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Recession Risks Remain High

Markets have calmed down quite a bit from the volatility of 2022.

This had led many people to believe that the worst might be behind us.

Maybe that is the case, but there are many data points suggesting we shouldn’t be too optimistic (at least not yet).

Let’s look at the data to see what it says.

Indicators a Recession is Near:

By far the bulk of the macroeconomic data is negative. In fact, many indicators suggest a recession is imminent.

While we haven’t seen anything bad happen yet, that doesn’t mean we’re out of the woods.

There are major economic drivers of the US economy that are flashing warnings signs:

  • Yield Curve
  • Leading Economic Indicators
  • Banks’ Willingness to Lend
  • CEO Confidence
  • Forward Earnings per Share

Let’s take a brief look at each of these items.

Yield Curve

The yield curve shows interest rates at various maturities.

When longer-term bond pay more interest than shorter-term ones, the yield curve is “normal”.

However, when shorter-term bonds pay more, the curve is “inverted”.

An inverted yield curve has a 100% success rate in predicting recessions. Currently, the curve is inverted, as shown on our first chart below.

A recession has always followed when the yield curve has been this inverted.

On average, a recession begins within 12-18 months after the initial inversion. This happened one year ago.

If history is any precedent, a recession should start by this summer.

Leading Economic Indicators

The Leading Economic Indicators (LEI) is a measurement of ten data points on the earliest stage of economic activity.

Right now, LEI is very negative. In fact, every time LEI has dropped this much, a recession has followed.

This next chart shows the LEI index. Green shows positive year-0ver-year growth, while declines are in red. Recessions are shown in the red shaded areas.

Typically, a recession starts 7-8 months after LEI growth drops by 3% year-over-year. This happened in December.

If history is any precedent, a recession should start by this summer.

Tightening Lending Standards

Banks are tightening lending standards and access to credit.

The US economy is driven by debt. When banks tighten, the economy slows.

Except for 1994, every time bank have pulled back on their willingness to lend money, a recession starts within months.

This suggests that we may already be in a recession.

CEO Confidence

Corporate CEOs have access to real time economic data on how their company (and more broadly the overall economy) is performing.

When CEO confidence falls, recessions typically follow.

Earnings Growth

The previous data points are all macro-economic data points.

The next has to do directly with stocks.

If we do enter a recession, corporate earnings will decline. In fact, we’re already starting to see that.

All of the data points above suggest risks in financial markets remain very high over the next few months.

However, there are data points telling us a recession may not be quite as likely.

Indicators Suggesting a Recession is Less Likely:

While the bulk of the data is poor, there are some data points suggesting that a recession may not be imminent:

  • The US Consumer has been Resilient
  • Light Vehicle Sales are Steady
  • Employment Numbers aren’t Bad
  • VIX has remained low
  • Market Breadth is Improving
US Consumer Spending

70% of the US economy is dependent on the consumer.

If the consumer can remain resilient, then there still remains hope that we will avoid a recession (or at least have a mild one).

The next chart, courtesy of Bank of America, shows that consumer spending increased in January.

This is an important indicator to watch over the coming months.

Light Vehicle Sales are Steady

Another indicator showing that the consumer is resilient and there is still overall demand in the economy can be seen in vehicle sales.

Light vehicles include almost every consumer auto. This categorization includes all cars and trucks weighing less than 10,000 pounds. (For reference, the maximum curb weight of a Ford F-150 is about 5,600 pounds.)

While this chart doesn’t necessarily show excessive strength, it also doesn’t show weakness either.

Employment Numbers Remain Strong

One of the most widely watched economic indicators is the unemployment number.

The chart below shows jobless claims. So far, unemployment has remained resilient.

This is very closely tied to the consumer spending data we mentioned above. When people have jobs, people spend money. Especially when prices are higher on just about everything they buy.

We’ve all heard of the layoff announcements by the Tech giants Amazon, Microsoft, Apple, Google, Microsoft, and more. These are concerning, and could be the tip of the iceberg.

But for now, those layoffs have not spilled over to the broader economy. At least not yet.

This is another data point we will watch with great interest in the coming months.

VIX Index

The VIX has reflected the relative market calm over the past few months.

While each recession has had a spike in the VIX, not every spike in the VIX has lead to a recession.

