working” anymore.
OK, we covered a lot of ground. Thanks for reading and I would love to connect if you would like. Email me at jonathan@treussard.com or call me at (949) 776 9696. Treussard Capital Management is a registered investment adviser that serves individuals, households, and organizations that would not have access to similar expertise elsewhere.