Life after Mag 7

0:10Michael Kramer:Very excited to welcome back Michael Kramer, who writes under Mott Capital Management and who runs the investing group on Seeking Alpha called Reading the Markets. Welcome back to Investing Experts, Michael. Great to have you back on. Good to be here. It's great to have you. So talk to us. We're at the beginning of December. You've been on a few times this year sharing your thoughts with the market, wondering if some bearishness is going to develop ever further, where there's been a lot of market volatility, a lot of questioning about where to go in this market and what this market even is. How would you synthesize your thoughts these days?

0:46I would say that the market has been sort of sideways with a lot of chop. I mean, really, if you kind of think about it, since the beginning of October, we've seen volatility really begin to pick up some with really while just basically trading sideways. ways, maybe there's a slightly upward tilt to it. But I don't really know that there's much happening. And it seems like the market is trying to go through this process of figuring out what the next move is. And I think there's a couple of different forces that are driving that right now. And one is obviously, you know, the AI. And I think we've spoke about this maybe over the summer.

1:33And it's funny because now the market is starting to think about some of the things that I believe we spoke about, which was, you know, one of my fears of is, you know, the amount of spending that was going on for these data centers and AI. I think another piece is that liquidity in the market has obviously been a big factor over the years. And the dynamics around that appear to be changing. and it's kind of made the fed it's brought the fed and the balance sheet back into focus the interesting thing i guess is that we're seeing again for the first time really some pushback on ai and whether or not that's the theme that the market really wants to have going forward and you're seeing some signs of rotation in the market although i don't know if it's all good or bad types of rotation, but it really should be causing people to think about life after MAG-7.

2:31Michael Kramer:What is life after MAG-7? Because that does seem to be the life that we're in right now. How do you see it continuing to develop given the fact that much of what you've discussed has or is now starting to come to pass or continuing to develop? For the first time in this cycle, we've seen the credit market finally weigh in on mag 7 and ai tech you know we've seen credit default swaps for oracle go uh from very low you know 30s and 40 values to you know 120 130 type values um uh you've seen them go up uh even for things like uh core weave which has been one of the AI names where it has a credit default swap that's now trading in the 700s, right?

3:19And these numbers all suggest probabilities of default over the next five years. So the fact that they're even rising, you know, tells you that the market is thinking about what's happening with all of this spending. And it's starting to kind of make bets in some ways or look for protection in the event that something turns out that maybe some of these companies are making bad investment decisions. And that was something we didn't see previously. I mean, this is my LSEG workstation. And this is Oracle's credit default swap. And I'm just going to zoom out a little bit here. I mean, you can clearly see the movement in it, right?

4:04And this was around the time of the tariff tantrum. And And this, of course, was during the period of time where the Fed was raising rates and tightening liquidity. So this was something you saw basically in every single stock or credit default swap out there. In fact, I have one that we can compare it to just to kind of make it so that everyone can get an example, a sense of what I'm trying to show here. What I'm going to overlay here is called the CDX Investment Grade Index. And when you compare that with Oracle, you can just again to show that this period of time in here, this was a normal pattern that you were seeing across the market.

4:47Now, this is where we are, right, where you're seeing a clear divergence in how the credit market is thinking about Oracle versus other investment grade type investments. And that's clearly a different path that we're on right now. And one reason why that's happening is because you're looking at companies like Oracle and Meta where their free cash flows have on a trailing 12-month basis have rolled over. They're no longer going higher. They're going lower. And the more they spend on CapEx, the more they invest into AI, the more likely it is that those cash flows can continue to roll over if AI doesn't start producing meaningful new revenue and meaningful new earnings for these companies.