The VIX is a relatively fickle index, and there is little to no predictive power in it. But it does tell us that despite the high economic risks right now, the market is not overly fearful.

Market Breadth

The last chart we’ll discuss has to do with market breadth.

In order for the overall market to move higher, its underlying constituents need to be doing well.

And in the past few weeks, there has been improvement.

This chart shows the percent of stocks within the S&P 500 that are above their respective 200-day moving average. (This is simply the average price of that stock over the past 200 days.)

The current reading is 68%. This is a healthy number. While this number in isolation doesn’t give us an “all-clear” to invest, it is a good sign.

Bottom Line

Despite recent market strength, risks remain incredibly high.

At this point, it appears that the rally we’ve seen this year is another bear market rally.

The next few months are very critical. If a recession hasn’t started by mid-year, then the Fed very well may have manufactured a “soft landing”.

Client portfolios remain conservatively positioned, as they have been for the past 8-9 months.

The further we get into this year without bad things happening in the market, the better the overall risk/reward profile of this market becomes.

We’ll publish a video in the coming weeks to discuss the specific scenarios we see happening over the coming months.

Until then, please do not hesitate to reach out with any questions.

Invest wisely!

A Recession or Not a Recession, That is the Question

“To be or not to be–that is the question: Whether ’tis nobler in the mind to suffer the slings and arrows of outrageous fortune or to take arms against a sea of trouble and by opposing end them.”

hamlet, act 3, scene 1

July was a nice month in the markets.

Which begs the question…have we seen the lows in this bear market?

Should we expect markets to continue to rise and suffer the slings and arrows of outrageous fortune? Or is this yet another fake-out like we’ve seen twice already this year and we go back into a sea of trouble?

The answer? It depends.

In most environments, it “depends” on a complex series of data points could shape the direction of the markets.

However, today’s environment seems more simple on the surface.

It depends primarily on only one variable: whether we are in a recession or not.

The reason is very simple…markets respond differently to pullbacks similar to what we’ve seen this year based solely on if it happens during a recession or not.

Let’s look at some historical context.

S&P 500 Performance: Recession vs No Recession

Markets can decline without the economy being in a recession. Since 2009, we’ve seen this happen a few different times:

  • 2011: US Debt Downgrade
  • 2016: Chinese Yuan Devaluation and Oil Crash
  • 2018: Random 20% decline in the 4th quarter

Each of these times, markets fell roughly 20%.

And each of these times, markets recovered losses within 18-24 months.

But there was no recession during these periods.

Our first chart below, courtesy of Ned Davis Research, shows this dynamic. The chart shows declines of at least 18% and separates it between two categories: whether it occurred during a recession or not.

The black line is the performance of the S&P 500 when there was no recession, while the blue dotted line shows the performance if there was an official recession.

We are currently two months past the recent lows, as indicated by the red dashed line.

Based on what the market has done historically, the results are very clear: if we’re not in a recession, we should expect the next 12 months to be pretty good. If we are in a recession, we should expect more volatility and a retest of the lows.

Which begs the question…are we in a recession or not?

Are We in a Recession?

Normally, determining a recession is pretty straight-forward: it is two consecutive quarters of negative GDP growth.

Both Q1 and Q2 this year were negative.

So by historical definitions, yes, we are in a recession.

But it may not be quite that simple this time.

We don’t like to get political in these reports, because the world focuses way too much on the self-absorbed, sociopathic political class.

But with mid-term elections around the corner, the incumbents are trying to change the definition of a recession.

It’s an overly transparent pre-election tactic. But we will reluctantly admit that in this case, they may have a point.

(To be fair to our politician friends, many economists agree that the first quarter did not resemble a typical economic recession.)

Let’s look at the data.

The first quarter GDP came in at a negative 1.4%, mostly because of two things:

  • Defense spending fell 8.5%
  • A trade imbalance due to a strengthening US dollar resulted in a negative 3.2% from total GDP.

Remove these two factors, and GDP is positive. In fact, if you simply remove the trade imbalance, GDP is positive.

Economic data in the first quarter was fairly positive as well, led by consumer spending, which was up 2.7%.

While the first quarter showed relatively good economic data, the second quarter was recessionary without question.

