It was an ugly week in both the bond and stock markets.

Headlines Did Their Part to Keep Investors in a Selling Mood

Geopolitical risk continued to rule the markets. Uncertainty in the economy, given worldwide distractions, was the theme of the week. Tensions intensified between Israel and Gaza. The Biden Administration asked for $100 billion in emergency funds to address humanitarian aid in Gaza, Ukraine, domestic border funding, and disaster aid for the next 12 months.

Inflation fears persisted and continue to do so. Interest rates hit their highest levels in more than a decade and a half. And then there was the renewed conversation that we are headed for a drastic economic slowdown and a possible recession.

The Fed Chairman Likes Bond Prices Falling (Yields Rising)

On Thursday, Oct. 19, Jerome Powell said the recent rise in longer-term bond yields is tightening financial conditions as the central bank wants, and this could mean there is less need for the Fed to increase rates further.

"It doesn't seem to be principally about expectations of us doing more," Powell told the Economic Club of New York. It looks to be mainly an effect of higher so-called term premiums, he said, and does not reflect expectations for higher inflation. He added that he is "not blessing any particular level" of longer-term rates.

Here is an additional summary of what Chairman Powell stated this past week:

1. “Additional evidence” of a strong economy may merit more rate hikes.
2. A return to 2% inflation will require below-trend growth.
3. He is committed to “sufficiently restrictive policy.”
4. “May still be meaningful tightening in the pipeline.”
5. Summer inflation data was promising, but September was less encouraging.

Surprisingly, the Fed is staying committed to their 2% inflation target. We think that is not only unlikely, but soon they may alter this path and announce the new normal is closer to 3%.

With or without Jerome Powell speaking, the bond market has clearly had a “mind of its own.” After spending much of 2023 at or below 4% on the 10-year Treasury bond market, yields have exploded higher.

You may recall a column we wrote back in the summer suggesting that if the 10-year broke 4.35% on yields, we thought you could see 5%. I received some pushback from that article, as a few friends and our valuable readers suggested that bond rates wouldn’t get that high. We recently hit 4.99%. And we may not be done. See chart below of the rise in yields since May of this year.

For long-time readers who have followed several of our investment strategies, you will certainly be aware of how good our historical TLT trades have been, especially as recently as 2020 when we moved from stocks to TLT.

TLT is an ETF that gives an investor exposure to the 20-year Treasury Bond. Recently, the ETF hit a new low on price action. Mish was mentioning to me the other day that so many people were recommending TLT as a good trade over the past few weeks. She went on several TV programs to try and stop that silliness. So far, it has been a bad trade, unless of course, you were short. See chart of the TLT ETF price action below:

“Inflation Will Be Sticky and Stay Elevated for Longer"

Those have been Mish’s comments for over two years. I guess one had to live through the 70’s and 80’s to understand this concept more clearly.

One way to evaluate the long-term cycle of inflation (unless, of course, you go to the grocery store or eat meals out at restaurants) is to divide TIPS (Treasury Indexed Protected Securities-which track the rate of inflation) by IEF (the 1-3 year Treasury ETF). The results show inflation winning out. See chart below:

No surprise, this week the 2-year and 10-year treasury rates closed at the highest yields since 2006/2007. See chart below:

Why are Interest Rates Continuing to Go Up?

With economic softening, geopolitical risk, and overwhelming debt, why would rates be going up further?

It is all about supply and demand. The US government has a problem. We have significant debts that need to be financed. To do that, typically, the US government holds Treasury Auctions and issues more debt. Over the years, buyers, including banks, brokerage firms, large pension funds, and sovereign overseas funds, have enthusiastically lined up to purchase as much of the notes and bonds as they could get. Not any more.

The Fed is dumping bonds from their own balance sheet (Quantitative Tightening) to try and tighten rates and curb inflation. China, once our biggest buyer of debt, is not only avoiding purchasing new US debt, but is flooding the market with old debt as they want to lighten their US holdings. Sovereign wealth funds no longer think our debt is attractive and credit worthy.

