Interest Rates, Bubble Bonds, and Stock Market Hope – May The Odds Be Ever in Your Favor

Interest Rates, Bubble Bonds, and Stock Market Hope – May The Odds Be Ever in Your Favor

by Jeffrey Miller, Partner, Eight Bridges Capital Management
October 19th, 2016

President Snow:  Seneca… why do you think we have a winner?
Seneca Crane:  What do you mean?
President Snow: I mean, why do we have a winner? I mean, if we just wanted to intimidate the districts, why not round up twenty-four of them at random and execute them all at once? Be a lot faster.
[Seneca just stares, confused]
President Snow:  Hope.
Seneca Crane:  Hope?
President Snow:  Hope. It is the only thing stronger than fear. A little hope is effective. A lot of hope is dangerous. A spark is fine, as long as it’s contained.
Seneca Crane:  So…?
President Snow:  So, CONTAIN it.
The Hunger Games, 2012

Just like President Snow, I think Chairwoman Yellen is playing a dangerous game with investors, giving them just a little bit of hope that someday monetary policy will normalize, that Fed Funds rates won’t be stuck right near zero forever. But a lot of hope, a real conviction that the Fed was going to embark on a hiking cycle, would be dangerous for financial markets, in particular bonds of all kinds, which are trading at levels that assume that the Fed never really will follow through. Hope has been contained. For now.

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But what would happen to bond markets if that hope turned into conviction that the Fed was really going to raise, or, even more dangerous (and much more likely), that credit spreads were going to widen?  Then we’d see massive losses in bonds, in particular high yield CCC bonds, which are currently performing poorly from a credit perspective but doing very well from a price perspective.

Effie Trinket: Happy Hunger Games, and may the odds be ever in your favor.
          The Hunger Games, 2012


Right now, if you are long high yield bonds, the odds of making a decent return going forward are definitely not in your favor.  Credit spreads are tight, and they are tight to an ultra-low risk-free rate. Not a good combination. At the same time, the fundamentals of the companies that issued those bonds are deteriorating, and the market for new issuance of high yield bonds is drying up. If you own a high-yield ETF today, you are making the bet that these spreads will tighten further, which is really a bet that the underlying fundamentals of these companies will get better not worse.  Seven or eight years into a recovery, when corporate earnings have been down for 5 quarters in a row, do you really think the odds are still in your favor?

Effie Trinket: Two hundred miles per hour and you can barely feel a thing. I think it’s one of the wonderful things about this opportunity, that even though you’re here and even though it’s just for a little while, you get to enjoy all of this.
            The Hunger Games, 2012

In many past letters I remarked that currents were shifting beneath the surface of what appeared to be a calm stock market. In particular, I repeatedly stated that banks were a buy and utilities and staples were a sell.  That trade has pretty much worked. As a result, I have cut my short position in utilities by 2/3, and have pared back my longs in banks.  Why?  Because those trades have worked on the back of the Federal Reserve providing some small rays of hope that they will raise their target for the Fed Funds rate in December. At the same time, other central banks (Japan in particular) are now indicating that they would like to see their yield curves steepen, which would help bank earnings and hurt the case for owning low-growth, expensive stocks just for the yield.  From July 8th through October 12th, Utilities and Telecoms fell more than 9% while Financials increased nearly 5% and Tech stocks nearly 10%.  The S&P 500 overall?  Up 0.50%.
Chart from Bespoke Investment Group, LLC
Haymitch Abernathy: Embrace the probability of your imminent death, and know in your heart that there’s nothing I can do to save you.
          The Hunger Games, 2012

This next part could have easily gone off on many tangents, but in the interest of brevity and clarity I cut about 90% of it.  The short version: prepare your portfolio for some increasing volatility.  Many ill-informed pundits have taken the recent absence of volatility to mean that it is gone for good. But many smart investors, like Tepper and Gundlach and Druckenmiller, who are paid to protect their clients’ money against large drawdowns are forgoing returns today (and incurring hedging costs to boot) in order to protect against an anticipated pickup in extreme events in the future.  Why?  Because they know that a financial market structure that is predicated on the inputs to the valuation models never changing in an adverse way is a market that cannot be saved forever. What the Fed and other central banks have tried to do by keeping rates at zero (or negative) for so long is to postpone the revaluation of risk-assets lower to compensate for the deterioration in the underlying earning power of the assets. That’s it. All they have been trying to do is keep asset prices up so that the owners of those assets (banks, pension plans, investors, etc.) don’t have to realize losses.  They have been playing a game of kick the can down the road.  But what if the game stops?  What if they can no longer delay the repricing?  What if, in other words, you shorten the time frame between repricing events but keep the overall price movement the same, instead of artificially elongating it?  Well then you get massively increased volatility, much beyond what standard Gaussian models would predict.  You get a market that displays characteristics of what Mandelbrot called “fractional Brownian motion in multifractal trading time,” and the more you shorten the time frame over which the market move occurs, the more volatile the market becomes.  And when that happens, you get market crashes.  So you can either embrace the probability of the imminent death of the bond market, or else there is nothing I can do to save you (well, your portfolio anyway).

Seneca Crane: Everyone likes an underdog.
President Snow: I don’t.
          The Hunger Games, 2012

The bond market is, probabilistically speaking, an underdog to perform well over the next 2-3 years. Unfortunately for primarily stock investors like myself, the stock market has become inextricably tied to the bond market.  As a result, I’m still positioned more defensively than I have been since 2007, with my stock positions net neutral and an overlay of options to take advantage of any sell-offs.  While the Fed may well be able keep a little hope alive that it will only very gradually raise interest rates, if investors begin to hope for more, to hope that the yield curve will normalize and steepen someday, then things may get dangerous. In that scenario, I wouldn’t want to bet on the underdog.
This week’s Trading Rules:

  • Bet on the underdog in football, not in financial markets.
  • Hope is not an investment strategy.

SPY Trading Levels:
Resistance: 214, a lot at 215/216, then 218.
Support: 212/213, then 210, 205, and a little at 200.  Not much below that.
Positions: Net neutral stocks (both long and short stocks). Short XLU, SPY, XLP, and BWX. Long options on SPY, KRE, XLF.


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