Week #41: Biggest Rout in 150 Years; Mortgage Rates (almost) Triple; Smart Beta Turns Dumb;

Hong Kong- Financial Ghost Town?; The 10 Commandments of Microcap Investing

Today at a Glance

• One Rout: Once in 150 years

• One Triple: 30-year Mortgage Rates (almost) Triple

• One Failure: Smart Beta Turns Dumb

• One Ghostown: Hong Kong Stock Market RIP?

• One Special Report: The 10 Commandments of Microcap Investing

One Quote

The Biggest Rout in 150 years.

In terms of total returns, this is the biggest bond market rout in 150 years. Last year was, in fact, U.S. bond investors' worst year since 1871, with a total return of minus 15.7%, even worse than the annus horribilis of 2009. For 2023, the year-to-date return has been almost minus 10%; annualized, that's minus 17.3% — even worse than 2022. We are looking at bond investors' two worst years in a century and a half.

-      Niall Ferguson

I always cherish a valuable historical perspective on today’s events.

And no one does that better than Stanford’s Hoover Fellow Niall Ferguson in a recent piece on Bloomberg.

The law of unintended consequences is wreaking havoc in the bond market. Two years of staggering losses - the worst since the late 19th century - caught investors flat-footed. The implications are seismic.

First, higher interest rates now matter. Deficits can no longer be dismissed as a relic of economic theory. The sheer scale of U.S. borrowing means every percentage point rise in rates adds $2.8 trillion in interest payments over a decade. Even by CBO's conservative estimates, with rates averaging just 4%, deficits still hit 10% of GDP. The budgetary impact is enormous.

Second, ramifications reverberate through the economy. Banks face hits from lower bond prices. Corporations struggle to roll over debt. Mortgage rates spike, pinching households. And the government's interest burden swells, consuming resources that could be deployed productively elsewhere. Taken together, these impacts are a potent economic headwind.

Finally, the current policy is unsustainable. Under Biden, already egregious deficits have gone vertical. With the economy near full employment, 2023's deficit tops 7% of GDP - unheard of outside recessions or wars. There is no plausible scenario where the debt-to-GDP ratio doesn't keep rising. The fiscal trajectory is catastrophic. 

In short, unprecedented bond losses, soaring rates, and reckless deficits point to one conclusion – the law of unintended consequences has ambushed both investors and policymakers.

The fallout will be widespread. Markets and the economy face major adjustments ahead.

One Triple

U.S. housing affordability is now at its lowest point in history

Soaring interest rates recalibrate how investors value real estate, the world’s largest asset class at $326 trillion.

Rising rates crush both commercial calculations based on yield and families buying a house.

Both are in big trouble.

Yes, bonds have crashed, putting pressure on government finances.

But more immediately, the 30-year fixed-rate mortgage has reached its highest level since 2002.

In 2021, 30-year fixed-rate mortgages comprised 70% of all issued mortgages in the country.

Here’s how U.S. 30-year mortgage rates have evolved.

Average 30-Year Fixed-Rate Mortgage

Rising home prices and low housing inventory mean that U.S. housing affordability is now at its lowest point in history, according to the National Association of Realtors

30-year fixed-rate mortgages hit their lowest point in U.S. history—2.65% in January 2021. Since then, they have skyrocketed to their current rate of 7.31%.

This rise has locked up the U.S. housing market.

Don’t believe me?

Just try selling a house.

Homeowners with low mortgage rates hesitate to swap a 4% mortgage for a 7.3% deal.

The best possible outcome is that mortgage rates have already peaked.

The Mortgage Bankers Association estimates that the U.S. 30-year fixed-rate mortgage will fall to 6.3% by 2023 and 5.4% by 2024.

Still, the low rates that characterized 2020 and 2021 are a relic of the past.

And higher rates will put pressure on global real estate values for the next decade to come.

Smart Beta Turns Dumb

Overpromise, Underdeliver

Smart Beta or Factor ETFs burst onto the investment scene a decade ago with a big promise.

