To The Moon

This market is confusing. Is there going to be a recession? What’s the interest rate trade? What can we assume about where the Fed’s discount rate is headed? Should we just take the 5% risk-free t-bill and get on with it?

I think there are solid cases for both the t-bill trade and the long equities trade. Here I’ll make both.

T-bills

T-bills have become much more popular with investors in the last year. Even more everyday people are talking about getting the 5% risk-free return. That’s attractive.

The t-bill trade isn’t what it was a few months ago, however. People were scooping up t-bills at 4+ % because they didn’t want to hold during a risky stock market. There were common fears that the Fed’s aggressive rate hikes would force a recession. That would pinch stocks.

We are now in a bull market. The S&P 500 has ripped upward. It is debatable if that is going to continue. There are surely cases to be made in either direction for or against a recession/equity correction. Perhaps it’s AI hype, or job numbers will continue to weaken until we see unemployment.

My view on t-bills is a little bit different, however. The Fed has moved the needle on inflation. They have paused rate hikes. Even if they have one or two left tentatively in storage, the pause is here. I would assume that rates lowering should happen in the next year or so.

As inflation comes down, the Fed will need to lower rates a bit to offer padding. Avoiding deflation is a necessity. Also, if recession or economic slowdown seems imminent and inflation stays on course back to normal then we could expect the Fed to step in by lowering rates.

When interest rates go down, bond prices go up. Buying treasuries now could help investors capture capital appreciation of their bonds. If the Fed acts nearly as swiftly as they did on the way up, lowering rates would bring substantial returns to bondholders. That’s a reason to buy.

Furthermore, it is unclear if we are in a “fool’s rally” so to speak. Sure, stocks have had some decent returns, and the VIX is even low. So much of the rally has been driven by tech names, however.

Normally I wouldn’t have an issue with a tech-led market. It’s what I grew up with. This particular tech rally is geared towards AI, though. Not all AI will be game-changing. Not all AI will be disruptive. Some AI has the potential to alter the way we do business, or even redefine it, but tech is on the back of speculation right now.

There are hopes that AI will create a boom or help tech businesses create enormous value. Nvidia is trading at ridiculous multiples. Is this market justifiable, or is a lot of it propped up on speculation and hype?

Nvidia was the first stock I bought when I turned 18. The returns have obviously been quite nice. I have trimmed nearly all of my position, though, because I just can’t rationalize its price. Nvidia is the stock martket champion of AI. Hype has been centered around it. Let’s look at what that hype is.

Price-to-sales (P/S) is 39.18 as of June 27. They are trading at nearly 40x revenue. They are expected to see robust revenue growth, perhaps tremendous, but 40x is excessive. Their P/B is 40.93. Value investors tend to look for the magic number 1.

There has been a lot of energy around this rally. It may be broadening out — spreading to more stocks in different sectors — which would be a healthy sign of a non-speculative market. If it is a fool’s rally, however, then taking the 5% is a deal.

Long stocks

I know that I just badmouthed the stock market’s rally. I’m trying to see both sides here, so bear with me.

The “recession is imminent” crew is getting old. It has been 2 quarters away for the last year and a half (maybe longer?). Things don’t seem like they’ll be the end of the world. Too much is going right.

There is a tight job market. The number of jobs added to the economy has slowed down, but job openings still outpace people looking. There is a labor supply crunch in the United States, and there’s a lot of demand waiting to be filled by any and all labor.

Baby Boomers have a lot of wealth, and they have shown strong spending growth in recent months. Consumer spending is increasing, so demand hasn’t slipped in the way we would expect during a recession.

Even if we have a soft landing or mild recession, it doesn’t seem like things will be catastrophic.

Let’s talk about catalysts for the market rather than just why there’s no “doomsday” situation.

There is more short interest in the stock market than there has been since 2008. A total of about $1 trillion. This might sound like a bad sign, but it could be a huge opportunity.

Shorts are expensive to maintain. First of all, investors pay interest to keep their positions, so even flat markets aren’t good for short investors. We haven’t had flat markets though, we’ve had a strong, consistent bull market that has roared up 20+% from lows.

That means that there are a lot of short investors who are deep in the red on their positions right now. Shorting can only be held for so long before people need to cover their positions and buy back the stocks that they shorted. When investors cover their shorts, it increases stock prices.

What has happened is an accumulation of enormous short interest alongside a rally. There will be investors squeezed out of their positions. If markets continue to be strong or don’t see severe economic turmoil, the widespread need to cover shorts would be dire.

The result could be a market “melt up”. Equities gaining from people betting against them being wrong. A parade of short sellers running to the market to cover their positions could substantially drive the S&P 500’s returns.

If returns broaden out beyond the “Magnificent 7” and the stock market holds strong, I’m anticipating short sellers to be catalyst for returns.