With One Headlight!

The image this song evokes (for me) is someone driving on a desolate country road, late at night, white knuckling as they try to get their beat up truck to someone or something, having just had a fight with someone.

I cannot think of better imagery for this market.

We got the rise in yields we were looking for, but equities had barely responded until just recently.

Since February 7^th, the S&P is up just over 1%. I’m sure I missed a couple of “all-time high” closes on this simple chart and a number of intraday “all-time highs.” Yet, April has not been kind to stocks and the past 4 days have been relatively brutal.

So as a bear, I find myself gripping the steering wheel, trying to figure out if we can drive it home (which for me is a 5% to 10% rapid decline). We weren’t full on bear for the entire ride, but close enough that I still have some work today. Even this current pullback hasn’t met 5%, let alone 10%.

So, do I keep driving, or do I slam on the brakes, get out of this beat up truck, and hope for the best?

Well, in keeping with the song, Me and Cinderella, we put it all together, we can drive it home, with one headlight!

That is a long way of saying that I think the recent selling pressure is just the beginning of a larger move.

• Yields are high and staying stubbornly high.
  • My current base case of 2 cuts for the year, in June and July, seems more like a combination of stubbornness and being too lazy to update than anything rational. It is the first time since last year that I had more cuts than are being priced in by the market. I probably should dial it back, but I remain adamant that it will cause the Fed an immense amount of grief in D.C. if they cut in September or November (right into the meat of the election). With that in mind, I’m clinging to the 2 cuts, in June and July, but barely. Oh, I do expect that we will also get one or two prints that show inflation is declining again.
  • The curve is finally responding, at least a little bit. We seem to have found support around -45 on 2s vs 10s and I expect that we will get back towards -20, which we saw in October when 10s hit 5%. We will start getting back some risk premium in the curve and that will not help equities.
  • As we’ve been saying during this entire Treasury sell-off, none of the issues that pushed us to 5% on 10s have been resolved (no China buying, huge deficits, ever increasing supply outlook, etc.).
• AI valuations seem questionable.
  • Yes, AI is transformational. But labelling everything that is machine learning, or even basic programming, as “AI” isn’t transformational. The number of things that come with some sort of an “AI” claim that are in fact something much simpler has reached a crescendo. The benefits, given current levels of AI, are not where AI ultimately will be, so why are we pricing in so much? I’m not alone in finding my use of many AI systems has declined as I found mistakes and realized that my knowledge didn’t expand when I used AI the way it does when I do the research myself.
  • Then there is the cost side. No matter how rapidly AI is improving, it seems difficult to believe that it is outpacing the cost of implementing AI solutions. From chips to data centers, to not just the cost of power, but also the availability of reliable power sources, the costs have risen rapidly. Is it plausible that the cost/benefit equation isn’t that appealing at the moment? Or, at least not as appealing as the market currently is pricing in?
  • It is possible that I’m just old, stubborn, and stuck in my ways, but I hate the concept of NVDL. I have no idea why we need leveraged ETFs on single stocks. The following rant is probably longer than it deserves to be, but I couldn’t help myself. The bottom line is this to me represents excess which I think will be squeezed out of the market before this pullback is over. I am not sure any company actually wants leveraged ETFs (and even inverse ETFs) on their stocks as it takes us so far away from the concept of capital created “under the buttonwood tree.”
    • Leverage can be created using a margin account, so what investor base is this appealing to? Those with too little money or sophistication to use margin, that just need 2x the daily returns?
    • Let’s not for a moment forget that leveraged ETFs are path dependent. Every time a stock bounces around, the leveraged ETF doesn’t match the total return multiplied by 2 from the original investment date. These are at best designed to be trading vehicles, but the share count here grew rapidly starting in early March, and while there have been some outflows, this is still a $1.6 billion ETF (charging 1.15%).
    • Finally, while the ETF is tiny in comparison to the underlying company, it does add some extra noise to the end of each day as it needs to be rebalanced.
  • We finally see some cracks on the AI and/or chip front during earnings calls. ASML, still up 28% from early January, dropped 7% yesterday on their results and outlook. TSMC countered overnight with what was portrayed as positive results, but the stock is moderately lower in pre-market trading and even the Nasdaq futures are up only about a ¼%. We “complained” in prior T-Reports that we were rallying on the same news over and over again, but that seems to be over, which won’t help the bulls.
• The Economy. “No Bounce” and “American Exceptionalism” are now so consensus that any slowdown in consumer spending, or signs that higher rates are finally taking their toll, will hit risk markets meaningfully (much has been masked by the rise of AI, just ask the Russell 2000, which is negative on the year).
• Credit weakness. It is all relative as spreads are quite tight and even high yield, which has had to bear the brunt of the selling pressure, is strong by longer-term historical standards. But, we have seen some fissures highlighting the “faux liquidity” of this market. There is enough liquidity on dealer desks that along with ETFs, algos, and portfolio trading, they can accommodate the shifting of risk. What remains unclear (and may yet get tested) is if that sort of liquidity is anywhere near to being big enough to handle an actual rebalancing to reduce credit exposure. I don’t think so, which will continue to put pressure on spreads. So far, when I look at ETFs like HYG, JNK, and LQD, I’m seeing few, if any, signs of investors “buying the DIP” in credit.
• Made By China. It seems that at least one major financial publication has a story about Chinese EV makers and their ability to sell cars cheaper than manufacturers here and in Europe. With less frequency we hear about their cell phones and tech in that area, but those stories are out there. I am still fixated (possibly irrationally) by TEMU and SHEIN. As Chinese brands compete, mostly in China, but increasingly in Emerging Markets and even some segments of European and U.S. markets, there will be margin pressure. Margin pressure that single stock analysts seem oblivious to, which is maybe where the macro can be helpful. After decades of outsourcing manufacturing to China it should come as no surprise that they are good at manufacturing for their own brands. Whether politically correct or not, I think it is safe to say that Chinese brands spent less on R&D than major international brands for a “variety” of reasons. Please see The Threat of Made By China 2025 if you have not yet read it!

