Is the Stock Market Severely Mispriced? With Jesse Felder

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1:24And now to the top analysis of today's markets.

1:41Is the stock market severely mispriced? Welcome to Real Vision Daily Briefing. It's Wednesday, August 30, 2023. I'm Ash Bennington. I'm joined today by Jesse Felder, founder of Felder Investment Research. Just a reminder that today's show is an extended Real Vision Daily Briefing, The second half of the show available exclusively for Real Vision members. Let's jump in to today's market analysis. Jesse, pleasure to have you with us. Good to be with you, Ash. So Jesse, big picture, where are we? Where do you see us 50 ,000 foot view right now? Well, I do think this, to answer your question, I think the stock market is seriously mispriced.

2:22You know, almost on any metric you want to look at, really. I think one of the charts we're going to get to is a chart that came from a piece that Mike Green recently wrote comparing the dividend yield, forward dividend yield on the S &P 500 to the 30-year tips yield. And typically, those things run pretty close together, but we've seen the tips yield soar much higher over the last year or so. And we haven't seen the dividend yield kind of keep pace with that. And that would have to come from stock prices falling in order to raise the yield, similar to bonds. I mean, there's a variety of ways you can look at that.

3:04One of the ways, another chart that I like to look at is the stock bond ratio, just spy to TLT, something like that. And on a monthly and quarterly timeframe, we've never been more overbought on SPY relative to TLT or QQQ, whatever you want, than in the history of those trading of those ETFs. So basically, we've seen interest rates go up a ton and the stock market hasn't responded in the way that you would typically expect it to. You could also look at something like just the basic price to earnings ratio. I did an interview last week, and we talked about how the forward P.E. ratio looks at about 20, S &P 500 is about 20 times earnings.

3:49But on trailing earnings, we're 25 times, and that compares to historical average of 15 or less. So that's a lot. And if you're looking and saying, well, the forward is only 20 times, then you're betting that analysts' projections of a rapid increase in earnings over the next several quarters is going to play out. And I would say the macro right now suggests there's a very big risk to that narrative, that if you're looking at a forward P.E. ratio, you have to be right on those earnings projections. And a lot of, like I said, the macro indicators suggest earnings are not going to be as strong. And probably we're going to see a continuation of the earnings recession that we've been in for a couple quarters now.

4:30Yeah, I'm very impressed by your analysis here. Incredibly detailed. Also very holistic in the way that you think about the interrelationships between credit markets and equity valuations. Let's take a look at that chart right now to show that divergence between 30-year real yield and the S &P 500. I guess that's total return that we're looking at. It's forward dividend yield. Yeah, that's the forward dividend yield and the 30-year tips yield. And because the dividend yield is essentially a real yield also, this is why I like this metric, and we got to credit Mike Green for this chart. But you really want to compare apples to apples, compare a real yield to a real yield.

5:12And this is what this chart is doing. And it shows this kind of gaping divergence where if stocks were priced in line with what the bond market is saying about inflation and whatnot, you'd have to have much lower stock prices to raise that dividend yield up significantly. And so, you know, it basically begs the question, why are stocks, you know, diverging so significantly from bonds? And so you could come up with a variety of potential answers in that regard to try and answer that question. Well, let's talk about that. By the way, one of the things that I wanted to point out, you talk about the striking divergence there.

5:48The other thing that's interesting about that chart is the striking convergence before the divergence, seeing just how tightly those two move together. And then seeing this really just intense breakout in regard to 30-year real yield, it's really striking. So what are some of the causal factors that you think might be driving what we're seeing right now? Well, I think there's two possible explanations, I think, that just come to mind immediately from looking at the trajectory and interest rates. One is the bond market doesn't believe the inflation genie has been put back in the bottle. The bond market believes that inflation is probably going to be a bigger problem going forward than maybe the stock market currently anticipates.

6:36Stock market seems to be pricing in a scenario where inflation and interest rates go back to our pre-COVID paradigm of very low inflation, very low interest rates. And bond market is saying there's something else going on here. And that, you know, to me, comes back to two things. One is the supply-demand mismatch in the Treasury market right now, something Bridgewater has referred to as the liquidity hole, which is essentially the Treasury has to issue massive amounts of new debt. At the same time, the demand for that debt has been falling. We have the Fed go from a buyer to now a seller of Treasuries.