Second quarter GDP was negative 0.9%. And the negativity was more widespread.

  • Inventory investment decreased 2.0%
  • Housing investments decreased 0.7%
  • Federal and State spending both decreased slightly
  • Business investment decreased 0.1%
  • Consumer spending rose by a more moderate 0.7% (down from 2.7% in Q1)

With the underlying strength in the first quarter, it’s not out of bounds to assume that we’ve only seen one quarter of truly negative GDP growth.

(For the record, we don’t think we should change the traditional definition of a recession, but we should always put GDP data in context, both positive and negative.)

Which makes the current quarter especially important.

If we have negative GDP this quarter, there is no question that we are in a recession. The question then becomes how bad it is and how long it lasts.

Atlanta Fed GDPNow

One way to keep track of current GDP estimates is through the Atlanta Fed’s “GDPNow” tracker. (You can view the site HERE.)

As of Thursday, August 4th, they are projecting a 1.4% GDP for Q3, as shown in the next chart.

Granted, the estimate has steadily declined since the start of the quarter, and we still have almost 2/3 of the quarter left. So anything can happen.

And this data is also based on human estimates, which can be skewed.

But it should at least give us some hope that maybe we don’t see a formal recession this year. And if we do see one, it would likely be fairly mild.

This morning’s jobs report adds to the hope that we may not be in a recession just yet. The economy added 528,000 new jobs this quarter, and as of July has officially recovered the number of jobs lost during COVID.

However, we shouldn’t get too complacent at this point.

While GDPNow is showing positive estimates for current GDP, there are huge warning signs right now that should give us cause for concern.

Inverted Yield Curve

Historically, one of the best recession indicators has been an inverted yield curve. This occurs when the 10-year yield on US Treasuries are LOWER than the 2-year yields.

The next chart, courtesy of Bloomberg, shows this inversion.

When the line goes below zero, the curve is inverted.

Right now, it is more inverted than at any time since Paul Volker started fighting inflation the early 1980’s.

It is more negative than COVID, than the global financial crisis, the tech bubble, and various recessions during the 80’s and 90’s.

We strongly believe that it is imprudent to ignore this data point.

But this data point isn’t a very good timing indicator of when a recession may happen.

In reality, it is when the curve starts to steepen AFTER it has been inverted that is a better indicator that a recession is imminent, and we haven’t seen that happen yet.

Housing Market Concerns

While the inverted yield curve is a bit more theoretical in nature, there are real economic data points that are showing signs of stress.

The housing market plays a huge part in economic activity, accounting for 15-18% of US economic activity on average.

Leading indicators in the housing market are showing reason to be concerned.

One of these is cancellation rates, as shown in the next chart from Redfin.

Cancellations happen when an accepted offer is withdrawn by either party.

In this case, the majority of cancellations are due to buyers backing out.

There are legitimate reasons for this happening:

  • Mortgage rates have increased, making it unaffordable for a buyer to proceed;
  • Property taxes have been reassessed higher, increasing the cost of housing;
  • People anticipating that prices may fall, causing buyers to withdraw offers.

Here’s a link to the article discussing cancellations:

The Deal Is Off: Home Sales Are Getting Canceled at the Highest Rate Since the Start of the Pandemic

Another reason for cancellations is a drop in consumer confidence, which has a big effect on economic conditions in the US.

Consumer Confidence

While the housing market is a large part of the economy, the consumer as a whole is much more important. Approximately 70% of the US economy is driven by the consumer in one way or another (this includes housing).

So when consumer confidence slows, economic activity typically slows along with it.

And the consumer is in the dumps right now, as shown in our next chart.

Right now, the consumer is the least confident they have been at any time in the past 60 years. This includes the Vietnam era, the inflation of the 1970’s, the tech crash, the global financial crisis, and COVID.

That is concerning.

But what does all of this tell us about the near-term direction of the market?

S&P 500 Index

All of the data listed above is not news to the market.

Despite these concerning data points, markets have rallied over the past seven weeks.

But the move higher since June looks almost identical to the one in March, as shown in the chart below.

Specifically, the pattern is a three-leg move higher into previous highs.

There was an initial leg higher, a move lower of roughly the same timeframe, then an extended move higher in both time and price.

The move in March followed the Ukraine invasion.