5:34And so this kind of gives me a sense that for the first time in this cycle, the market is starting to think about what could happen if these investments don't work out or if it turns out that the productivity enhancements that are likely to come from AI don't pay off anytime in the near term. And I think this is probably the greatest example I can show at this point. you know but it's not just Oracle that this is happening to I could you know change it and put in Amazon which happens to be a stock that I own but regardless I mean if we take Oracle out of the of you you can see Amazon's CDS has also started to rise I mean it's nowhere near where Oracle's is but the fact that it's rising is something that you know is noteworthy and so again like That's what I'm trying to reinforce, which is that for the first time, the market is questioning some of these businesses.

6:33And I think what that means to me is that you could actually see a period of time and you're seeing this a little bit now where it's possible, right? Because of the way the S &P 500 is constructed with this market cap weighting, you could actually see the S &P 500 go down, being dragged by some of the bigger tech names, while the rest of the index does reasonably well and outperforms. And so what I've been thinking about and trying to really express to my subscribers actually on a regular basis because our focus isn't sector rotations and things like that. But what I've been expressing a little bit over time has been this idea that it's time to maybe start thinking about other sectors of the market outside of AI.

7:22And that could be healthcare. healthcare is one of the sectors that I'm the most excited about because to me, that's where I think the biggest gains in AI could come from.

7:36Michael Kramer:You were sharing that last time you were on as well. Are they the same opportunities healthcare-wise when you're looking at that sector this past year? It's like it's kind of broadened out in some ways. And I don't remember the companies we spoke about at that time, but I think it was early summer. And so I probably had just bought United Health for myself personally and for my portfolio. And I really don't like to give personal this. No, we're not giving personal investment advice here. I'm not suggesting in any way or soliciting that you should be buying any of these things. but you know uh i'm trying to express some of the things that i've been looking at so like united health care obviously was one of the ones that i mentioned um you know i had bought shares of zoetis also over the summer because they're the you know they're an animal health care animal vaccines animal drugs and um one of the reasons why is because i own two dogs and uh treatments for dogs as they get older are is very expensive and so are some of these medications and just looking at boxes of medications I'm giving to my dogs and knowing that the price on these medications has been rising over the years, I mean, Zoetis seemed like something that made a lot of sense to me from that standpoint.

8:55But more recently, I bought, I've owned Illumina for some time as well, and I've owned Intuitive Surgical for some time also. So those aren't new positions, but it kind of gives a sense that, you know, I'm trying to rebuild my portfolio around these types of healthcare names. And I recently completed my position in another company called Grail, which was part of Illumina and was actually one of the reasons why I bought Illumina in 2023, because I liked that they were working on this early detection test for cancer. And just recently, they had come out with some results which looked favorable to me.

9:39And knowing that that data was coming had prompted me to go out and finish the position off and building it to where I wanted it to be back in mid-September. And that's another type of area where I think AI could be transformational, Right. Because imagine being able to detect cancer six months earlier. In some cases, it's it could be lifesaving. Right. And so I imagine being and the idea here being is going through the sequencing and having this ability to do things faster than maybe what we were able to do at previous points in time. So I'm looking for those types of things still. And, you know, I'm exploring things and thinking about things like Boston Scientific and things in these more of these medical medical devices.

10:29Striker, for example, makes parts of people, you know, if you need a shoulder replacement, they might make it. They have an orthopedic robotic surgery machine that does hips. So, I mean, there's just lots of different opportunities. And some of these stocks haven't performed nearly as well as the rest of the MAG7 type names, which I've owned for years. I mean, I don't want to make it sound like I'm a negative person on MAG7 because I've been in Google and Amazon. Amazon I was involved in starting in 2022, but Alphabet I started with in 2017. Microsoft I started off with in 2018 and 19 and Apple.

11:14And, you know, those have been core holdings for me for a long time. And it was all built on the idea of the cloud and usage and the dominance in the marketplace and how they just became part everyday part of our lives. And I saw that just increasing. and the AI piece kind of came later. But I always knew that if there was going to be something with AI, those were going to be the companies that were going to be the leaders there anyway. So, you know, but those positions, I'm actually have been also been telling my subscribers occasionally. Again, we don't really talk about this type of stuff on a regular basis, but I've trimmed those positions rather significantly over the last year.