7:18at the same time that the banking system has become constrained in buying treasuries, and foreign central banks have lost interest in buying treasuries too. So you have falling demand on the treasury side at the same time. We have$2 trillion of new issuance creates this liquidity hole that Bridgewater's been talking about. And where does that liquidity hole come from? That's the other side of this. It comes from the massive fiscal deficit that we're seeing. just widened pretty dramatically. I don't think we've, we're basically back to the worst fiscal deficit to GDP levels that we saw during the great financial crisis.

7:57And we're supposedly in an economic expansion right now. So we're in uncharted territory where we have a gaping hole in the budget here. We're not raising enough revenue to pay for the country's expenses. And we meet that hole by issuing a lot of debt. That in itself can potentially be an inflationary dynamic that is troubling the bond market. So I think the bond market right now is saying that interest rates are not going to come back down anytime soon. And inflation could persist in a systemic way or a secular way rather than just come back down due to cyclical forces and then remain low for a long period of time.

8:44And I think that the stock market is discounting something totally different. So it's a matter of who's right here. If the stock market's right, we need to see inflation come down and then interest rates follow suit pretty rapidly. Otherwise, if inflation is going to remain a problem and the bond market's right, stock prices probably are significantly mispriced. I mean, by and large, over a 40 or 50-year time horizon, I believe the bond market certainly has the better track record. Yeah, you know, that's kind of the running joke among people in the industry is that, yeah, the IQ of the bond market is a little bit higher than that of the stock market.

9:25Now, do you see both of those impaired sort of supply and demand impacts that are on the fixed income on the debt side being both durable? Or do you see that potential reversal for those trends? It sounds like it It seems as though it's a secular or durable shift that you see in your view. Yeah, I just think that with the trajectory of the fiscal trajectory of record, widening deficits and already widening from dramatically wide levels, that in order to meet that supply, you would need demand to grow significantly. And I just don't see where that comes from. So at some point, I think you have to believe that the Fed is going to have to come back into the market.

10:19They're not going to call it quantitative easing when they do, because it's likely that inflation will still remain a problem. But we've seen this. We saw this with the Bank of England last fall. Right. Right. And we've seen dramatically. I mean, it was a dramatic, dramatic move. Yeah. And we could see something similar here. If I mean, that 420 level on the 10 year treasury is a key level that I'm watching. If we don't stay sustainably below that level, then I think we're going to see problems. And, you know, for me, when you I've written about this for a couple of months now, the 10 year treasury yield is the most important chart in the world.

11:04And I've been reading since the start of the year. I mentioned Bridgewater talking about this liquidity hole. Ray Dalio has warned about this supply-demand mismatch for months now, building in the Treasury market. And Bill Dudley, former head of the New York Fed, right? Nobody understands, I think, the dynamics of these markets with Treasuries and money markets and things better than the New York Fed. has warned that he would be surprised if we don't see turbulence, quote unquote, turbulence in the Treasury market sometime this year. And he's referring to this liquidity hole. So I think all of these things, the technicals, the macro, and then just the smartest of the smart money in these markets are all pointing to the same risk, which is that bonds aren't necessarily done with their decline just yet.

12:03Hey, everyone. We're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

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13:15Jesse, so much to talk about there. I want to touch on the budget chart in just a minute. But since you brought up 10-year treasuries, such an important chart, as you point out. Now, you know, it's interesting to me because this has been one of those charts. You know, I'm not a kid any longer. And this has been a chart that's only moved in one direction my entire career following markets. Peaking out in 1981, yield about 16 % or thereabouts, just sky high. And that chart, if you look at it, it's literally just down into the right for 40 years until we bottomed during the global pandemic. I believe it bottomed sometime around October, November of 2020.

13:52And now we've seen this rollover and it's been pretty steep, not just in terms of the move, but the percentage move, percentage change because it was such a low base effect. And also the rapidity, that second derivative of the move. You know, I think the low there was around 0.7, around 70 basis points. Right now trading at about, well, just under the mark that you talked about, 4.118 on my screen for 10-year Treasury yield. Give us the broader context on this 10-year market, what you think about it, what you see, and what it means. It's a great point. None of us have traded during a long-term bond bear market.

14:32I don't think really anybody operating the markets today is really familiar with it, except for a handful of old-timers who were trading back in the 1970s. I was alive, but I was certainly not trading back then. I was not, you know, rumors not withstanding, I was not trading in the 1970s. Yeah. And so I think what all of us are dealing with and fighting really is this kind of anchoring bias, this recency bias of, you know, what has been familiar to us is the fact that, yes, there are times when interest rates rise, but they always peak and roll over and actually set new lows with every time, you know, they turn down.