The move in June really didn’t have any catalyst, other than the overall market being incredibly pessimistic.

In addition to the S&P 500, nearly every major US stock index looks identical.

The next chart shows the S&P 500, the Russell 2000 small cap index, the Nasdaq Composite and the S&P Mid Cap index.

Every one of these indices are at the same resistance level. This means that the market thinks these levels are important.

Regardless of the reason for the move in June, it has been strong. Earnings reports have been more positive than expected, and the market is starting to predict that the Fed will become more accommodative and “pivot” by slowing the rise of interest rates.

If the market is going to do it’s own pivot and head back lower, it must do so very quickly.

If it breaks above this resistance area, then we can begin increasing equity exposure in client portfolios, at least for a period of time.

If it heads lower, then we should expect a fairly quick move to test the lows from June.

Bottom Line

While a big consideration for the market is the current recession debate, markets are extremely complex systems. Relying on only one data point for decision-making would be foolish.

When looking at a variety of data points, it truly is a mixed bag out right now.

Recent market strength and earnings reports have been mostly positive. As such, the market seems to believe the Fed will slow down the pace of interest rate increases. (Frankly, this expectation seems to be unwarranted, especially after today’s employment numbers.)

For now, the move higher over the summer appears to be a typical bear market rally. As such, we have been intentionally slow to add equity exposure.

Why?

Mainly because there is still plenty of upside if the market wants to keep pushing higher. For example, the Nasdaq is down nearly 23% this year, even after a big rally over the summer.

And big stocks like Google, Microsoft, Facebook and Netflix still have massive upside potential at current levels.

If the market can get above the levels noted in the S&P chart above, there starts to be more proof that this rally may be more than just another temporary rally.

But if we do go into a recession, all bets are off. And there are many indications to suggest we are headed in that direction.

Bottom line is that we believe it is prudent to underweight risk right now, given the massive uncertainties in the market and the economy.

Invest wisely!

5 Themes for 2022 and Why We Hate Year-End Predictions

Fortune teller reading future with crystal ball. Seance concept.

We hate year-end predictions.

Maybe “hate” is the wrong word…it is far to kind.

We absolutely despise the cringeworthy year-end predictions that accompany this time of year. (Feel free to imagine other colorful adjectives we may use to describe them.)

Why?

  1. Because they are worthless.
  2. There is no accountability whatsoever for those who make them.
  3. There is no way to accurately predict such a complex system as the global financial markets with any consistency, other than using the most commonly occurring outcome of an historical return bell-curve.
  4. Did we mention they were worthless?

Case in point…the six largest investment firms in the world missed last year’s performance by nearly 20 percentage points on the S&P 500. Oof.

Our apologies in advance if you’re looking for our wild-ass guess expertly modeled estimate of what the S&P 500 will be on December 31, 2022.

As our clients hopefully know, we don’t try to predict what will happen. Instead, we try to listen intently to the markets and let our rules drive the investment decisions.

So instead of sharing our predictions, let’s instead share the five themes we’re tracking for the upcoming year.

Theme 1: The Fed

For those who regularly read our reports, there’s no surprise here that the Fed holds the top spot in themes we’re watching this year.

The Fed is the Alabama Crimson Tide of the financial world. They are always among the top few drivers of what will happen during the season. And unless you’re on the team or an alumni, most people are pretty tired of you by now.

More accurately, the Fed IS the driver of the market. It has been since 2009. So we MUST pay attention to what they are doing.

Right now, despite the talk from Chairman Powell about tightening and raising rates, they are still expanding their balance sheet.

Federal Reserve Balance Sheet has been increasing despite Powell saying they are tapering.

The increase in the Fed’s balance sheet is the single biggest contributor to both the increase in the stock market, as well as the re-emergence of inflation across the globe.

It is also a reason why we’ve only seen minor pullbacks since COVID began.

The eventual reduction by the Fed is very likely to lead to a much choppier environment for stocks, and at some point an outright bear market.

Whether that happens in 2022 or not is anyone’s guess.

But as of right now they are scheduled to begin reducing their balance sheet this year, not just slowing down the increase of it.

Paying attention to global markets when the Fed ACTS, instead of when they SPEAK, will be key for risk assets this year.

