State Of The Markets - What I see 😎
I spend quite a bit of time on the r/bonds subreddit. I love it because it’s a place where you can learn a lot and be challenged by people who really know what they’re talking about. Since I enjoy discussing how the bond market can be used as a risk barometer, I was recently prompted to give my general take on the state of the markets. It felt a bit like a checkmate; I was surprised that people wanted to hear my take. If they knew what a novice I was, they might think otherwise. Regardless, I don’t like letting people down, so I took my time to craft an answer. I want to share that same logic here, as a few people in my circle have asked what I’m doing at the moment.
What I’m doing right now can be broadly described as a "conservative approach." If you know me, you’ll know I was fearless in 2021 when I first began putting money into the markets. Of course, I quickly learned a lesson that I’ve vowed never to repeat. I entered the market at the exact moment many were exiting, and when you stay in while everyone else is running for the exit, you end up holding an empty bag. If you know me, you know I like to correct mistakes and make things right. So, while I remain fearless, I’m more cautious today because I understand why I experienced what I did back then. It’s been a fulfilling journey; fitting the pieces of this puzzle together makes more sense as time goes by. That being said, let me walk you through the indicators I’m using to gauge the broader market.
I wrote a blog about "yields" on April 13th yields, and I have to say, one of the most important tools I have come to appreciate is what is known as the yield curve (fig. 1). This is the US yield curve, and why we're using this will become apparent in the next paragraphs.
Fig. 2: Different Shapes of the Yield Curve
There're situations where interest on, say, the 2-Year debt becomes higher than on the 30-Year debt. This is not a normal situation and signals something is off. This is where I talk about one topic you hear me talk a lot about. Investors in the market of lending money, and every serious market participant, are always concerned about Inflation. I have talked about this a lot, and there's no need to go into it again. When investors think inflation is going to be a problem, as it always is, they begin to demand more interest on lending money for the long term. When they think a country's central bank is going to fight inflation (usually by raising interest rates on 1-month, 2-month, 3-month, and short-term debt), they move money into short-term debt to benefit from the government paying them high rates. Okay, pause here as this needs more clarification. The idea here is that investors are always seeking profits, and life in general shows everyone is always seeking what is best for them, and this is no different from the market.
Borrowed money with an expected interest payment is usually a guaranteed profit, or should I say RISK-FREE investment, especially if the person you're lending to is the US government. That is because the US government is someone you can always trust to pay you back with the interest they promise. Why the US government is trusted this much compared to all other nations should be clear from my last blog postUSA. It's risk-free. And because raising rates on the shorter term debt becomes more attractive, banks, institutions, and many other entities like this idea of risk-free profits, and thus, they all rush to lend their money to the government. This causes less money to be available for other parts of the economy that are necessary for economic functions. Sometimes, it's really not about the central bank raising interest rates on short-term debt but due to so much investment that doesn't make sense. For example, in 2008, there was so much investment in real estate that was fundamentally wrong. In 2020, the economy was on lockdown, yet the governments printed so much money that we had few goods being produced with more money chasing them, leading to irregularities in the markets. So, investors in the debt markets are so smart that they move before many central banks start thinking about addressing the problems they see. When investors flock to shorter-term debts, they're fleeing risk and thus cause economic stagnation. In a nutshell, this is called a liquidity crisis as money is sucked out of the economy, leading to a reluctance to spend. These are situations we have seen again and again. The yield curve is one of the best standalone indicators that can be used to pick up on these situations and help guide anyone. Of course, I don't just use it alone but combine it with other indicators.
This is becoming a long post but very necessary for me to pass my point across. Overall, the curve is normal and this shows things are normal. However, we have to identify other things like AI spending, the US debt, which just reached $40 trillion, and inflation, which remains around 3.5% yearly. Unemployment is relatively low at 4.2% and the overall US bond market hasn't really signaled that we should panic. Meanwhile, any self-thinking person in 2020 would have seen that something was wrong with the way money printing was happening, so there should have been many who saw what was happening in 2008 when banks were signing mortgages to even people who could not pay back the monthly payments. In a nutshell, there were serious issues, and to make things worse, interest rates leading up to that crash surged higher at the short end due to the US central bank trying to subdue inflation in the 2000s. Though it was not very apparent at the time, the Fed (US central bank) had already raised rates at the short end to slow the economy, and those still reckless in 2007-2008 felt the pain. Look at the yield curve in Fig. 3, which shows yields in 2006 were higher in the short term than in the long term, indicating that something had deviated from the norm.
Fig 3. US yield Curve 2006
We have had such situations as in Fig. 3 in the 2020s, but many solely focused on the yield curve have taken a negative view and this has cost them a lot as the markets have kept making higher highs, especially as many have begun spending so much on the new AI technology. I came to understand that, as many rushed out of the markets, the Fed began moving into the markets to inject money/liquidity.
Fig. 4. FED Cash Injections Into The System. (CC. Dominik Nordmann, CFA, CAIA)
That's to say, the Fed has been actively stepping into the markets, buying debt issued by the governments and some mortgages, and thereby ensuring the crisis we saw in 2008 and 2020 doesn't happen. This has meant that many who relied heavily on just the yield curve have been dead wrong and have sat out of the markets in anticipation of another 2008 or 2020, with markets selling off. The bond market has also tried to signal this but has been priced out due to the Fed's continuous buying or cash injection into the economy as shown in Fig. 4. Is this the new normal? I very much doubt it because at the moment, we have a new Fed that is signaling they may be inclined to not support the economy in this manner (with talks of balance sheet reductions). So you see, I have a lot of things I'm considering and thus acting with caution especially as we witness a new revolution in AI. This is like the steam engine, the printing press, railroads, washing machines, computers and the internet. All these technologies led to significant changes for our world but a similar thing is seen in all; many go in hoping to win big. This over-indulgence leads to unjustified spending, leading to growth without foundations and ultimately corrections. AI is no different but at some point, it's going to happen.
Let's wrap this up in this paragraph with what I'm seeing. Having laid a few fundamental foundations, I need to say what I said to those prompters from Reddit. I said the yield curve is normal, indicating somewhat normal conditions even though the differences in interest rates among the different debts are quite tight, signaling something can easily tilt the curve thus necessitating caution. However, though markets have continued to make all-time highs, we have to look at specific sectors of industries. Even though the broad market index like the S&P 500 has kept making new highs, some companies within and even giants like Microsoft have seen declines of -32% from their peaks. Some companies like Nvidia have tapped the debt markets hoping to raise $25 billion in debt and ended up seeing investors willing to hand them more than $80 billion. At the same time, Amazon has gone into the debt markets and struggled to borrow what they needed. Also, even the US treasury is having poor performance borrowing too. So there's reason for caution, and even though I continue to invest cautiously, I do admit that a lot doesn't make sense and caution is warranted. Finally, I said, if there's one thing I have learned, it is that time in the markets beats timing the market. Though I invest cautiously, the bond market is my risk barometer and tells me when to invest a big amount while continuing to invest small and consistently. It doesn't matter the ups and downs as with time (5 - 10 years), the odds are in one's favor as opposed to acting on monthly timeframes. Also, I found that the risk-free return provided by the bond market and even the average annual return of about 10% provided by broader market indices are usually not surpassed by active fund managers. So I will stick to time and target the market beta.
That being said, I routinely study companies that have sunk significantly from their highs then ask; does this company have good financial health? Do they have active products or services that customers are demanding? It is that simple and this is how I approach these markets now while holding the view that staying in cash is also a good place to be.
Thank you for not timing the markets.
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