15:17And so this idea that we've seen reversal. And yeah, you're absolutely right. To look at that long-term monthly chart is critical because we've broken out of that downtrend. And one of my favorite quotes, I'm going to bungle it, but Paul Tudor Jones, when you see something break out of a range, it's a sign that something significant has changed and it's probably going to continue in that direction for a time. So you can look at it, I think, the 10-year treasury from that longer-term timeframe. We've broken out of that downtrend. That's a key signal that the bond bull market, the 40-year whatever bond bull market has done.

15:54And I think when you look at the trading and the 10-year treasury yield just over the last couple of years, to me, it looks like it formed kind of a bullish flag pattern where we just kind of corrected in a downward kind of channel since October, that October peak. And then we broke out higher out of that pendant pattern. And it suggests to I mean, just from a technical standpoint, that we could trade up towards 5%. The fact that the supply and demand dynamic validates that, and we're seeing what Bill Dudley and Ray Dalio and Bridgewater kind of warned about, we're seeing that play out is all kind of pointing in that direction and validating that technical view.

16:38You know, one of the interesting factors here, Jesse, is that no matter what happens next, we're sort of in unprecedented territory, right? So we've broken this trend in a significant way to the downside. But we've never seen this kind of reversal before. So kind of no matter what happens, I know that there have been some others. I remember the 1991 recession going from about 5 % to around 7.5%. We did see the breakout and then see the resumption of the longer-term secular trend. But it seems as though no matter what happens, we're kind of in uncharted waters. And by the way, we should just point out talking about uncharted waters, there was nowhere to go if you look at that as a 40-year secular trend.

17:13And once you reach the zero point on that chart, there's really nowhere to go but up. I suppose you could stay at the bottom. But it's sort of just all of this feels like inflection point one way or another. Absolutely. And I think it's hard to overstate the importance of this, right? Because interest rates are fundamental to the pricing of every type of security, every type of asset class around the globe. And so the fact that we are seeing this major reversal represents nothing short of a paradigm shift for markets. Right. Now, let me ask you a question. You mentioned a number before, 420. Other than the meme-worthy factorness about it, what is it about that number that you see as a critical inflection point on this yield?

18:07Well, it's right around the highs from last October. So to break out to a new high sustainably above that, I think would be another clear signpost along the way that we are are seeing the technicals play out, as I suggested, which is, you know, if that is a bull flag pattern in the 10-year, you measure the flagpole and it's, you know, it projects a target close to 5%. So a breakout above 420 would take you to, you know, not in the straight line to 5%, but to 5%. And I think the fact that you don't hear anybody talking about potential for 5 % on the 10-year Treasury is a sign in itself that sentiment towards bonds is not nearly as bearish as it should be.

19:01I think if I were a bond bull right now, I'd want to see a lot more bearish sentiment in the Treasury market than I see today. I'd want to see some of the things I like to look for in the financial media is headlines that are talking about the relentless move higher in rates or the unstoppable move higher in rates. It's when somebody starts, when people start extrapolating moves indefinitely into the future, that's when you know sentiment has gone too far. We just haven't seen, I haven't seen any of that kind of media reflecting the mood in the bond market, reflecting a really bearish mood in the bond market as of yet.

19:43And so that tells me that I think there's still room to the upside for rates. Well, let's talk a little bit about that. So I have a couple of questions for you. What would it take to get to 5 % on the 10-year yield? What do you handicap the probability of that happening being? And what would happen when we got there? I mean, would that just be something that we would see a lot more gloom and doom in stock markets if we saw that type of kind of asset mix? Yeah, I mean, I think what would it take to get there? I think it would take just a continuation of the current trend, right? I mean, what's going on right now is I meant, I just bring it back to this liquidity hole, is Treasury is trying to sell$2 trillion worth of debt in the second half of the year, and are there buyers for that debt?