Theme 2: Inflation

The second theme to watch this year, and the natural follow up to the Fed, is inflation.

We’ve all seen it recently. From cars to steaks to milk to $10 packets of bacon. Everything costs more.

In fact, inflation just recorded the largest year-over-year increase in 40 years. It rose 7% in the past 12 months, as shown in the chart below.

On the surface, this looks ominous. We haven’t seen an inflationary environment since the 1970’s, and that decade was not a good time to passively invest in stocks.

However, our belief is that inflation will not increase and stay at elevated levels.

Instead, we think it will occur in waves.

We wrote about inflation numerous times last year (click to read):

Lumber is a good example of our inflation-wave thesis.

After skyrocketing the first part of 2021, lumber prices subsequently collapsed. Now, they are skyrocketing again.

Take a look at the extreme moves in lumber recently.

This chart is pretty amazing. We’re talking about the price of LUMBER. Not some phantom crypto-coin being schlepped by a Kardashian.

Lumber is an excellent case study for this environment. There are demand influences, supply chain issues and quality differences in various types of lumber that contribute to this massive volatility. And for the most part, it does not have governmental influences on it like the cost of healthcare does.

Inflation has far-reaching ramifications. Not only for asset prices and the economy, but for society as a whole.

Higher prices hurt consumers. They hurt businesses without pricing power. They cause massive price adjustments in all sorts of areas. Inflation also has massive political implications as a disgruntled populace focuses its frustrations on political leaders.

This quote by John Maynard Keynes is fairly long, but worth the read:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

– John Maynar Keynes

Sounds pretty applicable to today. It was written in 1920.

We don’t expect inflation to cause massive societal disruptions this year, but we sure can see the foundation being laid for that to happen.

Inflation needs to be near the top of things to watch this year. And the coming decade for that matter.

Theme 3: Interest Rates

The third major driver of markets and the economy is the prevailing interest rate environment.

The COVID Crash in March 2020 pushed yields to their lowest levels in history. Not just recent history. All-time history. In the entire history of recorded financial records, dating back to ancient Egypt 4000 years before Christ, interest rates were never lower than they were two years ago.

Since then, they have marched higher. And they are currently trying to move beyond their highest levels since COVID began, as shown in the next chart.

Higher interest rates affect many areas. Real estate, fixed income markets and global currencies all have some sort of tie to interest rates. Not to mention more complicated instruments like derivatives and futures contracts.

Stocks are a bit different.

Higher interest rates aren’t necessarily bad for stocks all the time.

In fact, stocks tend to do just fine when rates rise.

The next chart, courtesy of LPL Financial’s Ryan Detrick, shows the performance of the S&P 500 each time the 10-year yield has risen by more than 1.00% (or 100 basis points).

Since 1962, there have been 14 times when the 10-year Treasury yields has risen by more than 100 basis points. Stocks were higher 11 of those times by an average of 17.3%.

Granted, most of these periods occurred during the massive bull market we’ve had over the past 40 years, but this is still an impressive statistic nonetheless.

While parts of the market are likely to suffer as interest rates rise, we shouldn’t assume that higher interest rates will automatically make stocks go down.

We are likely to find out if this holds true again this year.

Theme 4: Risk Makes a Comeback

The S&P 500 had an excellent year in 2021. CNBC and most financial news outlets primarily focus on the performance of this behemoth index.

But last year did have its share of risk if you looked outside of the large cap growth stocks.

The chart below shows the performance of various assets since last February.

The S&P is the leader by far. It was up almost 22% before the turn of the new year, since last February alone.

However, other assets didn’t perform so well during that same time:

  • International stocks were barely higher (Up 3%)
  • Small Caps lost value (Down 7%)
  • Emerging Markets down big (Down 13%)
  • China was substantially lower (Down almost 30%)
  • Even the high-flying ARKK investment ETF, run by Cathie Wood and epitomizing the speculative edges of the markets, fell by nearly 50% since last February.
  • Bitcoin is down nearly 40% in the past two months (not shown on the chart above). Not what we consider to be an effective a store of value, especially with inflation at 7%.

Why did the S&P returns exceed other areas of the market so much?

Simple…nearly 30% of the index is in the top 5 stocks. And those stocks did amazingly well last year.

