Pro Perspectives 10/31/22

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October 31, 2022
 
It’s Fed week.
 
We’ll hear from Jay Powell and company on Wednesday.
 
The market has priced in a 75 basis point hike.  That would bring the effective Fed Funds rate to just above 3.75%.
 
From there, the interest rate market is pricing in a coin flip chance between 50 bps and 75 bps at the December meeting. 
 
That could get the Fed Funds rate to 4.5%. 
 
Remember, it was their last meeting, in September, where they created the expectations for this, and did so through their “survey of economic projections” (SEP).  These are forecasts made on the economy, by each board member and each regional Fed President (total of 19 forecasts). 
 
Here’s a look at how these Fed officials presented the outlook in the September meeting…
 
Let’s focus on the Fed Funds rate projection (circled in yellow). This was revised UP a full percentage point.
 
That projected an additional 125 and 150 basis points of tightening by year end.  It’s that aggressive posturing by the Fed that sent the interest rate markets in an upward spiral (not just domestic markets, but global).
 
They went a step too far with the tough talk/ restrictive forward guidance. 
 
And with that, we found the uncle point for the global financial system.
 
The UK government bond market broke, and required a rescue from the Bank of England.  Stocks made new lows on the year.  The dollar made new highs on the year, and then the Bank of Japan was forced to intervene, to defend the value of the yen against a strong dollar (which is driven by the U.S. rate outlook). 
 
With all of this going on, both the Australian and Canadian central banks responded with smaller than expected rate hikes in their respective October meetings.  They balked. 
 
So, back to the Fed.  Given the exposed fragility in the global financial system to the current level of market interest rates, will the Fed pull the trigger on another 75 basis points this week?  Probably, but the treasury market has that rate increase more than priced-in (and consumer and mortgage rates do too, as they are based on treasury rates). 
 
The big questions:  Will the Fed acknowledge: 1) the rate sensitivity that has been exposed in the financial system, 2) the cooling inflation picture, and 3) the likelihood of a (less inflationary) fiscally conservative change in Congress coming?  Let’s hope so.  If so, the market will dial down (maybe dramatically) the rate outlook for December.  Rates will go lower, the dollar will go lower, stocks will go higher, the stability will improve.  
 
For perspective on just how “aggressive” the Fed talk is, versus what they really expect, let’s take a look at what the Fed’s long-run forecast for rates looks like now (in these Fed projections), relative to the past 10 years.
Notice that in the very low inflation environment of the past decade, where deflation remained a bigger risk than inflation, the Fed’s projection for the long-run level of the Fed Funds rate was not only higher, but much higher than the current long-run projection (which is just 2.5%).
 
Does this reveal the Fed’s true view, that after ballooning of government debt (globally) there is a very low ceiling on where rates can go (given debt servicing and financial system risk)?    

Pro Perspectives 10/31/22

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October 31, 2022
 
It’s Fed week.
 
We’ll hear from Jay Powell and company on Wednesday.
 
The market has priced in a 75 basis point hike.  That would bring the effective Fed Funds rate to just above 3.75%.
 
From there, the interest rate market is pricing in a coin flip chance between 50 bps and 75 bps at the December meeting. 
 
That could get the Fed Funds rate to 4.5%. 
 
Remember, it was their last meeting, in September, where they created the expectations for this, and did so through their “survey of economic projections” (SEP).  These are forecasts made on the economy, by each board member and each regional Fed President (total of 19 forecasts). 
 
Here’s a look at how these Fed officials presented the outlook in the September meeting…
 
Let’s focus on the Fed Funds rate projection (circled in yellow). This was revised UP a full percentage point.
 
That projected an additional 125 and 150 basis points of tightening by year end.  It’s that aggressive posturing by the Fed that sent the interest rate markets in an upward spiral (not just domestic markets, but global).
 
They went a step too far with the tough talk/ restrictive forward guidance. 
 
And with that, we found the uncle point for the global financial system.
 
The UK government bond market broke, and required a rescue from the Bank of England.  Stocks made new lows on the year.  The dollar made new highs on the year, and then the Bank of Japan was forced to intervene, to defend the value of the yen against a strong dollar (which is driven by the U.S. rate outlook). 
 
With all of this going on, both the Australian and Canadian central banks responded with smaller than expected rate hikes in their respective October meetings.  They balked. 
 
So, back to the Fed.  Given the exposed fragility in the global financial system to the current level of market interest rates, will the Fed pull the trigger on another 75 basis points this week?  Probably, but the treasury market has that rate increase more than priced-in (and consumer and mortgage rates do too, as they are based on treasury rates). 
 
The big questions:  Will the Fed acknowledge: 1) the rate sensitivity that has been exposed in the financial system, 2) the cooling inflation picture, and 3) the likelihood of a (less inflationary) fiscally conservative change in Congress coming?  Let’s hope so.  If so, the market will dial down (maybe dramatically) the rate outlook for December.  Rates will go lower, the dollar will go lower, stocks will go higher, the stability will improve.  
 