11:54I would say I've cut them all basically by half.

11:58Michael Kramer:What would you say, speaking of being early on tech and this AI development, what would you say about this announcement from the White House about accelerating their push into the robotics side of things? And what would you say about that push? And will it meaningfully catalyze that sector of the industry? I didn't read the news specifically, so I can't really respond to that. But, I mean, robotics, I think, is something that could be important. I mean, I was looking at Teradyne for a long time just watching it, and I could never find the time that I thought was right to buy it, and now it's gone up tremendously, so it totally would make no sense to me anymore.

12:43But, you know, and again, but the robotics portion was fairly a small part of their business. The problem with the robotics part of the market is that I haven't really been able to find many publicly listed companies that are in robotics that trade here in the U.S. I mean, there's a few in Japan, but I'm not going to Japan to buy anything. And so that was one of the biggest struggles that I've had in that area, which is, you know, an intuitive surgical is really one of the only ones that I've been able to find from a healthcare standpoint that makes anything like that. So I've struggled finding robotics.

13:24But again, I think robotics is important. But the problem is right now is that so many of these stocks have gone up so much that if there is a broader correction in tech and AI, these robotics stocks would probably be hit just like the quantum stocks would be hit because they're all part of the same momentum trades. And so I would be kind of shy away from looking at those things just because I think that they're part of that broader basket. And I don't think that they necessarily would fare any better in an environment if we were to see a move away from AI.

14:05Michael Kramer:Taking the broader picture into more of a context as it pertains to the market, what would you say the jobs data, what kind of effect is the jobs data having on things? What kind of effect are these interest rate conversations having in effect? How much is that a part of your analysis and how much is that playing a part of your thinking these days? You know, the funniest thing I was telling a friend of mine that the greatest thing that probably happened from my viewpoint over the last month or two was that there was no government data. Because it kind of gave me an opportunity to really watch the market in a way that I hadn't been able to do before, which was a market that was moving on no economic news on a regular basis.

14:55And I began to realize that although in my writings I've kind of written about volatility and option positioning and all the other stuff, it really crystallized to me how much the market just brushes all of that really aside, right? Right. And and it's not that it the economic data itself, the market positions for. And then what you see is the post positioning knee jerk reaction when you get the move. And so the economic data, the way I think about it now, sets up the positioning. And then once the news comes out, you get that unwinding of that trade. And so not having the data really allowed me to kind of hone in specifically to take that filter, that noise out that we get and see more closely how the market structure has evolved, let's say, over the last four or five years.

16:00And while I think the Fed plays an important role in liquidity and rates and all this economic data matters, the way that it's interpreted by people watching is not necessarily correct, not realizing how much positioning around these events drives that outcome in terms of how the market moves. And so while I think these pieces of data matter a lot for things like bonds and currencies, and I don't know that the interpretations that are received post-economic data are necessarily the correct ones anymore.

16:42Michael Kramer:Anything you want to say about the bonds and the currencies? Yeah, I mean, I think the most startling thing to me is really what's happening in bonds. First of all, we talk about rates going down, but I think the funny thing is, or the odd thing, is that no matter how much the Fed has cut, and the Fed's cut a pretty decent amount already, and we know that they're planning to cut more, but it seems like everyone has missed the fact that the 10-year rate doesn't go down, right? The 30-year rate hasn't gone down. The 30-year rate is still trading around 475, and it's just basically 25 or 30 basis points away from being back at the highs it was at not that long ago.

17:25And even on the 10-year rate, it's only 50 to 75 basis points away. I mean, in the market today, that could move very quickly if it were ever to revert. I mean, even with the terrible ADP jobs data we got today, you didn't really see a very big reaction in the bond market from it. And I think that's a really important and telling thing. It's telling us that the market that, and I've kind of theorized this again with my subscribers for a long time, I think 4 % on the 10-year is the floor for it. And the reason why I think it's the floor is because the curve is simply too flat. The curve, if we look at a chart of the 10-year minus the 3-year, the 10-year minus the 3-year is only separated right now by 33 basis points.

