Markets Update - October '23

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IN THIS PUBLICATION:

• Now that nearly everyone is bearish, it might be worth taking a good look at the bull arguments for a rally into year-end.

• Gold’s recent performance is sending higher rates for longer vibes that investors need to consider.

• VCs are telling their portfolio companies to stay private until 2H24 (if they can afford to).

“Do You Remember” 2022?

September was a risk-off month for markets, and October has started the same way. We’re seeing higher US Dollar and lower equity prices, both led by a strong move higher in yields.

• The move in yields is important from a technical perspective because we’re breaking out of the range that has been in place since Q4 2022.

• The technical setup around the Dollar Index (DXY) is also important as the 50-day moving average crossed the 200-day moving average a while ago.

• This all points to stronger momentum behind the narrative of higher yields for longer – notice how the 50-day moving average has bounced twice around the resistance set up by the 200-day moving average.

The recent move higher in yields has been led by (1) the surprise decrease in the number of rate cuts the Fed expects in 2024 (2) the 2024 year-end rate forecast by the Fed being penciled higher than the neutral rate and (3) stronger than expected US Employment data – all of which means increased worries that inflation will stay higher for longer (something we covered last month), which should support the case for even higher rates.  

• We even had Jamie Dimon recently flag how businesses are not prepared for a world where yields hit 7%. This whilst everyone else is talking about the 5% level... if Jamie’s thinking about a 7% world, so should we.

At this point, it would be completely reasonable for you to ask: Higher yields for longer is something we’ve heard all year though, so what’s the reason you’re once again bringing this to our attention?

• One of the key charts that clearly outlines a well-covered market risk is the air gap between the NASDAQ 100 and US 10Y Yields.

• Since mid-summer we’ve seen Tech and US 10Y Yields, which usually carry an inverse correlation, move the way they are supposed to (i.e. higher yields = lower tech, and vice versa), with this trend accelerating in September. This is a reversal of what mostly took place in the first six months of the year.

• Whether this is a new normal or not remains to be seen, but there’s a huge gap to close between the two – and this should be top of mind for anyone actively investing in markets.

• As a reminder, the Magnificent 7s now makeup 35% of the S&P 500, have an average PE ratio of 50, and they explain almost the totality of the market performance so far this year.

• It also doesn’t get enough mentions that this concentration is something exclusive, for the most part, to the US.

The key question we’re asking ourselves right now is: with the bear narrative (higher rates, higher energy prices, higher US Dollar) so well understood, does the market believe enough of these risks are priced in, and instead of a move lower, we bounce back from here?

Consider this:

• Seasonality usually implies that the worst is now behind us.

• Key stock indexes have hit the most oversold levels since September 2022.

• Drawdowns are in line with recent episodes over the past year so far.

• Hedge Funds are far away from being positioned for a bull squeeze as they are close to having record low exposure to the market (net exposure at 43%, which according to Morgan Stanley, is just the 16th percentile in the past 5 years). In fact, Goldman’s Prime Brokerage highlighted last week that “the amount of shorting in US equities since mid-August is the largest in six months and ranks in the 98th percentile vs. the past decade”.

• For the S&P 500, when YTD performance through September is anywhere between 10%-20%, Q4 performance has been positive 84% of the time, with a median of 5.5% for the last quarter.

• Same story for the NASDAQ: when the index is up +10% entering Q4, the average return for the last three months of the year is 6.2%. If it’s up +30% in the first nine months, then the average return for Q4 is 11.6%.

• The Magnificent 7s might be trading at outrageous PE multiples, but when adjusted for growth, they are currently trading at a discount as their PEG ratio sits at 1.3 vs. 1.9 for the median S&P 500 stock, according to David Kostin at Goldman Sachs. This would put them at the most significant discount since January 2017 (this discount has only happened five times over the past decade) on a growth-adjusted basis.

• The big caveat here is the ‘G’ in PEG. In order to believe this discount, you’d need to get comfortable with the AI-juiced growth expectations that have been built over the past year.

