Transcription
Hello and welcome back to Braavos Research. This is your host Peter. Today we're going to be taking a look at the yield curve because it's always an excellent tool to look at in order to understand what is happening in markets right now.
We're obviously seeing a little bit of volatility on stocks today. Now, on the actual S&P 500 index, that volatility is relatively mute in terms of the big picture. We're still hovering at around all-time highs. But taking a look at the NASDAQ 100, we're seeing a little bit of a reversal here. We've had that false breakout right here. Not a particularly constructive sign from a price action standpoint with a lot of the big names that were successful in the April to October period being hit particularly hard in this recent sell-off. We have Palunteer, for example, that's down 10% today, really showing signs of having topped back again in late October. We have Nvidia that is also down roughly 3% today. Also topped in October. So even if on the surface it looks like we're seeing a relatively stable market, the truth is we're seeing large rotations taking place underneath the surface.
Now you're going to hear all sorts of opinions regarding what this means and the potential for there to be a large bare market as a result of this. And so whenever that's on the table, it's important to zoom out and understand what are the broader dynamics that are at play today. And the best way to look at that is through the yield curve. So this is the 10-year minus threemonth yield curve. So it's the most classic 10-year minus the Fed funds rate, right? Short-term interest rates. And it's essentially a reflection of what monetary policy is doing or what the objective of monetary policy is. When you have an inverted yield curve, we know that tends to be tight policy. That's when they call monetary policy restrictive and that tends to be followed by a recession or slowdown. Now in the case of 2022 2023 we didn't get a proper recession but we did get a rise in the unemployment rate generally had a big cooling of the labor market a big cooling of the economy during this period.
Now what's peculiar about both the state of the yield curve and the labor market today relative to other steepenings right this is steepening out of the yield curve inversion is the speed at which this is taking place. So, so we really started to see the yield curve begin to steepen and the labor market bottomed or I should say peaked. The unemployment rate bottomed in May of 2023 and ever since then, so it's almost been 2 years of the yield curve steepening alongside a rising unemployment rate. Now, typically from the bottom of the yield curve or the bottom of the unemployment rate, you look two years out and you're already towards the end of the recession, right? So this is very peculiar in the sense that typically things play out a lot quicker, a lot more violently. And today we haven't seen a proper panic in the job market. We haven't seen large GDP contractions as you usually see when the economy is really heading into a recession. This has been much more gradual and longlasting over the course of the last few years.
And so we wanted to take a look at what happens. And so at the end of the day, the yield curve is a prediction of what is going to take place over the next year and a half, right? It's the monetary policy that's being set and so it's going to filter through the economy over the next year and a half. And so we wanted to take a look at what typically happens in the past when you've had such a steepening of the yield curve over the last 2 years, which is roughly the amount of time that it takes for the monetary policy to impact the economy. And we can do that very simply here. And you're going to see where I'm going with this. The results are quite fascinating. But you can see here we can look at the rate of change. So, how much the yield curve has gone up over the last 36 months? So, over the last 3 years, what has the yield curve been doing? It's gone up by roughly 1.4%, 140 basis points. The last time that happened was in May of 2022. Before that, April of 2009. Before that, October should say November of 2001, November 1991. Basically, we can put vertical lines here every time that we've had the yield curve do what has happened today in the past. And if we overlay the unemployment rate on top, you can see systematically we've seen the unemployment rate peak right around that moment. Either it was already peaking and moving lower like in these cases or it was just about to peak like in 1991, 2002, 2009. The only exception to this was actually in the 1980s here. And this makes absolute sense. When the yield curve is steepening, it means the economy is weakening. So the unemployment rate is rising and the central bank is loosening its monetary policy in response to that weakening. And typically that leads to an economic expansion over the next year and a half.
And so this is why over the last few months now, we've really been of the opinion that the economy can begin to reacelerate. And so the unemployment rate can start to peak and head lower. Now that will of course eventually mean that the yield curve will eventually begin to reinvert if the economy heats up again. Maybe we get some inflationary pressures and ultimately that can perhaps lead to a actual economic downturn down the line. But for now the here and now is that monetary policy has been loosening with a rising unemployment rate which is very very textbook. And now we should be expecting a reaceleration with the unemployment rate beginning to turn back lower.
Now needless to say that a falling unemployment rate if that's what's in front of us over the next year or so tends to be a good thing for the stock market. Right? We can see that by simply overlaying the unemployment rate on top of the US stock market. And you can see directionally they are very much aligned. stock market tends to move up with the fall in the unemployment rate which makes sense right this is how things should actually work and when there are severe job losses like here and here the stock market declines and you see GDP contractions now what's very interesting of course is that we've seen the stock market rise significantly here with the rise in the unemployment rate now a lot of this can be attributed to large technology companies that have thrived in this environment that have been able to expand their profit margins regardless of what the job market is doing that's led to the highest level of concentration in the market in decades right since 1999 really where the only thing that seems to have worked is tech stocks now it's a paradigm shift in the market if we all of a sudden see a return to normal in the sense that we see the unemployment rate turn back in the other direction again what does that mean does that mean that all of the good things that happened for tech here unwind mind. No, but it can mean that you see a significant rotation take place from the overbought, the overvalued, the tech names that were bit up to extremes during this period and into more cyclical parts of the market that tend to do well when you just have very natural economic growth.