18:21That's it. So why would anyone want to go out and buy a 10-year bond when they can just keep rolling over three-month treasury bills on a regular rate, on a regular timescale, and only be losing 33 basis points, avoiding all that risk that comes associated with owning a longer duration bond? This yellow line marks the zero bound. Now, if we go on a weekly chart now, this is going to show us where the curve is on a historical basis, right? Notice that the curve typically peaks around 385 to 400 basis points above. The 10-year normally peaks 385 to 400 basis points above the three-month treasury rate.

19:05If we use the Fed funds rate as a proxy for where the three-month treasury rate will be, I mean, let's just say the Fed funds rate bottoms somewhere around 3%, which is what the market is pricing in right now. So if the Fed funds rate bottoms at 3 % and we use a three month as a proxy, it means that the three month would probably also be around 3%, which is 70 basis points. That would still only put the spread at around 100 basis points. So unless the Fed is going back to zero, the curve is too flat, even if the Fed cuts. And so this is why I think bond yields at the back of the curve haven't gone down nearly as much as people think they're going to go down just because the Fed is cutting.

20:00Here's the 30-year minus the three. And it's really the same thing. It typically peaks nearly 450 basis points above Fed funds, above the three-month Treasury bill. So again, Like if they cut another 75 basis points, that's going to put this somewhere around 175. You're still only halfway there. At a 3 % Fed funds rate and a 3 % Treasury bill rate, you would think that the 30 year would be closer to 7%. And I think that's why you don't see rates going down at the back of the curve, mostly because the market is basically not sure exactly where the Fed ends up cutting. because right now, the way this thing stand, the curve is too flat for where we are in this cycle.

20:50And my guess would be is that we're likely to see, and we're not talking about post-GFC. We're not talking, these values aren't all pre-GFC. This is 2011. This is 2014, right? Rates were at zero. That meant that you had a 30-year rate in 2014 at 388, 389, basically 4%. right? So if the Fed's going to stop cutting at three, then the 30 years should probably be closer to seven. If the Fed's going to stop cutting at two, then the 30 years should still be somewhere around six. What that tells me is that this is the reason why you're not seeing rates on the back of the curve going down. The other interesting thing is that when you look at the U.S.

21:35five-year minus a Japanese five-year, this is also fascinating to me because what you do is you take then the Japanese yen and you overlay it with this chart, and you basically see a really huge divergence which is forming right now, right in here. And what this is suggesting, if you just kind of zero in on this part of the chart, is that basically the Japanese yen has been weakening and strengthening versus the dollar based on the movements and the changes in the interest rate differentials. And right now what's happening is this giant divergence. The yen, despite the spread shrinking, is weakening versus the dollar.

22:19The yen really should, based on this chart over the last, let's call it five years, the yen should be somewhere, call it around 130, not somewhere around 155. And so that's telling you a message too. The message it's telling you is either rates, five-year rates, 10-year rates are too low in the U.S. and they need to go higher. It's telling you that the Japanese yen is too weak and it needs to, or it's telling you the Japanese yen is too weak or it needs to strengthen. The third option would be is that Japanese rates are too high and they need to come down. I don't think Japanese rates are too high because the BOJ is likely going to be raising rates and they have a 3 % inflation problem.

23:03I don't think that, and I don't know if the yen is undervalued or overvalued, because I don't know where U.S. rates are going to go. So if you kind of combine the steepness of the yield curve with where the FX market is, it would suggest to me that U.S. rates should be higher, not lower, on the back of the curve, because it's too flat currently. So that was a lot to digest, I'm sure.

23:33Michael Kramer:You talked about the Bank of Japan telegraphing a rate increase later this month. And earlier this week, we saw this big rise in Japanese government bond yields that we hadn't seen since, speaking of the GFC, since 2008. What are you expecting to happen at the December Fed meeting? What does this news out of Japan, what do you think it portends for the US? And what do you think it will mean for investors moving forward as we end the year and maybe even into 2026 as well? I mean, in theory, right, because it seems like we're living in a really strange time where things are broken and detached from what the norm used to be.