• Additionally, as per GS: “History suggests that the upcoming 3Q results may catalyze a momentum reversal in the largest tech stocks. Since 4Q16, the mega caps in aggregate have beaten consensus sales growth expectations 81% of the time and have outperformed in two-thirds of earnings seasons.”

• As we wrote in our latest Research: “If yields are rising but stable or declining volatility continues, some hedge fund managers may wish to ramp up their positions into year-end in an attempt to make back some of the underperformance over the year. This could create the illusion of reflation, in which certain segments of the market imply that growth is about to take off, even as a recession approaches. Case in point: in 2008, West Texas crude oil approached $150 per barrel just a couple of months before the crash.”

• The recent correction might just bring investors the entry points they were waiting for to close off a strong year of performance.

• Letting Morgan Stanley wrap it up: “The work done by Morgan Stanley QDS team shows that US and EU L/S hedge funds are typically buyers of equities in Q4. Historically, when global equities are strong from January to August, the drawdown in September/October tends to be low. This yearʼs January-August performance would imply a mild drawdown in September and October of around -5% for MSCI World. “Sep/Oct lows are typically not revisited so the asymmetry is strongly in your favor.”

The bear narrative is well understood. At this point, we think it’s worth analyzing the bull arguments in depth as the bull squeeze could be rather violent.

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Rates

• If you assume that July was the last rate hike, then the bond market is behaving in a very different way than in previous cycles.

• This likely means that the bond market is not expecting the July hike to be the last one.

• If that’s the case, then it probably means that there’s more downside to bonds despite the fact that, as Jack Farley highlighted, “Incredibly, ultra long-duration Treasury bonds have now lost more in % terms than stocks did during the Great Financial Crisis. The drawdown in extended duration Treasury ETF now exceeds PEAK-TO-TROUGH losses in S&P 500 during stock market crash of 2007 – 2009”.

• Bonds are, for the most part, a segment of the market we’d avoid getting exposed to right now until the macro outlook, from a Central Bank’s policy point of view, becomes clearer.

Gold

• Gold has an inverse correlation to real yields.

• Since 2022, US 10Y real yields have moved from -1% to +2%, a 300 basis points expansion. Despite that, gold’s performance (broadly flat) is rather remarkable given the macro backdrop.

• Recently though, gold has been performing poorly (highlighted in red above) – another indicator that the higher rates for longer narrative is once again picking up steam with more credibility than at any point so far this year.

• We’re watching price action in the gold market for two reasons: (1) it’s another informative macro indicator of what the market thinks about both rates and inflation (2) we think gold is in a long-term bull market, and so any significant weakness might present additional attractive entry points.

IPO Market & VC

• Private markets have been the sexiest segment of finance of my generation.

• Apparently, after a decade of annualized double-digit returns, in Q4 2022 US-based VCs IRR fell to -16.8%.

• Two things to note: (1) the fact that we’re almost in 2024 and that we’re still talking about 2022 VC returns is pretty incredible (2) we all know that marks in private markets can be easily manipulated… so I’d see this -16.8% as the best VCs could come up with (reality is probably significantly worse).

• On the IPO side, 2022 and 1H23 were not a particularly great period of time for dealmaking.

• Goldman is out there claiming we’re now seeing a migration from a window-based IPO market (where there are only short periods of time where IPOs can take place) to a fully open market (where the range of options for issuers is broader, pricing is better, and there’s more appetite for larger offerings).

• But the recent performance of Arm ($53bn market cap) and Instacart ($7.5bn) - key IPOs that were used as barometers for the odds of a resurgence of the IPO market - has forced VCs to tell their portfolio companies to wait.

• As per Mike Volpi, a general partner at venture capital firm Index Ventures: “In our portfolio we would advise: unless you really need to, hold back. The market has been rough in the past few weeks… Unless you need to go out, I’d wait until the second half of next year.”

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Thanks for reading through! Obviously, none of this is investment advice.

As always, we'll see you out there...