Therefore, there is huge supply and lessening demand. That drives up the yield (as the bond price goes down) at auction. This is happening over and over. The market is huge, and it is now seeking its own equilibrium. It is an unfavorable interest rate cycle right now, and it can continue. Financial instrument movements often go well beyond investor expectations, and that may happen with fixed income prices.

Can Interest Rates Go Higher?

You bet. We spoke with our friend Jeff Hugh the other day. He will be a contributing writer to our new site we are about to launch for investment professionals. Jeff is an experienced and smart analyst when it comes to evaluating the technicals of the stock and bond market. Jeff told us that he thinks fixed income rates could eventually go to 8% or even 10%. We hope not.

Here are some facts that may interest you about our current debt and housing market given higher interest rates.

Debt:

• CPI inflation is back up to five-month highs.
• US deficit spending is now at WWII levels as a percentage of GDP.
• Over $2 trillion in Federal debt has been added since June. This is less than three years after $4 trillion in stimulus.
• The last time interest rates were this high, the total US debt was $25 trillion lower.
• Total US debt is now up $650 billion since it crossed $33 trillion one month ago.
• On Friday, total US debt jumped by another $58 billion.
• Total US debt has grown by $22 billion per day for the last month.

Housing:

• For the first time in 23 years, 8% mortgage rates are officially back.
• Less than three years ago, the average rate on a 30-year mortgage was 2.6%
• Existing home sales fell 2% in September, now down 15.4% over the last year to their lowest since October 2010. First-time buyers made up just 27% of sales, well below the 40% historical average.
• Existing home sales are now below 2008 lows and at their lowest since 2010.
• The median price of a home sold in September was $394,300, up 2.8% this year.
• Higher rates, higher home prices, less supply, and almost no affordability plague the market.
• The current median monthly payment for homebuyers just crossed $3,000 this month.
• A house, car, and student loans will cost you an average of $4,140 a month now.

Very few people are going to sell their homes if their next mortgage is going to cost you three times what you financed the last one for. See chart below:

Current Fixed Income Investments

More Americans have investments in fixed income, either through their savings, checking, or even retirement accounts, than they do in equities. Almost all 401k Plans have a default conservative option that utilizes a stable income election, which still attracts a significant portion of 401k assets, especially in turbulent times like these.

Also, people have moved big portions of their assets to money market funds (over $6 trillion). It is likely that investors in the US are more invested in fixed income securities than stocks.

Unless they are in risk-free fixed income instruments or funds, do you think most investor know how much risk they are taking in these other fixed income investments?  Do all the wealthy, retired owners of municipal bonds realize they are probably down 5-10% year-to-date while collecting their monthly tax-free income? How many Americans holding a blend of 60/40 (stocks to bonds) are aware that the 40% in bonds is down 5% or more this year alone? I think not. Let’s put it in perspective.

1. Most bank savings and checking accounts: paying less than 1% (this includes Schwab, JP Morgan, Wells Fargo, and others). They are making a huge amount of money on cash deposits.
2. If you have investable capital somewhere like Interactive Brokers, a firm we use, you are earning more than 4.5% (or more) sitting in cash.
3. Today, if you invest in other fixed income assets, you can earn well above the 4.5% listed above. If you are invested in 90-day T-Bills, you are earning 5.5%. If you are invested in 10-year notes, you are earning 4.9%, and 6.4% for AAA corporate bonds. However, these options carry duration (time) risk, and if interest rates go higher, you could be underwater quickly.
4. Investment property cap rates are now 4.5%, and the S&P 500 earnings yield is at 4.2%.

Cash and Treasury Bills are now paying a higher yield than real estate and the S&P 500. In other words, risky assets are paying less than risk-free assets. This is the first time since 2000 that Treasury bills are yielding higher rates than the S&P 500 earnings yield. See chart below:

What About the Stock market?

Our risk gauges remain neutral, and our newest SPY investment strategy is 50% invested. We see a potential basing period here that looks like it is trying to find a bottom, though that doesn't necessarily mean it will.