We’ve seen a lot of technical analysis that supports a larger pullback.

I didn’t even mention Geopolitical Risk as a further catalyst for stocks to recede, but that remains on my list. We cover much of this in last weekend’s Geopolitical Risk – Hedging the Unhedgeable.

A Heart Warming Story

Even I’m feeling bleak, so let’s get back to the Wallflowers, or at least Jakob Dylan. Back when Nashville was still Nashville and not NashVegas, some friends and I hit a “live music” bar. Back then (let’s call it the early 90s) it was more difficult to find live music than you would think, especially if you’ve been to NashVegas in the past few years. I think the place was called Gilley’s (I think it was more than just a take on Urban Cowboy, but that is all vague now, and not important).

We were listening to music (presumably with a long neck Bud in hand). To be honest, it seemed ordinary at best, but then someone noticed that the table in front of the stage was occupied by a single person – Bob Dylan. He was there to watch his son perform. What I will remember from that night, forever, is that no one bothered Bob. This legend was there, at some mediocre place, on a weeknight (we had time to kill in B-school) and people left him alone, because he was there to watch and support his son. Yes, whenever he finished his drink, someone would place another down for him. He would acknowledge it, but there wasn’t a long discussion. No need for selfies (they weren’t even possible back then), but you get my point. I thought it was amazing that people had the self-control to let this legend simply be a father, and to me, it is a reminder of how good we can be as humans.

Maybe I needed something positive to dwell on, with everything going on in this world ☹.

Bottom Line

Back to business.

• Bearish at the long end of rates, neutral at the front end. Think we can push back towards 5% on 10s, well above previous ranges, as positioning and liquidity are not helping anything in this market.
• Credit should be less susceptible to spread widening (or price declines in high yield and leveraged loans) based on fundamentals, but I think we will test demand for liquidity versus availability (the image of an eye dropper being used to suck up water from a fire hose comes to mind). Look for more credit weakness. 65 to 70 is my target on CDX IG.
• Bearish on equities and would look for this move that began last week to get closer to 10%. This is the market that I’ve been fighting and I lost a headlight, but think I can get us there with one headlight!

In the end, geopolitical risk was the initial catalyst for weakness in risk markets (credit and equities), but the issues testing the market have moved well beyond that.

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