The rest of the financial world experienced weakness or outright bear markets already.

The main question for this year is whether the rest of the world can do well if the top stocks in the S&P 500 do poorly.

If they can, which is an excellent possibility, then there will be more opportunity in owning things outside of the big tech companies. In our view, this is the likely path forward.

But if they can’t, and the rest of the world remains weak while the heavy lifters in the S&P 500 deteriorate, then it could be a difficult year across the board.

There are mixed messages here, and the answers are not clear. So you must adapt as the things develop, whether they become bullish or bearish.

Theme 5: Another Damn Election

It’s a mid-term year, and the fully saturated political environment is going to soak us once again.

In an ideal world, politics shouldn’t influence asset prices. But in our world they do.

Remember the performance of Chinese stocks from the chart above? A number of Chinese companies have excellent business models, fantastic customer bases and thriving businesses, but political influences caused massive declines in the performance of their stock last year, and it brought down the entire stock index in that country.

With this being an election year, there are some key areas of the market that could be made into whipping boys this year.

The two most likely targets? Big Tech and Big Oil.

We’re starting to hear rumblings from Washington about their intentions.

The big social media companies are scheduled to testify to Congress soon. And our beloved politicians won’t miss the opportunity to send an outlandish quote hurling through the echo chamber to get on the front page nationwide.

Same with big oil. We’re already hearing from President Biden that oil companies are gouging the American people. Maybe he’s right, maybe not. But we should expect them to be a target this year as well.

Despite of whether there is political influence or not, midterm election years tend to have increased volatility on average.

The next chart, again courtesy of LPL Financial, shows This chart shows the average return of each year of the 4-year Presidential Cycle since 1950.

Specifically, it shows that Midterm years have an average drawdown of 17% during the course of the year.

It also shows that on average, stocks are higher by 32% a year after the lows.

While each year has its own specific characteristics and abnormalities, the Presidential Cycle data suggests we should see some volatility this year, but should expect a nice recovery.

Bottom Line

Bottom line, the market is finishing up a strange year in 2021. The S&P 500 did great, but other areas didn’t do as well.

And markets are off to a fairly rocky start to the year so far. But the overall trend still remains higher, at least for now.

Where the market ends up at the end of the year is anyone’s guess. But we’ll keep adjusting portfolios as the data warrants, and will work hard to both protect and grow your hard-earned wealth.

Invest wisely!

The Wolf and the Crane

Aesop was a Greek storyteller who lived from 620-564 BCE. His stories were verbally passed down through time, and often included tales of animals and inanimate objects that could speak and solve problems.

Many of Aesop’s Fables are commonplace even to this day. We are all familiar with the story of the tortoise and the hare.

But a lesser known fable is that of the Wolf and the Crane.

In the fable, the Wolf gets a bone stuck crosswise deep in his throat. He asks the Crane, with her long neck and lengthy bill, to reach in and pull the bone out. If she successfully removes the bone, he promises to reward her very handsomely in return.

So the Crane uneasily put her head into the Wolf’s throat, and removes the bone.

But when the Wolf felt that the bone was gone, he started to walk away.

The Crane anxiously asked, “But where is my reward?“

The Wolf whipped his head around and snarled, “Haven’t you already got your reward? Isn’t it enough that I let you take your head out of my mouth without snapping it off?”

The moral of this story is that you shouldn’t expect a reward when you are serving the wicked. (FYI, the full text of the fable is at the bottom of this page.)

This may seem harsh, but it is appearing more and more that the Fed is the Wolf.

And we are the Cranes.

We have benefitted from 12 years of strong markets on the back of the Fed printing press. The excesses of the banking and housing expansion before 2009 were never truly worked off. Only covered by a tsunami of digital dollars.

The Wolf, aka the Fed (and more broadly the largest U.S. banks), asked us to do something for them: increase consumption by using low-interest debt. Oh, and to buy stocks.

And we consumers obliged.

Total consumer debt has consistently risen over the past 30 years, as shown in the chart below.

Total consumer credit since 1990

Consumers benefitted in the form of easier access to credit and interest rates that are literally the lowest in recorded human history.

Investors benefitted as well.

