I am pessimistic on equities as we get into the dog days of summer -- and the main reason is related to rising interest rates and credit -- but I see a path to safety for investors willing to do their homework.
It's true that the Nasdaq was up nearly 32% in the first half of the year. But that's only half the story. The rest is that almost all of those gains were powered by a handful of mega-cap names like Nvidia (NVDA) and Tesla Motors (TSLA) . What I find remarkable is usually growth stocks underperform in a period of rising rates, much like they did in 2022 when the Nasdaq lost a third of its value. I can attribute some of the rally within this tech-heavy index in the first two quarters to an oversold bounce back rally that feels more than overdone here.
Then there was the artificial intelligence theme that also helped goose performance in many tech names in the first half of 2023, which feels more than fully priced into these names. For example, Nvidia is trading at over 100-times trailing earnings, 55-times forward profits and nearly 25-times forward sales. But I also believe these mega-caps are also being bought for what are fortress balance sheets such as with Microsoft (MSFT) and Alphabet (GOOGL) .
As we start the second half of 2023, the inversion between the Two-Year and Ten-Year treasury yield is around 110-basis points, as high as it has been since the double-dip recession in the early 1980s. In addition, the central bank has raised the Fed Funds rate some 500-basis points since the Fed began its most aggressive monetary tightening in four decades in March of 2022. The Fed is also likely to implement an additional quarter-point rate hike later this month. Money supply growth has also gone negative since late last year.
What all this means is the price for credit is becoming much more onerous, and, at some point, a significant "credit crunch" could develop. I have written many times this year how this has negatively impacted the commercial real estate sector. This is especially true for the office, retail and some other sectors of commercial real estate that are seeing substantial declines in asset values. Some $1.5 trillion of this real estate debt needs to refinanced over the next three years. The problem is debt that has been routinely issued at 4% to 6% during nearly a decade and a half of the Federal Reserve's easy monetary policies has become much pricier.
Let's talk now about 9% to 12%, with more stringent credit criteria and conditions. But commercial real estate is hardly the only area that will have a much more difficult time raising capital or rolling over existing loans. This is one reason why, as a biotech investor, I am spending much more time analyzing balance sheets and cash burn rates on the small and mid-cap names I research and own. I am trying hard to confine my investing to names that have no further need to raise capital or at least have three years of operating cash on hand.
Most of these positions are held via covered call holdings adding another layer of risk mitigation. A lot of these names like Exelixis (EXEL) , Dynavax Technologies (DVAX) , Vir Biotechnology, Inc. (VIR) and Fulgent Genetics (FLGT) are well-known to my regular readers. Biotech simply is too risky a sector as it is without having to worry about the need to address balance sheet issues in this deteriorating credit environment.
Anyone investing in small- and mid-caps in other sectors would be wisely served to give an extra layer of scrutiny to those companies' balance sheets before making any investing decision as well.