Time to be Contrarian?

IN THIS PUBLICATION:

• Tech’s recent performance might allow less speculative investors to finally find upside without needing to rely on overly optimistic assumptions.

• Commodity stocks tend to be high beta in a recession, and thus investors might want to consider locking in some profit.

• The reversal in bond prices has not happened yet, but inflation and yields have fallen in all but one recession since the 1960s.

Consensus

Amongst the consensus views that have built up in recent months, the three worth exploring are:

• Rates will go higher

• Tech stocks will continue to unravel

• Commodities and commodity stocks will outperform

At the time of writing, the S&P500 has not yet entered bear market territory (a +20% decline), but it’s getting closer by the day. A typical recessionary bear market would range between 35%-40% in magnitude.

The Nasdaq100 has fallen 25%, but there is massive internal dispersion between the profitless tech stocks, some of which have fallen by 90%, and the large-cap cash-rich leaders like Apple, down less than 20%.

One of the most dangerous things during vicious bear markets is an increase in correlation across assets – where basically everything falls in unison.

Some of the pressure on all risk assets that drives these correlation events will come from rules-based funds such as risk-parity mandates, which mainly focus on controlling realized (actual) volatility as the key ingredient to the structure of many of these funds. In plain English, this means that when volatility picks up, these investment funds become forced sellers.

This matters because some of the largest funds in the world follow risk-parity strategies (Ray Dalio’s Bridgewater being one, clocking in at $100 billion+ of assets under management), which, during most of the last decade, when volatility was abnormally low, meant that they spent most of their time in the market as net buyers. But this has started to change since COVID-19, and it has surely continued into this year, with higher volatility forcing these funds to continue to sell assets.

Bond volatility is now approaching the levels experienced in March 2020. The key difference between then and now is that:

• In 2020 the central banks responded to market weakness with rate cuts and massive QE (buying up assets and expanding their balance sheets).

• Today they have just embarked on rate hikes and QT (balance sheet contraction).

Actions by the Fed could increase cross-asset volatility even further, thus maintaining the downward pressure on risk assets, instead of reverting it like in 2020.

This year has experienced one of the worst combined drawdowns for equity and bonds (i.e. buying the dip has so far been fruitless as the market continues to move lower). Other typical safe havens such as the Japanese Yen and Gold have provided little (Gold) or no (Yen) protection.

Given this tricky background and policy response, what should investors do?

Clearly, that depends on current positioning and investment objectives, but it may be time to go against the grain.

Technology

There has already been a significant re-rating in technology stocks. The longer-duration names with stable balance sheets that generate tons of free cash flow are likely to continue to be the dominant companies of the future. We all know that recessions eventually pass and, whilst downside risks remain, the current price action might be the first time in many years where tech valuations begin to allow less speculative investors to find enough upside without relying on overly optimistic assumptions in their financial models. (This is of course assuming that tech investors have been using financial models and not throwing darts blindfolded at a wall of logos that a McKinsey analyst recommended based on the firm’s 2050 TAM forecasts.)

This doesn’t mean YOLO’ing into beaten down stocks right now, but for longer term investors who can withstand a couple of years of volatility, averaging in over an extended period can also hedge against a couple of outcomes:

• A recession could seriously damage cyclical stocks like the commodity names (see below) and

• The Fed may switch to a more accommodative (tech-friendly) stance (fewer interest rate hikes) if it’s clear that weaker growth has lowered the inflationary risks, or if it becomes clear that inflation has peaked.

Commodity Stocks

The structural tailwinds for commodity stocks are powerful. There’s been severe underinvestment since the energy bust in 2014 in favour of greener investments, but lately, we’ve all finally come to realize how renewables are not yet ready to overtake oil and gas, and that the same energy transition will drive demand for many raw materials well into the future to power the technologies involved in the vision for a greener future.

However, in a recession, these generally become high beta stocks (high beta stocks are more sensitive to market movements up or down) that get hit hard in correlation events. Whilst this doesn’t alter the longer-term outlook, investors still need to be aware of the short-term downside potential in these commodities names, especially after a very good run.

Investors could lock in some profits by selling stock but remain partially invested by rolling some of the proceeds into a long call position (called ‘cashing out’ or ‘stock replacement’ strategies). Some of this dry powder could then be used to buy back into the higher quality tech names.

Fading Rates

Whilst the Fed still has a lot of tightening to do, the market may not. US two-year yields have already priced a significant amount of tightening. For investors, market expectations are often more important than the Fed’s actions. (A bit nuanced, but this is the game being played between the market and the Fed. The Fed signals what they ‘plan’ to do to see how the market reacts, but the market reacts based not necessarily on what the Fed says they’re planning to do, but on what they believe the Fed WILL do, which is rarely the same as what they say. Additionally, market participants must guess what other investors are going to do, based on the same guidance from the Fed, but possibly interpreted differently by the full universe of investors. And yes, if this sounds like The Wager scene from The Princess Bride that’s because it is and if you don’t get this reference kindly unsubscribe from our publication… 😉)

If the Fed now tightens aggressively (debating whether to hike by 50 basis points rather than 75 basis points is NOT a dovish outcome) and the economy starts to suffer, then investors might pare back their expectations for the magnitude of interest rate hikes. This would show up in yields for medium to longer-dated maturities starting to roll over (come down).

Eurodollar futures are futures contracts for interbank funding (the rates that banks lend to each other for overnight liquidity needs) and generally follow the expectations for rate hikes and cuts. The Jun 2023 future is implying a funding rate of 3.6% (100 minus the futures level, which is 96.4 in the chart below).

If the market begins to believe that 3.6% by mid-2023 is too far too fast, these futures should rally (up from the current reading of 96.4 on the chart above). Alternatively, investors can buy call options on the Eurodollar future (though these are professional markets where the notional size of one Eurodollar contract is $1,000,000). Yes, buying call options on futures contracts pricing overnight funding rates in 2023… and we wonder why people sometimes refer to the markets as glorified gambling.

Long-dated yields should also fall if we are heading into a recession (and once the rules-based funds discussed above have completed their deleveraging). Therefore, calls on the 20+ year maturity US Government Bond ETF, ticker symbol TLT, might be an alternative way to position for an economic slowdown. In a recession, long-dated yields go down causing bond prices (TLT) to go up.

The reversal in bond prices has not happened yet, but inflation and yields have fallen in all but one recession since the 1960s (in 1974, they also fell, but not to the level they were when the recession began).

A recession has not begun yet, but the Fed is tightening, and risk assets are reacting. If a recession arrives, many of the consensus trades will reverse and investors should start to anticipate that scenario by diversifying exposure into some of the recent losers and taking profits on the recent winners.

Thanks for reading through!

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