The next chart, courtesy of our friend Lance Roberts with Real Investment Advice, shows the Federal Reserve balance sheet versus the S&P 500 Index. We discussed this chart in our Strategic Growth video series HERE.

Each time the Fed turned on the printing press since 2008, stocks went up. After all, this was the goal of their policy. They wanted stocks to go up in order to create confidence in the real economy.

Flooding the financial system with liquidity worked, and it continues to work to this day. If we look at all the problems in the world right now, it is easy to see that U.S. stocks simply don’t care about any of them.

GDP cratered over 30% in the second quarter of 2020. We’re in a global pandemic that is nearly two years old. There is massive unemployment, huge inflationary pressures, supply chain disruptions, major tax legislation, self-induced geopolitical messes, natural disasters, generational social discord, increasing wealth disparity…the list goes on.

Despite all of this uncertainty, we haven’t had a 5% pullback in almost a year.

As Jay-Z might say, “I got 99 problems but the market ain’t one”.

At least not yet.

This summer we wrote The Fed is Stuck. In it, we discussed the mechanisms that allowed the Fed to have a direct impact on financial markets.

Now, there is discussion that the Fed will start to reverse course.

Over the next few months, you’re going to hear a LOT of the word “taper” from the financial media. And rightfully so.

The Fed has created an economy and financial system completely dependent on its easy money policies.

If we can agree that the massive liquidity injections had a positive effect on the markets, one would also assume the opposite to be true.

So it is logical to begin to discuss the potential consequences as the Fed begins to reduce its support of the financial markets.

What Happens when the Fed Tapers?

Merriam-Webster defines “taper” as a verb that means “to diminish gradually”.

When the Fed “tapers” its asset purchases, it simply means they will slowly reduce the amount of money they are force-feeding into the financial system.

This HAS to happen at some point.

There is no way to continually print trillions of dollars and expect to not have any consequences.

So far, the only “consequences” have been mostly positive.

Inflation has been a consequence, but up to this point it has only been in the form of asset price inflation. Stocks have risen, bonds have risen, and real estate of all kinds have risen.

Federal Reserve Chair, Jerome Powell

What we haven’t seen is the negative inflation that will inevitably stall the economy. But it is starting to appear. In Austin, multiple restaurants have started to raise prices. Your grocery bill is likely a bit higher this fall than it was a year ago. Let’s not even talk about housing affordability.

At first, we the consumer will absorb the real economic inflation. But as these inflationary pressures build, the Fed simply can’t continue on its current path. We are nearing a point where the Fed must stop doing what it is doing.

So what is the Fed actually doing?

It is doing two things: shoveling $120 billion per month into the financial system and keeping interest rates artificially low.

So there are technically two things the Fed could start doing: reduce the $120 billion number, or increase rates.

Taper or Raise Rates?

At their meeting next week (September 21-22), it is widely expected that Jerome Powell will announce a tapering program.

This means that they are likely to reduce the $120 billion number. That leaves two very simple questions: By how much will they reduce it, and over what timeframe?

While most people are predicting the Fed to taper, it actually might make more sense for them to raise rates first.

The financial markets have been focused on the flow of assets into the system. The $120 billion per month results in a net increase in demand. When demand outpaces supply, prices go up. A reduction of the $120 billion would then logically either slow the rate of increase in the market, or at some point lead to an actual price decline.

But an increase in the interest rate environment would have a more subtle effect.

Adjustable rate debt would go up. The interest rates on new loans would likely go up. And what would essentially happen is the cost of funds would get slightly more expensive to slow down major purchases and leverage.

This would be a good thing in the early stages of an inflationary environment.

It also would result in a positive surprise to the financial markets.

That said, it’s very difficult to predict what the Fed will do. And even more difficult to predict how the market will react to it. We’ve yet to read much about the potential for the Fed to raise rates before slowing down their asset purchases.

Either way, it would be more of a surprise if they did NOT act next week.

So we should expect a clearer path forward from Mr. Powell next week, and a path that includes a slow down of Fed activity.

The Wolves Inside the Fed

One other reason to expect a tapering announcement next week is less grounded in economic reality, and has more to do with political grift.

Members of the Federal Reserve do not have major restrictions when it comes to their own personal investments. Or at least they didn’t until last week.