20:27And in order to attract buyers, they're having to offer higher and higher yields. So I think it's just a simple supply demand dynamic that if there's not the natural buyers for this stuff, that yield's going to have to go higher to attract more buyers. So that's kind of what I think that's all it would take is just a continuation of that liquidity hole materializing. And I think it's important to talk about too, why it didn't materialized earlier in the year because, and Greg Jensen at Bridgewater recently did a podcast on this topic, suggesting that the debt ceiling kind of interrupted the pattern in this liquidity hole, that the fact that the Treasury was unable to sell new debt, had to run down the Treasury general account to almost nothing as a part of that debt ceiling negotiation process, really

21:26bolstered liquidity for a period of time. And now that debt ceiling issue is kind of out of the way, Treasury is free to sell all this debt. Now we're back to this liquidity hole is opening up again. Now, what does that mean if we did head towards 5 % on the 10-year? Well, I just put it this way. The correction that we've seen in stock prices in August, which the media, we didn't even see much of a correction, but the media was already, you know, Wall Street Journal, you know, August living up to its reputation as a terrible month for stock prices, you know, and all this stuff. Even at the lows, we were still more overbought on SPY and QQQ, more overbought relative to TLT than any point in those ETFs history.

22:09So what does that, how does that work? Well, stocks sold off, but bonds have sold off even more. So how do you get that ratio, the stock bond ratio to come down, well, you need stocks to fall faster than bonds. And so I think if the bond, interest rates go up to five and TLT breaks down to new lows, you're going to need stock prices to fall even faster than that to kind of bring some normalization to this ratio. You look back at previous times when the ratio was similarly overbought. It was early 2018. 2018 was not a good year for stock prices. And I think prior to that was that 2007-ish timeframe.

22:51It's times when Fed's raising interest rates and stock prices have not yet responded to the lagged monetary effects that haven't quite kicked in yet. yet. And so I think that's where we are in this process. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

23:21Yeah, TLT, of course, iShares 20 plus year treasury bond ETF tracks price, not yields, so you'll see it moving in the opposite direction as the yields. We talked through this a little bit, Brian, maybe you could show the chart of what was happening in the deficit right now in the U.S. Because I think this is something you touched on a little bit before, but when you see it visually on screen, Jesse, it really is quite striking to see those gaps really materializing in a significant way, you know, minus 5%. We went down at the trough of the pandemic to minus 15 % U.S. budget balance as a share of GDP.

24:00But we are now significantly below the 5 % mark. As you said, I think quite eloquently, this is something that looks like a crisis moment, and yet we're not in a crisis. Absolutely. I mean, typically what you've seen with this is, you know, in the post-war period, is you get a widening deficit during a recession because revenues come down, right? Tax receipts come down, and the government spends more as kind of fiscal stimulus to try and help the economy through recession. So deficit widens, and that's kind of a normal process. When the economy heals, right, tax revenue grows and comes back in again.

24:41And fiscal spending can kind of come back in again because the economy is starting to heal. And so you get the deficit narrowing again and even a surplus in the late 90s. What's happened this time, I think, is especially notable because, as you point out, During the pandemic, you had that kind of counter-cyclical fiscal stimulus. We saw revenues come down. We saw the deficit blow out. But since then, we've seen a very, very strong recovery in the economy, one of the strongest recoveries in economic growth on record. And what has the deficit done? It has not improved by kind of any measurable way.

25:28And in fact, it's already deteriorating again. And so this is a new thing for our country, really, that we have not seen a worsening fiscal situation during an economic expansion, at least to this degree. And it suggests that there's potentially an inflationary dynamic being promoted by the fiscal side of things today that's going to create a very serious challenge for the Fed for years to come. And you pair that kind of secular inflationary impulse from the fiscal side of things with other dynamics. And it suggests that maybe the bond market's right, that the inflation genie is not put back in the bottle.

26:14And there are other things going on here. Yeah, I mean, the other interesting thing about that chart that's worth remarking on is that you can see moves on both sides of the ratio to the negative. We just saw today the downward revision of Q2 2023 GDP in the U.S. down to 2.1%. So you see not just the expansion of spending, but also the contraction of GDP. So you're getting it on both ends in that ratio. Yeah. Yeah. And I mean, I think the thing to really worry about here is if we are headed for a hard landing and not a soft landing, you know, and this might be another thing that bond market is trying to price in, is where does this deficit go during the next recession?

26:58What does it look like in the next one? If we're already at 7%, 8 % during an economic expansion, are we going 15%, 20 % in recession? And if so, you start worrying about things like a debt spiral. And that's not just my language. Larry Summers has mentioned it in recent months. When you have a former Treasury Secretary talking about a debt spiral, it's something to pay very close attention to, I think. By the way, while we're talking about all of this, I wanted to bring up a clip. This is a deep dive called Will the Fed Continue to Embrace a Longer-Term Hawkish Stance? Our own Andreas Steno-Larsen interviewing Danielle DiMartino Booth and Dennis Lockhart.