JPow is the ZodiSPAC Killer

Good afternoon,

US Treasuries are headed for the strongest start to a year in more than two decades and the stock market has only been up this year…until dropping shortly after this morning's opening.

Let’s dive into our market outlook for the first half of this year and answer some market signal questions you've been shaking us down for answers to.

The Watchlist

• A steady slide in Apple shares pushed its market value below $2T, the latest casualty in the tech stock rout (BBG)

• South Korea to impose a $2.2M fine on Tesla for failing to tell customers about the shorter driving range of its EVs in low temperatures (Yahoo)

• SpaceX is raising $750M in new fundraising, valuing the company at $137B (CNBC)

• Drugmakers including Pfizer, GlaxoSmithKline PLC, Bristol Myers Squibb, AstraZeneca and Sanofi plan to raise prices in the US on 350+ unique drugs in early January (Reuters)

• In November, existing home sales fell for a 10th straight month, the longest streak in National Association of Realtors data that goes back to 1999 (NAR)

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What We're Watching for 2023

2022 was down bad at Quibi-level proportions – pretty much unsalvageable and do we really have to discuss this in yet another review.

Dustin Moskovitz, former Facebook co-founder, perfectly summed up last year: “I’m CEO of the Asana company, but lately, Jay Powell has been CEO of the stock price.”

So as we head into 2023, here’s what the street is thinking about, worried about and hopeful for.

Has inflation peaked?

It would be an understatement to say that inflation is the most important thing driving markets right now. Along with the future path of interest rates (which is very much inflation driven right now), it’s pretty much the only thing investors care about.

It’s a relevant question both at the macro level and the micro level. At the macro level, if we do have a recession this year, it will be because the Fed drove interest rates too high for too long in fear of inflation.

At the micro level, inflation without adequate wage growth makes us all poorer. Yet rising rates and the anticipation of a slowing economy mean that companies are less willing to hand out large raises (you would need a >7% raise to make more in real terms). If you haven’t seen it already in bonus meetings (or meetings for a lack thereof), expect many companies in the first half of this year to adopt a “well you should just be happy to have a job” attitude. At the same time, they’ll be raising prices on their customers, which further contributes to inflation.

Is zero COVID in China over? And will its economy be ok?

China’s about-face on COVID is as abrupt a policy change as you will ever see in modern politics, especially in a one-party system like China. But as bad as zero COVID was, going from one extreme to the other will also be problematic.

China was scared to let COVID rampage through its population due to several reasons — a largely unvaccinated elderly population, lack of confidence in its domestically developed vaccines, little prior exposure to COVID (thanks to its previous strictness), and an easily overwhelmed health system. Now as it downplays the threat of COVID and allows its citizens to carry on as normal, those fears are being realized. Fever medications have sold out at many pharmacies as the hoarding of health supplies hearkens back to the early days of the pandemic in other countries.

At the same time, China is still reeling from a property crash. While the government has promised some relief to troubled property developers, the Ponzi loop of constantly pre-selling future condos in order to fund the construction of currently promised condos has broken, possibly forever. This type of process requires a ton of trust as well as some naivety. Once that trust is broken and people wise up to the underlying shadiness, it’s nearly impossible to spark things up again. If China can get over the COVID hump, then perhaps a surge in consumer spending can nullify some of the property pain. But if its health system gets overwhelmed, then it will suffer both a humanitarian crisis as well as an economic one.

What will replace crypto, tech, and venture capital?

For much of the past few years since the pandemic, it looked like crypto, the tech sector, and VC-fueled startups were unstoppable. Sales were good, institutional money was rushing in to chase returns, celebrities were more than happy to pump their favorite meme stocks and crap coins. Then inflation and higher rates ended the party.

Suddenly – and shockingly – profits and valuations mattered. Many of the best investments of 2020 and 2021 declined >80% in 2022. The destruction of trust from the implosion of TerraLuna and FTX ushered in a new crypto winter with knock-on effects that hurt the semiconductor industry.

Markets don’t need an exciting headline to keep chugging along. Profits drive long term returns, not narratives. But, in the short-term, a shot of adrenaline from something exciting could get the stock market out of its doldrums.