As former employees of large investment firms, we have dealt with trading restrictions for many years. Heck, even a small, independent firm like IronBridge has trading restrictions and requires disclosure of investment holdings. These are important so that we aren’t abusing our knowledge of future trades that we may do for all of our clients, and “front-run” the trade hoping our investment actions will boost the price of that stock.

However, the Federal friggin’ Reserve bank, the most powerful financial institution on the planet, does not have restrictions on what their active, policy-creating members can and can’t do.

Case in point…last week it was revealed that the Federal Reserve Bank of Dallas President Robert Kaplan (pictured below) owned nearly 30 positions in individual stocks valued at over $1MM per stock. He had 22 stock purchases last year of over $1MM per trade.

Dallas Federal Reserve President Robert Kaplan, aka a Wolf

Mr. Kaplan actively sets monetary policy. And that policy is designed to literally make stocks go up.

Conveniently, as the Fed is about to change course and start to taper, he announced that he magically found his ethics and will sell all of his individual stock holdings.

Funny how that works.

Mr. Kaplan isn’t the only one either.

Boston Fed President Eric Rosengren conveniently found ethics as well. He announced he would be selling all of his individual stock holdings by September 30th.

There are only 12 people who officially vote on Fed policy. And two of them (that we know of) are going to liquidate their holdings at the same exact time the Fed is changing their easy money policy.

This is a different kind of wolf, but a wolf nonetheless.

Maybe it is coincidence. Maybe these gentlemen are noble, ethical people. Maybe the Fed won’t reverse course and will keep pumping. Maybe stopping the massive amounts of liquidity going into the system isn’t going to slow this market down.

Or maybe they know exactly what they are doing.

And maybe like the Wolf, they won’t care what happens to the market and economy when they stop.

After all, we Cranes escaped the financial crisis and COVID crash with stock prices and home prices higher than when it all started.

Cognitive Dissonance

The other thing to watch in next week’s meeting is that the Fed will likely blame everything but themselves for the inflationary pressures building in the real economy.

This cognitive dissonance is important because it allows them to change policy without worrying about the negative consequences of what their change in policy might do to asset prices and the real economy.

This allows them to sleep at night believing that what they did was noble.

And maybe it was noble.

But if there begins to be negative fallout from the Fed stopping the printing presses, we should not expect the Fed to reverse course this time. In fact, we should expect the opposite going forward.

The Fed believes we have already received our rewards. We were “saved” from the jaws of the financial crisis and COVID crash.

The Fed didn’t chew the heads off of us Cranes. They “let” us escape unharmed.

And for the first time in many, many years, it appears that they are truly about to change from an easy monetary environment to a less accommodative one.

Therefore, now is not a time for complacency.

The markets are getting closer to a major top. We may not be there just yet, but we are definitely getting closer.

We don’t know if it will be three months, six months or five years before things change, but we are closer today than we were yesterday.

So stick to the basics:

  • Stay disciplined. Don’t let a small loss turn into a big loss.
  • Do not let your emotions get the best of you. Don’t become overly bullish or overly bearish…anything can happen.
  • It’s okay to be wrong. We can’t pick the top. And we won’t try. But if things are not working you need to change course. What’s not okay is to stay wrong and try to fight the market.
  • Use data to make decisions, not narratives. Always remember that the media exists to sell commercials, not give you objective investment advice.

So let’s watch what the Wolves will do next week with great interest. Whatever the Fed may do, we will be prepared.

Invest wisely!

The Wolf and the Crane

“A Wolf had been feasting too greedily, and a bone had stuck crosswise in his throat. He could get it neither up nor down, and of course he could not eat a thing. Naturally that was an awful state of affairs for a greedy Wolf.

So away he hurried to the Crane. He was sure that she, with her long neck and bill, would easily be able to reach the bone and pull it out.

“I will reward you very handsomely,” said the Wolf, “if you pull that bone out for me.”

The Crane, as you can imagine, was very uneasy about putting her head in a Wolf’s throat. But she was grasping in nature, so she did what the Wolf asked her to do.

When the Wolf felt that the bone was gone, he started to walk away.

“But what about my reward!” called the Crane anxiously.

“What!” snarled the Wolf, whirling around. “Haven’t you got it? Isn’t it enough that I let you take your head out of my mouth without snapping it off?”