Small-cap stocks in general are struggling. Interest rates and a potential economic slowdown affect this part of the market more than any other. See chart below:

Given the rise in interest rates that we previously mentioned, it is no surprise that smaller company stocks have been going sideways since the start of the first interest rate hikes 18 months ago. See chart below showing the longer-term picture for the IWM.

Looking at large company stocks and the S&P 500, we noticed that we are at a low reading of the number of companies that are above their 200-day moving averages. These kinds of numbers usually suggest an oversold market, and one that could turn soon and turn quickly. See chart below:

Earnings Season is Upon Us

According to FactSet, 17% of S&P 500 companies have reported their third quarter 2023 results, with 73% beating their earnings estimates and 66% reporting revenues above estimates.

The stock market began the week looking positive and favorable based on many analysts’ earnings expectations. It deteriorated midweek due to Powell’s comments, as referenced above, and the prospect of further rate tightening. Interest rates dominated the story from Wednesday on.

This coming week, it will be all about earnings as many of the biggest S&P 500 companies are to report. It will move the market one way or another. See earnings schedule (and market cap of companies) below:

November Could Be the Turning Point

As stated above, we remain cautiously optimistic about the prospects that the stock market is trying to find a bottom. Our S&P 500 color charts show a slow improvement in the number of stocks above their 20-, 50- and 200-day moving averages.

Seasonally, a few of our favorite analysts believe that we are entering a positive period for stocks. See their comments below:

A Comment on Gold

Given the inflation rhetoric, along with geopolitical stress and the possibility of an expanding regional war in the Middle East, gold had a favorable week. This was unexpected given the fact that gold often behaves inverse to the dollar (which was strong this week) and interest rates rising.

Nonetheless, it moved quickly higher this week and sits around long-term resistance. The following two charts speak volumes on gold. If it should punch through old resistance, it may be on the way to new highs. Stay tuned.

Finally, here are some other market factors worth mentioning.

Risk-On

• Despite the bad short-term action, the new high/new low indicator appears to be basing out for the S&P 500 and Nasdaq Composite.

Risk-Off

• Markets got beat up this week, with 3 of the 4 key US indices now below their 200-day moving averages, with both the Dow and the S&P 500 failing to reclaim key support levels.
• 3 of the 4 key US indices (excluding the Nasdaq) now have negative trend strength scores (TSI), and 2 indices are now negative on the year.
• Volume patterns continue to look negative, with zero accumulation days seen over the past two weeks for the SPY and only one for the Nasdaq.
• Speculative sectors led the market down this week, with poor performances in Semiconductors (SMH), Homebuilders (XHB), and Consumer Discretionary (XLY), while safer plays such as Retail (XRT) and Consumer Staples (XLP) were slightly up.
• Pretty much all global equities, with the exception of those that have exposure to new military conflicts, were all down this week while commodities served as a flight to safety.
• Market internals, according to the McClellan Oscillator, flipped negative for both the S&P 500 and Nasdaq Composite.
• Cash volatility is at its highest level since March of this year.
• The number of stocks above key moving averages are all negative, but also hitting oversold levels. They could be due for some mean reversion.
• Large-cap multinationals have actually held up the best in the market and are outperforming the S&P 500 along with small-caps and mid-caps.
• On a short-term basis, Value (VTV) is now outperforming Growth (VUG) for the first time since the beginning of the month.
• Foreign equities (EEM & EFA) are in bear phases, but look oversold and likely to be subject to some mean reversion.
• Commodities are bucking the trend of equities, with soft commodities (DBA) and oil (USO) holding on to their bull phase in both price and momentum.
• Gold (GLD) exploded off of its 200-week moving average, moving back into a bull phase on the weekly charts.

Neutral

• Both the Nasdaq and S&P 500 are still maintaining a bullish phase on the weekly chart, but SPY needs to hold up above $420 next week.
• Even with the hard selloff over the past several days, risk gauges remain neutral.
• Interest rates on the longer end of the curve hit new highs, and treasuries seem oversold and overdue for mean reversion.

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