Market Comment - August

At first sight, navigating financial markets looks easy. Investors have been focusing on the same themes for quite some time. Rising interest rates, the discussion about an equity market bubble, and geopolitical conflicts remain the main topics on investors’ minds. Knowing the outcome of these three obstacles for financial markets would be extremely rewarding. Unfortunately, nobody knows the future. Betting is the only solution, and every single theme is extremely complicated.

A sharp rise in interest rates would be harmful to the US government, as interest payments would eventually take up a much larger part of the budget. A 2.50% rise in interest rates, if fully reflected across the more than USD 40 trillion debt stock, would imply an additional USD 1 trillion in annual interest expense. Kevin Warsh is an intellectual word salad. He is very hard to predict. But in the end, a strong rise in yields is not affordable for the US government. The only guide is the US government bond market, and it is in bad shape. It would not come as a surprise if, at a certain point, the US Treasury were to intervene to stop the rise in interest rates. Unfortunately, it would probably take a crisis for such action to become necessary. At what level interest rates start to become a threat to equities is still far from here. In August 2000, Fed Funds traded at 6.50%; in January 2007, at 5.25%. We are now at 3.75%. On the other hand, both the US and European economies remain strong. Rising interest rates are not unusual in this economic environment.

So, let’s talk about the bubble. “When I see a bubble forming, I rush in to buy, adding fuel to the fire,” George Soros wrote in his book The Alchemy of Finance. In 1996, Alan Greenspan called the US stock market “irrationally exuberant.” Yet, by the year 2000, the Nasdaq had almost increased sevenfold. Stan Druckenmiller thought he had spotted the bubble in 2000. He lost more than USD 500 million with the Quantum Fund by shorting companies that were ultimately worth very little. He covered his bets just before the market meltdown in 2000. In January 2000, the Nasdaq dropped 13.85%, followed by a rally of 43.90% into March 2000. During October 2008, we thought we had picked the ultimate bottom. The market rallied 27.13%, only to lose another 29.78% until March 2009. Bull markets, like bear markets, end in extremes that only a few can imagine.

Geopolitics remain almost impossible to predict. All parties involved are stubborn, so an end is hard to imagine. Currently, we do not believe that the price of oil will escalate significantly to the upside. That is all that matters.

During the month of July, there was broad agreement that the Mag 7 companies would run into trouble because their capex spending had pushed free cash flow numbers towards flat or negative territory. Beginning in August, exactly those companies started to rally strongly, helping the Nasdaq to a monthly gain of 4.19%. While semiconductors traded broadly flat (-0.08%), software was among the best-performing industry groups, gaining 16.25%, as measured by the software ETF IGV. This is the sector investors had agreed would become the big AI loser. Fool me once….

Instead of building a top, which looked to be unfolding perfectly from June to July, the market shot up once again, leaving another trading range to the upside. Fool me twice….

Despite rising rates, continued geopolitical conflicts, and bubble fears, “It’s the economy, stupid,” as James Carville famously put it in 1992. The framework could simply be that the market continues to climb the wall of worry. After such a strong, 17-year-long bull market, people like to worry. We are trading at extreme levels, both in terms of absolute gains and valuations. But again, the market may move to much more extreme levels than anybody can imagine. Fool me three times.

Sector leadership is still difficult to trade. After an extended period of underperformance, technology seems to be getting back on its feet (XLK +6.40%), second only to the best-performing sector, Energy (XLE +7.41%). Meanwhile, defensive sectors are having a hard time, especially Consumer Staples (-0.09%) and Utilities (-4.76%). Industrials have started to underperform strongly (XLI -2.59%). Several companies are complaining about higher costs and supply-chain issues. Sustainable leadership is hard to find. The only sector trading down over the past four weeks was Consumer Discretionary (-0.63%).

We are heading into the worst seasonal period of the year, which starts with the month of September. Unfortunately, we cannot spot a decent top that provides us with a meaningful amount of downside.