For better or worse, greed drives risk taking. And perceived opportunities for large windfalls (whether real or not) drive greed. At the beginning of the year, analysts seem overly cynical as market returns this year seem to imply a complete lack of opportunity. Cheaper valuations are good for future expected returns, but valuation is a terrible market-timing indicator. Long-term investors may put their money to work now versus a year ago — but don’t expect a quick turn around.

Will housing bust in 2023? And take the economy down with it?

The housing market will likely make or break the U.S. economy this year. Housing is both a significant component of GDP — construction and housing related services account for roughly 17% of U.S. GDP. It’s also a huge driver of consumer and bank confidence. Americans have a lot of their wealth tied up in housing — so rising real estate values make people feel richer and spend more.

At the same time, banks make a lot of loans (e.g. mortgages) that are backed by real estate — healthy housing markets make banks confident that they will be repaid one way or another and encourage them to keep lending more and more.

Thus, housing markets drive both consumer spending (rising net worths encourage spending) and credit growth (rising collateral values stimulate lending).

But a frothy housing market also drives inflation, albeit indirectly through rising rents and OER (owner’s equivalent rent, where homeowners are asked what they believe they would need to pay to rent their home). So, a key part of the Fed’s inflation fighting toolkit is to raise rates and slow the housing market.

That’s exactly what they’ve done over the past 12 months. In order to combat high inflation, the Fed has pushed interest rates up rapidly. And because mortgage rates are closely tied to the rates controlled by the Fed, mortgage rates have skyrocketed as well.

The rate on a 30 year fixed mortgage has gone from under 3% to 6.5%. While it doesn’t affect the lucky folks who’ve already bought and locked in a low rate, it significantly increases the monthly payment for those looking to buy. And monthly payments are how most homebuyers gauge affordability — they compare their after-tax take home pay to the prospective monthly mortgage payment to decide whether a given house is in their affordable range. Thus, an increase in monthly payment equates to a decrease in the price a home buyer can afford to pay. This should ultimately lead to a drop in home prices.

Sticky prices

It will take some time. Unlike stocks, the housing market is much more illiquid. So, when prices are unfavorable, sellers disappear as nobody wants to lock in a bad price. That means the first sign of problems in the housing market is not a drop in price, but rather, a drop in transaction volumes.

Sellers who can afford to wait for better economic times do so. And this time around, many can afford to wait thanks to locking in extremely low mortgage rates over the past few years. Thus, would-be sellers are extremely unlikely to exchange their current bargain rate for a much higher one (if they were to sell their current home to buy a new one).

That means you should expect a decline in new listings to depress supply and artificially prop up prices for a while. In other words, in the short-term, the lack of agreement between sellers (who want to sell for 2021 prices) and buyers (who need to pay a lot less due to higher mortgage rates) will result in a dearth of transactions. This will allow home prices to lag reality – the deals that do get done will generally involve less price-sensitive buyers who are willing to overpay.

Ultimately, it will depend on the resilience of labor markets and whether job losses occur in large enough numbers (a big if) that it forces many of those impacted to sell. When you’ve lost your job and can no longer afford to pay your mortgage, then you can no longer be picky on price. These fire-sale transactions would put heavy downward pressure on home prices.

Forward looking data points to difficult times ahead

Make no mistake, the cards are stacked against the housing market. The Case-Shiller Home Price Index (above) shows home prices barely off record highs, but its calculation methodology is lagged, as the most recent reading is an average of the preceding three months). More forward looking indicators from RedFin are starting to sound the alarm bells (as of November 2022):

• The number of homes sold was down 36% year over year.

• The number of new listings was down 25% versus November of 2021.

• Listed homes were on the market for on average 15 days longer than during the same time a year ago.

• For most of the time since the pandemic, months of housing supply (i.e. total supply divided by number of houses sold per month) hovered just a tad over one month. Now it’s at 3 months of supply (not far off the pre-pandemic average).

• In May of 2022, nearly 60% of homes were selling above their listing prices. Now it’s 26% and the percentage has been dropping for the past six months.

Before you ask to speak to the manager, it’s important to keep in mind that while these changes sound alarming, the housing market has been extremely frothy and distorted since 2020. So thus far, a lot of these changes represent reversions to the previous norm rather than disastrous plunges.

The worry is that they are now happening against a backdrop of financial tightening (higher interest rates) and economic weakening, and should all of these things persist together, it could create a negative feedback loop and a lot more pain than the Fed is planning for.

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