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Why Michael Gayed sees Phase 2 of a coming credit event going from treasuries to corporate credit to junk debt to highly levered companies (1:23) and why we’re heading back to an era of dividend focus (5:45). Fed credibility and how they’ve left themselves very little wiggle room (8:20). This is an abridged conversation from Seeking Alpha’s recent Investing Experts podcast.
Transcript
Rena Sherbill: Michael Gayed runs The Lead-Lag Report on Seeking Alpha. He writes on Twitter a lot. Runs his own portfolio. A lot of insight and nuance to be gained.
Michael Gayed: My conviction around things is never around the mile marker. It’s always around the conditions that favor something happening. I always go back to this idea that conditions favor probabilities, they dictate the probabilities, probabilities dictate the outcome.
So you have to look at the overarching dynamic in the background to, sort of see what is more likely or not, right, from a risk perspective. Now, in July, I was pretty adamant in the idea that the market may have peaked in July as AI mania was at its apex. And I was basing that off of history.
When you look historically going back to late 1920s, and you look at different months where the S&P peaked for the year, 8.3% of the time, stocks peak for the year in July. Now, that’s not because it’s 1 in 12, it just so happens to be one-twelfth.
But 8.3% of the time, historically, it’s a non-zero probability that historically markets tend to peak in July. 40% of the time, they tend to peak in December for the year. So it is true that there does tend to be that drift higher into the end of the year.
But in July I was saying it could very well be that we’re in one of those 8.3% of the times in the calendar because of the lagged effects of the fastest rate hike cycle in history.
Now, I started the year saying I believe we have a melt-up scenario for equities, but that towards the end of the year there will be some kind of a credit event on the realization that higher for longer is going to cause significant bankruptcies for a lot of companies that operate on very razor thin margins and that have been living off of zero interest rates for the longest time.
The term credit events is just another way of saying VIX spike. It’s just another way of saying significant drop very quickly in risk assets. It turns out what I now call Phase 1 of the credit event has clearly taken place in treasuries.
In other words, you saw this tremendous sell-off in long-duration treasuries. Everyone, including myself by the way, thought that that dynamic was over after what happened last year; instead, it only got worse. And it happened really aggressively.
I put a post out in September saying treasuries are the credit event Phase 1, and you’ve seen a lot of disruption from what’s gone on in the volatility of the government bond market side. We have yet to see and I still think that that’s coming, it’s just a question of when.
We’ve yet to see what I call Phase 2, which is the credit event going from treasuries into corporate credit, into junk debt, into highly levered companies. If that scare happens in junk debt, in high yield issuers, yes, it would make sense that everything would break pretty meaningfully.
You would have some kind of a VIX spike, some kind of a crash. And I keep going back to the conditions I’d argue really do favor it because everyone is seemingly not realizing that there’s no precedent for what the Fed has done.
RS: And what do you feel like in terms of there not being a precedent for what the Fed has done – where do you think that leaves the bonds and the treasuries as we move forward into somewhat knowable, but also unknowable terrain with the Fed?
MG: So I think it’s important to distinguish – there’s a difference between being bullish on treasuries to capture yields, right? And being bullish on the flight to safety dynamic, which is the idea that treasuries for a moment in time counter equity volatility.
So I go back to a credit event means credit spreads are widening, means a VIX spike, means volatility in equities is rising. So there’s a direct correlation between credit spreads widening, default risk getting repriced into the bond market, and stocks acting more violently, generally speaking.
Treasuries are, I keep emphasizing, it’s not that they’re a hedge to the stock market. Treasuries are a hedge to credit spreads, which means they’re a hedge to volatility in the stock market, which is what makes them a hedge to the stock market, which I know that sounds a little Dr. Seuss like, but the transmission mechanism is around corporate credit spreads widening.
So if you have that Phase 2 dynamic where credit spreads widen the VIX spikes, my expectation would be, and admittedly I’m a little biased in this, would be that, for a moment in time you would see that flight to safety into long duration treasuries, into long duration government debt.
