Andy Krieger's Thoughts on the Market - 27 September 2023

In my August update, I outlined a broad macroeconomic forecast which, for the most part, I still like. First and foremost, I warned of a sharp spike higher in the 30-year US treasury interest rates. This is playing out pretty much as expected. Rates have shot up from 4.16% to 4.78%, nearly a 15% move, and the bonds trade like there is still more to come. I wrote that we might see the yield reach 5.3%, and I stick with that call.

I also warned that the stock markets were nearing a significant top, and they are now showing some serious signs of cracking. The Nasdaq has dropped about 8.7% from the recent highs in July, and it feels like this could be the start of something much bigger. For the first time all year, both good news and bad news are leading to stock market weakness. This is pretty much what I was anticipating, and I see no reason this paradigm can’t continue.

One of the basic principles which I have followed for the past 30+ years is that with regard to markets, history doesn’t repeat itself, but it does rhyme. What does this mean? It means I don’t look for market movements to perfectly replicate themselves over time, but I do expect certain similar patterns and relationships to emerge. This can manifest in lots of ways. Sometimes we see a market re-testing prior highs and lows that may have been set decades earlier. Even if the traders don’t recall certain levels, the markets have a type of built-in memory.

Other times, the general relationships between various markets will shift and adapt, but suddenly, prior relationships will play out in surprising ways. I can go into long philosophical reasons for this, but let’s just keep it simple. Patterns often play out in similar ways because ultimately people drive markets, and people haven’t really changed all the much. As a species, there are certain patterns that recur. There is often a type of herd mentality, plus we are often driven by fear and greed. It is this combination that leads to the building up of massive bubbles, with massive overvaluation and undervaluation.

Fear is a funny animal. Sometimes it drives us to give up on the right positions just before the market is about to start going our way. We hit our maximum pain thresholds and bail out at precisely the worst time. Other times it leads to insane overvaluations as the fear of missing out drives people to chase prices higher and higher – or lower and lower. At the end of every major bear and bull market there will always be many people who are left stranded; people who buy the top because they just can’t stand the pain of missing out on a great money-making opportunity, or people who bail out at the bottom because they can’t shake the fear of losing even more money if the market decline were to continue. Looked at on a collective basis, we see this mentality driving markets way beyond sensible valuations.

If the fundamentals continue to play out as expected, we should see a continuation of market weakness over the coming weeks and months. In fact, we should see an acceleration to the downside. So far, the equity markets have managed to shake off the effect of a five hundred and fifty basis point rise in interest rates, but I think the recent action in the bond market is working as an alarm clock, alerting people to the reality that things really have changed. To me, it is astonishing to see how sanguine the markets have been. Higher rates are certainly digging into home sales, as many prospective buyers are struggling to afford dwellings due to mortgage rates having jumped all the way to 7.5%, but consumer spending has remained surprisingly strong.

Is the housing market overvalued? In some areas, it is extremely overvalued. In Miami and along the east coast of Florida, the huge influx of people since the onset of covid has created a distortion in housing values. This is a simple example of too many buyers chasing over too few goods. The end result is simple – prices go up. In this case, they have gone up a lot!!

Do I expect the housing markets in Miami, Palm Beach, and Boca Raton to crater? Not really. We will see some price adjustments lower, but probably not a dramatic sell-off. The buyers who moved to Florida from the northeast, for the most part, are overall too strong, and they are not feeling any particular pressure to sell. Can we see another 10% or 20% downward price adjustment? Sure, but I don’t expect a rout.

Other markets scattered across the country are also overvalued. Places like Phoenix, Austin, Las Vegas, and others are overvalued by more than 60% according to a few studies I have seen. Will they correct down as well? Yes, but the big moves I am anticipating are not so much in real estate as in stocks, fixed income, currencies, and commodities.

Last month I also wrote about the oil market getting primed for a surge higher. This has happened, with oil prices having exploded higher by 16%. This move is complicating the Fed’s troubles, as energy prices could easily derail the Fed’s fantasy of a straight-line decline to an annualized rate of 2% inflation. Energy prices will continue to play an important role in Fed policy going forward, so we need to watch that market closely.

Moving to the currencies, I have been bearish on the yen crosses as I have been anticipating a massive flight to safety due to strains in the global financial system. Those trades are starting to work well, but largely because the dollar’s strength against the British pound, the euro, the Aussie, and Swiss franc has dominated the rise of the dollar against the yen. I believe strongly that the yen’s strength on the crosses will eventually be enormous, with the crosses reaching shocking downside levels, but we are not quite ready for that. Once the dollar finally tops out against the yen, these moves will accelerate.