Historical back tests suggested they would beat the market by focusing on specific equity traits.

However, a 10-year data review by the Financial Times reveals a far less impressive story.

Three key takeaways that stand out.

Firstly, Factor ETFs didn't outperform the market.

The S&P 500 had a median monthly return of 1.78% over the decade.

Alas, no single Factor ETF category matched this. The Momentum Factor was the closest, delivering 1.61%. Smart Beta overpromised and under-delivered.

Secondly, the diversification benefit of Factor ETFs was bunk. Smart Beta ETFs claim to help diversify portfolios. But the data showed otherwise. The International Factor ETF had the lowest correlation with the S&P 500 at 0.89. That borders on no diversification at all.

Third, Factor ETFs increased volatility. Yes, the Minimum Volatility Factor lived up to its name. But other categories like Size and Momentum were more volatile than the market. Once again, the promise failed to live up to reality.

The takeaway?

Factor ETFs have failed to live up to the hype. Their inability to beat the market, provide real diversification, or consistently reduce volatility suggests that investors might be better off with low-cost, tax-efficient S&P 500 ETFs.

One Ghostown

Hong Kong Stock Market Crumbles

Hong Kong's stock market was once Asia’s epicenter of vibrant financial trading. Today, Hong Kong's stock market is devolving into a financial ghost town. Trading volumes are plummeting. Foreign investors are losing interest.

Three critical factors explain why.

1. Global Economic Fragility & Geopolitical Concerns

The Hong Kong Stock Exchange blames high interest rates and global economic instability. Increasing U.S.-China tensions weigh heavy on sentiment. In addition, declining faith in China's economic model and the slow-motion real estate collapse have spilled over to Hong Kong's stock market.

2. Taxation

Hong Kong's decision to increase taxes on share trading in 2021. This has deterred many traders. Buyers and sellers must pay a 0.13% tax on trades in Hong Kong-listed shares. This has led to a significant drop of about one-third daily turnover compared to 2021.

3. Regulatory Tightening

China's regulatory crackdowns on internet-technology companies have cast a shadow over international investors' confidence. Crackdowns by Chinese authorities on individuals and companies have shaken confidence. Buyers are reluctant to buy on the dip.

The bottom line?

External economic pressures, unfavorable tax changes, and dwindling investor confidence weigh heavily on economic sentiment.

Does this sound like the death knell for the Hong Kong stock market?

Probably not. But it does mean the end of a freewheeling era as mainland China tightens its grip.

One Special Report

Why Invest in Microcap Moonshots?

A microcap stock is a publicly traded company with a market capitalization of less than $500 million.

Wall Street investment banks snub them. The financial media ignores them. Even savvy hedge funds with large teams of analysts give microcaps the cold shoulder.

So, if microcaps are so unpopular, why should you focus on them?

Blame- or thank- “the miracle of compound interest.”

From 1927 to 2016, the smallest 10% of stocks in terms of value in the U.S. generated a compound annual return of 17.5%.

That compares with 9.2% for the highest 10% of U.S. stocks.

Compounded over time, this difference is staggering.

Invest $10,000 today for a return of 9.2%, and you will end up with $25,092 in 2033. Invest that same $10,000 at a return of 17.5%, and you’ll be sitting on $57,546.

That’s more than 2x the difference over a decade.

Of course, the smart money knows this.

Warren Buffett- the best investor in history- made his first million by investing in microcap stocks. As Buffett has said, if he were starting today, he'd do the same today:

If I was running $1 million today, or $10 million for that matter, I’d be fully invested … It’s a huge structural advantage not to have a lot of money … The universe I can’t play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.”

The good news is that it leaves the field wide open for small investors.

That said, microcap investing poses different financial and psychological challenges.

That makes the experience far different from speculating on a short-term bounce in tech - or buying and holding a major index like the S&P 500.

Want to learn more about what it takes to invest in microcap stocks?

Download my free Special Report: The 10 Commandments of Microcap Moonshot Investing.