The whole concept of that flight to safety is that money goes into treasuries when there’s fear, because what is it that investors are fearing in that moment of high volatility? They’re fearing that they won’t get their money back that they lent to some highly indebted issuer. So they go up the quality scale ultimately to treasuries, ultimately to the U.S. government because U.S. government can’t default. It’s got a money printer.
Now that’s only a moment in time dynamic. That’s a sequence in periods of high volatility. That’s what’s been missing the last two years. That’s also what’s been, unfortunately missing and hurt my own funds, my Mutual Fund, my ETFs (RORO) and (JOJO), because they’re designed to try to play that dynamic.
But I do think it makes sense that, treasuries went from being the source of credit risk to, if I’m right, going full circle to being the beneficiary of the next phase of credit risk, which is default risk rising.
RS: What kind of sectors are you looking at that peaks your interest the most or maybe that you think investors aren’t looking at it in maybe the exactly right way?
MG: I think broadly speaking, we’re going to go back to an era of dividends focus. Whether it’s through REITs or the utility sector or consumer staples or healthcare, at some point, tech AI relative momentum ends.
At some point, you have to believe, and always a question of when, investors get back to their senses and start saying, you know what, we can’t just keep on pricing things at a price to earnings of 30, when you can get a very inexpensive company yielding, from a dividend perspective, 4% or 5% or even 6%.
So I think you are going to see a pendulum shift away from capital appreciation back to the dividend, which means any sector which is dividend-centric probably does start to see flows.
Now, I do think this gets to be interesting in particular when it comes to healthcare in that to the extent that investors and asset allocators still want to buy into the growth style. Growth style is primarily tech, but the next biggest sector typically is healthcare as far as that growth style of investing. So for healthcare to work, I’d argue it has to be funded from sales on the tech side because it’s the next major bucket that can absorb inflows and absorb capital.
So I just think in general the hatred of dividend names, that’s probably pretty exhausted at this point. And if I’m right on that, yeah, there will be some really good opportunities for, going back to traditional blue chip, dividend-type investing as opposed to speculative PE expansion trading.
Everybody that I talk to, and I talk to a lot of financial advisors, they’re itchy to want to buy small caps as a way of playing catch up to large caps because they’ve done so poorly. But the reality is, as long as rates stay elevated, that is going to be a major headwind. And every time it looks like small caps want to run, they get hit pretty badly.
So I think it’s more of the same of whipsaw risk around everything outside of large caps. And then at some point, large caps themselves, “the generals,” they fall to the soldiers when it comes to market dynamics.
RS: Where do you figure in the Fed in terms of rate hikes – how do you see it developing? Do you see any changes? And are you pretty much in agreement with the consensus out there?
MG: Look, the Fed only responds when credit spreads widen. The Fed doesn’t really care about the stock market. The Fed cares about default risk rising because that’s what impacts the real economy. And to the extent that credit spreads stay tight, then the Fed is going to stay tight with its monetary policy.
I do think that they have probably backed themselves a little bit into a communication wall in that by constantly saying higher for longer, what if there is some kind of exogenous tail events where, as I keep mentioning, Japan might end up being a source of global volatility and risk through the reversal of the carry trade concept?
And then what if the Fed has to respond? Well, it seems like they might end up breaking their own credibility if they keep on saying higher for longer than suddenly have to do an emergency rate cut.
My point is they’ve left themselves very little wiggle room in terms of their ability to be flexible when they keep using that terminology. Now, they’re going to do what they need to do at the end of the day, right? From their perspective.
But if a lot of this is ultimately around Fed credibility, their ability to fight inflation, well then if there’s a concern around suddenly a deflation pulse or a deflation scare, now their credibility is going to be questioned on that end, right, too.
So as far as what the Fed does next, my crystal ball is as murky as everybody else’s, but I suspect that history will prove to be right in the future, which is to say that the Fed follows, the Fed often is late both ways to raising rates and to cutting rates, and this time is not different.
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