In the short term, the dollar is a bit over-extended, so we should expect several weeks of corrective, choppy action, but there is a good chance that the dollar will then resume its climb against most major currencies. This, however, is not the major story. There are far more exciting things on the horizon.

In a strange way, the general calm in the stock market, and the optimism in the face of sharply rising interest rates reminds me somewhat of 2007. At that time, interest rates in the 30-year treasuries were trading around 5.3%. Stocks had been climbing steadily higher for years, and many Wall Street analysts were forecasting the end of the business cycle. The story of mortgage-backed securities, however, brought that fantasy to a violent end.

Mortgage-backed securities told us the story of Wall Street geniuses, who had decided that a portfolio of garbage would legitimately warrant a triple-A rating as long as the portfolio had enough varieties of garbage. The story also told us about greed, as these analysts claimed that the magic of diversification would yield the magical result of triple-A status because they convinced a lot of otherwise intelligent people that they really could create a silk purse out of a sow’s ear.

There were hundreds of billions of dollars of this junk that was sold all over the world. When the world woke up to this illusion, the results were catastrophic. Banks around the world got slammed, investors got crushed, and suddenly interest rates were a lot, lot lower. In a few short months, the stock market dropped by nearly 60%. Ah, the beauty of herd mentality!

When the fantasy ended, the markets brought the entire global financial system to the brink of collapse. Emergency lending measures, forced takeovers of banks, stock markets cratering, and a collapsing dollar told us pretty much everything we needed to know about the strategy of the Wall Street geniuses.

At that point, the yen’s strength really played out in two phases. The initial phase was a violent dollar sell-off against pretty much every major currency, with the yen leading the way. The second phase involved a massive unwind of yen crosses as the yen continued to explode higher while nearly every other currency crashed against the dollar. Do I foresee something like this playing out in the current environment? With some variations, it is quite plausible, but with a twist. The current environment is still very dollar constructive, as the U.S. labor market remains tight, consumers remain quite strong, and the Fed will almost certainly need to keep rates higher for longer than nearly anyone expected…until things crack.

The yen’s initial relative strengthening has been relatively modest, as the dollar is still appreciating against all the currencies, including the yen. It is just strengthening faster against other currencies than the yen because the yen is nearing some critical levels that are likely to trigger some aggressive intervention by the Bank of Japan.

I view this part of the trade as the foreshadowing of a major shift. My hunch is that a move towards 5.3% in the 30-year bonds will be the final straw that breaks the back of the stock market. There are many things which could drive interest rates up towards my target. Some of these things are associated with uglier consequences than others. A government shutdown coupled with a further jump in oil prices would be particularly unpleasant, but a host of other triggers could also do the trick. Frankly, a simple technical move that forces progressively heavier amounts of hedging by big portfolio managers could be sufficient. Remember, markets love to keep extending to levels that don’t make sense as they force more and more participation along the way. Many managers still ascribe to the soft-landing fantasy, and they really seem surprised – and worried -- that the Fed has given no signals that it is truly ready to stop hiking rates, let alone start cutting rates any time soon. They need to adjust their portfolios and their hedging strategies, and that alone could force another 10% or 11% move in the bond market.

It is the next phase of the move that will get very interesting. That is the phase when the stock markets start to crack in earnest, breaking down hard. Inflationary pressures will remain sticky, as the labor market is still tight and oil prices are high. The cost of money is high, and that will likewise fuel more price hikes as companies struggle to maintain their profit margins in the face of higher financing costs. This limits the flexibility of the authorities to address what will be a softening economy. In fact, this is the most dangerous time for the Fed. The consumer will finally feel the squeeze and be forced to cut back. Plus, the consumer is already starting to max out on credit. The labor market will start to soften – finally – but the authorities will be handcuffed.

This is when the dollar finally tops out against the yen, and Japanese investors start to aggressively unwind chunks of their multi-trillion-dollar and euro-denominated overseas holdings. The dollar’s decline against the yen would be vicious in this sort of scenario. The last major decline from 151.80 down to 126.20 would look tame compared to what might come next. If this scenario plays out, then it would unfortunately be a very, very difficult environment to navigate.

Chaos is rarely good for the small investor, and we could easily have chaotic conditions for quite a while. The Russians and the rest of the BRICS countries would welcome this environment, and they would not be accommodating with any increases in their oil production. If anything, they want to squeeze the U.S., and Europe further, to finally break the hegemony of the U.S. and the dollar.

Without delving into this macro scenario too deeply, let me point out a positive aspect to this somewhat ugly scenario. We are likely heading into the best macro trading markets of the past forty years, and as traders, we should be well-positioned to earn astonishing returns on our capital. In 2007 and 2008 we generated net returns in excess of 380%, and I think we could have markets that offer even better opportunities than we had during that period.

In the meanwhile, I wish you all good luck.

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