24:16Rising rates in Japan sort of removed the low point anchor in the world, meaning that, you know, when a Japanese two-year was trading at negative 12 because they had negative interest rates, you could see U.S. rates lower, right? Because they were all kind of everything kind of moves a little bit, you know, together. There is, you know, you know, you can see that there is some movement that happens together. And so, you know, if right now, if you're seeing rates in Japan rising and basically in order to keep the spreads from completely, you know, going haywire, right, then it would mean to me that rates in the U.S., rates everywhere in the world are going to be somewhat elevated relative to where they had been before.

25:07Because again, like if you look at a Japanese five-year and a U.S. five-year, you can see how they've kind of gone together. But if you look at this spread, I mean, the spread has been fairly, you know, consistent. It's not like it's been between 40 basis points at the low and as high as four and a half basis points at the high. But the point is, if Japan kept raising rates and the U.S. rate kept going down, you know, you wouldn't want to be in a scenario where this rate like flipped or something. Like that's what you're seeing actually happening right now in Italy compared to Germany, which is interesting because this is creating big distortions too.

25:51So you can see how the rates in Germany and Italy tended to go together. But if you notice more now, they're coming together. Notice that the rate in Italy is falling while the rate in Germany is kind of flat. And this is actually a really important thing. It kind of, again, demonstrates the changes and really the kind of political things, the instabilities that are going over and dramatic shifts that we're getting in Europe. The spread has fallen to just 70 basis points, meaning that an Italian 10-year today is only seven basis points above a German versus where it was during, remember, the euro crisis, right?

26:36the debt crisis. Remember, I mean, at one point, the Italian 10-year was trading 500 basis points above the German 10-year. Basically, what's happened is that the German 10-year is no longer viewed as, based on this chart alone, is no longer viewed as safe as it used to be. And we'll say, well, what do I care about what's happening between Italian and German spreads? Well, I can tell you why you want to care about it, because it affects what's happening here in the U.S. too. This is a chart of financial conditions, and you can see that basically ebbs and flows in financial conditions here in the U.S.

27:07go with the spreads. But also, more importantly, if I just kind of shimmy things around here a little bit, is that if you go to some of these high-yield spreads that we were just talking about, this is the high-yield spread of high-yield index option adjusted spread. And then you add in the spread with Italy and Germany, you can see how they kind of go together. So all of these things, I feel like, matter a great deal. And so if, for example, you suddenly see rates in Japan going up and rates in the U.S. going down, and those spreads really start converging too much, it could lead to the yen actually strengthening too much versus a dollar.

27:48And that would be something the BOJ doesn't want. And so the idea here being is that if Japan is raising rates and rates in Japan are going up, I would expect the curve around the world to rise along with it.

28:02Michael Kramer:What else would you add to this conversation? What else do you feel like is important for investors to be keeping in mind right now? It seems to me like something is happening in the market. And the backdrop has changed because like of what I said at the beginning with the credit spreads, because of the fact that you're seeing rates in Japan rising, The carry trade is basically going away. And that's been a source of liquidity for the marketplace as well. And so I think the main takeaway is that we need to start really being focused on other things than Mag7, AI, and big tech. Because the thing that I learned the most in the year 2000 isn't that the internet wasn't revolutionary, because obviously it was.

28:52But the companies that were the leaders in that bubble period didn't come out as the leaders. Whoever has heard of Yahoo, right? I mean, we've heard of it, but the company has been irrelevant for two decades, right? But they were AOL. These companies were all sort of the leaders then. They're no longer really relevant today. And so it really will be more exciting to me to find the leaders of tomorrow and that the leaders of today may not necessarily be the ones that lead the next leg of the market higher, you know, whenever that should occur.