The price of oil jumped, and interest rates followed. This has equity investors nervous. What would they do?
The short answer is, do not panic. (We often wonder when it is time to panic, but I digress.) People are finally concluding we did long ago. Interest rates are going higher. People look back 20 years and see interest rates at very low levels. They come to the erroneous conclusion that those low rates are normal, when in fact they are the anomaly.
Investors are finally repricing bonds because they are concluding that higher rates are here for the foreseeable future. But they are mistaken for the reason why. Inflation is rising for several reasons. The first is monetary. The Fed is printing money directly, and the government is printing money secondarily by issuing bonds. Both actions increase the supply of money and credit. It is this monetary expansion that leads to higher prices.
This chart shows how the growth in public debt correlates to the inflation rate as measured by the CPI. The second reason we have inflation is that war always raises prices. War causes shortages, which raise prices. IN the current situation, the war with Iran is causing a shortage in oil globally, and Ukraine and Russia have disabled refineries, causing shortages of diesel, jet fuel, and gasoline. Higher energy prices increase the costs of manufacturing and food production, so their impact pervades the economy. People also want to point at data centers for the rise in energy prices. This is misguided, as the new power plants being built to power data centers run on natural gas, and the US has a surplus of this energy source.
The fear of inflation is taking another whack at bond prices. Interest rates are rising on both 10-year and 30-year bonds. The chart below shows that the yield to maturity on 1’0-year govys 1’0 has broken out to a new near-term high.
This was predictable as the yield to maturity on 30-year govys broke out to near-term highs a few months ago.
The question people[le should have is “are interest r “tes going to skyrocket higher over the next year? Or are interest rates in their final move for the intermediate term? “We happen to “ink the latter. Rates ripped higher from the C19 low, consolidated as people tried to figure out what is going on, and are now making the final move higher for the intermediate term. We would not be surprised to see 10-year yields jump to 6% while 30-year rates jump to 6.5 to 7%.
We think these higher rates will scare investors into selling stocks, so we expect October to be a difficult month. We do not think this will be the beginning of a new bear market. We see it as a repricing. These rates will be high enought to scare the government into talking about acting in a financially responsible way. (We do not actually think they will do so.) That job will provide some confidence to investors, and these higher rates will be enought to attract investors. They will buy bonds, and we think this will keep rates stable for a couple of years. As a result, we think the equity sell-off will be short-lived. In our base case, we think stock prices will bottom sometime between late October and November after a 15% sell-off. At which point we will look to buy the dip.
If one is going to sell an index, we suggest selling the weakest on, which is the Russell 2000, the index of small-cap stocks. We can see from the chart above that the IWM, the ETF that tracks small-cap stocks, has massively underperformed the QQQs, the ETF that tracks the NASDAQ 100.
Interestingly, equity investors are not concerned about a sustained sell-off. The implied volatility of options trading on IWM is just 18%. This is below the long-term historical realized volatility of 32% ove the past 100 years.
Given this state of affairs, whether you need a hedge for your equity portfolio or want to speculate on lower prices, we suggest buying a put on IWM. With IWM trading at $281.92, consider the following option.
One will pay $927 per option to initiate this trade, and IWM will have to fall by $11.19 by option expiration to make a buck. Since this option is out of the money, there is a 33% chance of making money on the trade if you assume a random walk. With rates rising and equity investors showing a bit of exhaustion, we think the probability of a profit is higher than that.