And so that's exactly what's happening right now. This is why the S&P 500 is at all-time highs right now. Yes, of course you can see a little bit of volatility in these types of rotations, but when you've got underlying growth that remains strong, it's very unlikely that we're going to experience any kind of significant market peak. And you can see that again by taking a look at the equal weighted S&P 500 ETF that's doing very very well. So when you strip out the excess contributions of the large cap tech names like Nvidia, Microsoft, it's getting completely crushed recently. Well, the performance of the average company in the S&P 500 is actually pretty strong, right? You look at a ETF like XLI, the industrial sector, it's performing exceptionally well. And we can see that through our trades on WAB, that's been performing very well here. XPO that we just closed, that's also been performing very well. So, even within our trades, we're seeing the best performers in our positions being those more cyclical parts of the market. We can also see that by looking at the relative performance of the NASDAQ 100 against the S&P 500 that is getting absolutely crushed right now. You can see that again it peaked in October and it's been falling and now we're seeing a proper breakdown of the tech sector against the S&P 500. Not necessarily something we want to fight. This is a pretty important from a price action standpoint. This is a pretty important development. If I add a few moving averages here, you can see that they are beginning to curl down here. So, what had been a pretty strong uptrend and outperformance from the April low in these tech stocks as we had a kind of a continuation of that weak job market and a concentration in those tech stocks. All of that seems to be getting put into question.
Now, this reminds me a lot of what was happening right here. This is extremely similar what took place between February of 2021 and May of 2021. And this is by the way something that we've highlighted multiple times here already just over the course of the last few months. This type of rotation happens and they can last quite a while. Right. Back in 2021, it's the exact same type of thing where you had a very uncertain economic environment that led to a significant outperformance of the tech names of the large cap tech names during the pandemic and in the immediate aftermath of the pandemic. And then something crazy happened in early 2021 where the economy actually began to recover and you had things like the ISM PMI begin to curl up. And we can see that by looking at the ISM PMI that had been recovering here already in late 2020, but really solidified its strength in 2021. And that's when investors began to offload their tech stocks and rotate into the more cyclical parts of the market. And that's where you had XLI begin to move up. You had the small caps begin to outperform and all those cyclical parts of the market that had been beaten up in that period began to pick up again.
Now back here, it wasn't the end of the tech sector, right? The rotation eventually did come to an end because the companies were still in good shape. The economy was strong and so tech companies do well when the economy is strong and they're able to grow their earnings. They're able to grow their profit margins and so they came back up right up to all-time highs a few months later. I would suppose that this is something that to a certain extent happens again. Right now, we're clearly seeing a rotation towards the more cyclical parts of the market and we're not going to be fighting that trend down the line. And it's very possible that this turns into a buying opportunity for tech and eventually leads to a second wave of outperformance in terms of the directional bias on the S&P 500. Just because there's a rotation out of tech does not mean that we necessarily should become bearish overall on the S&P 500 index. Again, you look at the S&P 500 during this period of rotation. It did quite well, right? And very similar, this came shortly after the yield curve steepening. So let me add the yield curve here so you get the full picture. But from a monetary policy position, this is an extremely similar situation where by the time this rotation took place, you had seen multiple months, even you could argue 2 years, right? Two full years of a loosening in conditions. The yield curve had steepened from0.5% all the way to 1.5% over the course of those two years. in a similar way to how we've seen a steepening take place from negative 1.5% to now almost 1% on this yield curve. So the timing is not exactly the same, but we're seeing things play out in a very similar fashion.
So we're going to keep on looking for bets in parts of the market that are working. We did get caught a little bit offguard by this whipssaw here that prompted us to initiate two tech positions, AMD and Rambus. And both of these were stopped out in this weakness. We managed to keep the risk very limited. We cut those positions right before earnings and only suffered very slight losses on these after earnings. We still have a little bit of exposure to TSM. But as you can see, that too is a stock that is suffering right now. So, it's possible that even TSM is a stock that will need to be closing down because what we really want to be prepared for is when this period of volatility because this is what it is, right? The tech sector moving lower is leading to a lot of choppiness, a lot of difficult conditions here. As we're seeing rotations, we're seeing earning seasons being difficult. Ultimately, even if there's a little bit more draw down here, there's going to be we think a recovery coming out of this and we want to be positioned in the sectors that going to be outperforming in that period. And again, when you look at 2021, right, you could very much argue that the initial rotation out of tech that lasted from maybe January of 2021 till March of 2021 caused a lot of choppiness, a lot of volatility here. The market did come out of that with those cyclical parts of the market really driving the performance in March, April, May of 2021. And then later that year, you finally had tech drive the rest of the rally up until the very peak.
So, I know there's a lot of different pieces of the puzzle here that we're presenting, but the point is that this volatility is not a symptom of something lurking underneath the surface. Not in our opinion, something that's completely normal, completely natural. It's difficult to trade in and there's definitely whipsaws that are happening. We can see that the VIX the volatility is quite elevated which is making us a little bit cautious in terms of initiating new trades not necessarily because we're expecting or we have a high conviction of the market moving lower but because when volatility is high you have stocks making large swings and that increases the possibility of our trades getting actually whipsaw. we would much rather be long on the market as volatility is declining and so perhaps there's a little bit more room for this to continue as again you see some large breakdowns especially on stocks like Nvidia that is on the brink of a larger breakdown and there's still a stock that makes up a big chunk of the S&P 500 index and if it breaks down here comes down to that target that we had of the previous all-time high that's a 15% decline that's going to cause some volatility on the stock market but this is primarily being driven by rotation When you look at the earnings releases of these companies, AMD, Rambus, they beat expectations and they have strong forward guidance. We're not seeing this big dynamic, this big shift of investors readjusting their growth expectations. It's really just a an adjustment of how capital is being allocated across different sectors. And investors are really seeing this. What we're seeing as well is a cyclical recovery happening. And so that leading some capital to shift away from the tech sector and leading to some rotations, some volatility.
So hopefully this provides a good overview of how we're thinking about the market today. If you enjoyed, make sure to leave a comment down below. If you have any questions, comments, feedback, we do our best to get back to you as quickly as we can, as much as we can. In the meantime, I wish you good luck on your trading and see you next.