Dear Trusted Partner,
The stock market generated a third consecutive month of losses. Concerns weighing down the market ranged from higher interest rates (long end of U.S. Treasury yield curve) to inflation reaccelerating (supercore inflation increasing month over month for the last three months) to a less confident consumer (Conference Board survey). All of this brought downside pressure to all three major domestic indices. The tech-heavy NASDAQ led the way with a loss of -2.78% for the month. The S&P 500 and Dow Jones Industrial Average lost -2.2% and -1.36%, respectively. Our proxy for the investment grade corporate bond market, the iShares Investment Grade Corporate Bond ETF (Ticker: LQD), was down -1.94% in October. Notably, our precious metal gold proxy (Ticker: IAU) showed divergent strength, appreciating +8.2% during the same time frame. This month was the first month in a while where we experienced gold prices materially outperforming all other asset prices.
While there has been much focus on what the members of the Federal Reserve have been saying over the last few quarters, the rise in interest rates has taken over the attention of market participants. With the near-historic rise of longer-dated U.S. Treasuries, investors have just started to discount all long-duration assets like stocks materially. From a corporate leadership perspective, these higher capital costs are assisting in a broad adjustment to the return of capital policies as we have had a considerable drop in the number of stock buybacks since March of 2022. Stock buybacks have been a material tailwind for equity prices over the last decade. The impact on privately held small businesses is also significant as the recent NFIB survey shows that average small business short-term loan costs 10% (or at their highest rate since 2001). From a valuation perspective, we are currently witnessing the stock market offer a negative equity risk premium for the first time since 2002. The rise in the 10-year U.S. Treasury yield, which eclipsed 5% last week, has dwarfed both trailing and forward-looking earnings yields of the S&P 500. We discussed the relative value of the S&P 500 and the corporate bond market a quarter ago, but now interest rates from every U.S. Treasury inside of 10-year offer a superior yield. Historically, periods of negative equity risk premium come with broad downside pressures for equity prices.
Finally, the housing market continues to be plagued by a 30-year low in demand for mortgages. Interest rates hovering at 8% is suppressing demand. The low housing supply and a strong labor market have prevented a material pullback in housing prices. From a seasonal perspective, housing inventory tends to grow between March and June, so it is unreasonable to expect inventory to rise for another five to six months. As we have mentioned before, a recent Federal Reserve report indicates that housing prices have more of an impact on household spending than the stock market. Intuitively, this makes sense, as more Americans have more equity ownership in real estate than in the stock market. Suppose the average American consumer has near-term concerns that the price of their house will fall. In that case, they will be reluctant to spend at the levels necessary to maintain economic growth. As a result, the first couple of quarters of 2024 will be crucial to see how much housing inventory grows.
Please see the following updates on existing positions held at the firm:
EOG Resources (Ticker: EOG)- Pioneers Natural Resources (PXD) agreed to be acquired by Exxon Mobil in a prominent deal that continues the belief that we will see a wave of consolidation in the E&P industry. As EOG is a peer of PXD, the company benefited from the transaction news. Developments in the Middle East continue to provide a short-term boost to energy prices, which should also help EOG. We believe the best-in-class operator has significant tailwinds over the next few years and plan to hold accordingly unless a material development happens.
iShares Gold Trust ETF (Ticker: IAU)- Precious metal gold saw its best month since the first quarter of the year. Unrest in the Middle East, paired with a continuing discussion of a monetary policy pivot from the Federal Reserve, gave gold dueling tailwinds to generate divergent strength compared to the decline in other popular broad asset classes. The haven gained approximately 4.5% in the two weeks following the Hamas’ surprise attack on Israel at the start of the month. We continue to hold a significant position in gold and have not broadly added to our position since February. Our concentration will center around the Federal Reserve and the comments from the various voting members of the FOMC.
RiverNorth Capital and Income Fund Preferred (Ticker: RMPLPR)- We have started to acquire a small position in this CEF (closed-end fund) preferred stock that matures on October 31, 2024. Once we invest a more significant allocation into this position, we will send a more extensive brief. Currently, the preferred will generate approximately 7.3% for the one year that will look to own the position. The asset coverage ratio has consistently exceeded 200% since its creation. This preferred, like other CEF preferreds, is governed by the Investment Act of 1940, which requires the fund sponsor to maintain $2 in assets for every $1 of preferred stock outstanding. We like the value (risk/reward) of this investment. The last three weeks represent the first time in a couple of years that we have acquired this position at an annualized rate of return of more than 7%.
Investment Grade Corporate Bonds- We continue to prefer this asset class. We are centering our research around short-dated (less than 24 months and, ideally, less than 12 months) high-grade or investment corporate bonds. One of the main reasons why we are focusing on a short time horizon is because while interest rates on corporate bonds are at 20-year highs, spreads (the difference between the rates of a specific corporate bond and the risk-free U.S. Treasury) are still very low. If our view over the next year of a global economic recession is correct, then the spreads should widen (or get more extensive). When invested over a short term, you can help neutralize the downside pressure in bond prices when bond spreads widen. We are continuing to witness opportunities where we can invest new capital in good quality credits under short-term horizons where the annual yield is more than 6.2%. This note can serve as a reminder that exposure to broad bond or fixed-income funds will generally increase duration or interest rate risks. Investing in individual bonds is one of the primary reasons why our account portfolios have been able to outperform bond funds over the last couple of years. We invest in individual bonds and can control the risks of our assets better.
If you missed our quarterly video call held on October 4. Please reach out to us, or you can visit www.GrahamCapitalWealth.com to get a link to watch the replay of the discussion that Michael Berkhahn and I had about a wide range of topics. As always, don’t hesitate to contact the team with any questions.
Best regards,
Stash J. Graham
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