For perspective on just how “aggressive” the Fed talk is, versus what they really expect, let’s take a look at what the Fed’s long-run forecast for rates looks like now (in these Fed projections), relative to the past 10 years.
Notice that in the very low inflation environment of the past decade, where deflation remained a bigger risk than inflation, the Fed’s projection for the long-run level of the Fed Funds rate was not only higher, but much higher than the current long-run projection (which is just 2.5%).
 
Does this reveal the Fed’s true view, that after ballooning of government debt (globally) there is a very low ceiling on where rates can go (given debt servicing and financial system risk)?    

Pro Perspectives 10/28/22

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October 28, 2022
 
We finish the week with another big day for stocks. 
 
The bad earnings news from the tech giants has gotten a lot of media attention this week, but the earnings season for corporate America, overall, continues to be solid. 
 
We've now heard from over half of the companies in the benchmark blue-chip index (S&P), and over 70% have beat earnings estimates, growing earnings at 2.2% compared to Q3 of last year.  
 
As a reminder, heading into this earnings season, there was a lot of chatter about a big contraction in earnings (i.e. negative growth).  It hasn't happened.  
 
With that, and some intervention-induced stability in the financial system (BOE and BOJ), stocks are having a big bounce for the month — following a down 8% September, with an up 8% October.
As you can see in the chart, we end the week with a bullish technical break.
 
You can also see, the big force within this downtrend (denoted by the yellow trendline) has been the Fed, and the related inflation outlook.
 
On that note, it's important to remember what data drove the big 5% swing in stocks on October 13th (the bottom), which ultimately ended up 2% that day.
 
It was the September inflation report.
 
Why did stocks bounce? Because the hot spots in that inflation report (like new cars and rents) have been cooling (actually falling), but have yet to show up in the government's numbers.
 
Add that to the very tame inflation numbers over the prior three months, and we could be looking at a collapse in inflation by next year, as most of the effect of the 300 basis points of tightening has yet to be felt in the economy (still lagging). This, as the current level of market interest rates is proving to destabilize the financial system.
 
With all of this in mind, the Fed meets on Wednesday.
 
If they are paying attention, they should dial down the temperature in the interest rate market. Especially given the recent polling, that shows a likelihood of Congress flipping on November 8th.
 
In that scenario, the spigot on any additional fiscal spending would be closed. Moreover, the inflationary policies that have already been approved (including Build Back Better/IRA) would be challenged. If that plays out, the Fed would find themselves in a position where they have overtightened, already.
 

Pro Perspectives 10/27/22

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October 27, 2022
 
The Fed spent much of last year denying the obvious inflationary pandemic response from policymakers, and the subsequent evidence of that inflation.
 
That inflation denial by the Fed, gave the Democrat-controlled Congress the ammunition it needed to push through additional fiscal spending. 
 
Only AFTER Jerome Powell, the Fed Chair, secured a reappointment from Biden, did the Fed flip the switch and start talking about aggressively taming inflation. 
 
When that switch flipped for the interest rate outlook, it also flipped on the valuation of the high flying, high growth tech stocks.
 
Why?  As Warren Buffett once explained (my paraphrase), at zero interest rates into perpetuity, the valuation on the stock market is essentially infinite.   There are no alternatives.  Those that are required to earn a return (like pension funds), are forced to reach for return (by taking more risk).
 
Driven by this dynamic, the high return FAAMG stocks (Facebook, Amazon, Apple, Microsoft and Google), became the favored investment of the professional investment community — to such a degree that it represented nearly a quarter of the valuation of the S&P 500 at one point last year.   
 
But now we have interest rates.  Now there are alternatives. The Treasuries inflation bond is paying over 9%.  And as Wall Street analysts are plugging a much higher discount rate (interest rate) into their cash flow models, they are getting a lower price target (in some cases, much lower). 
 
This rising interest rate environment (especially from zero) is most damaging for growth stocks, which is why we entered the year expecting a transition in favor from growth stocks to value stocks. 
 
Indeed, if we look at the Vanguard Value ETF (VTV), it's outperforming the Growth ETF (VUG), down 8 percent vs. down 31 percent.
 
With that, we've looked at this chart many times in my daily notes, in anticipation of this shift from growth to value. 
 
As you can see, the last time value was this cheap, relative to growth stocks, value went on a nearly 10-year run of outperformance.
 
If you want to take full advantage of the tailwinds for value stocks, join us in my Billionaire's Portfolio subscription service.  You can invest alongside my portfolio, full of stocks with the potential to do multiples.  You can learn more here.  

Pro Perspectives 10/26/22

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October 26, 2022
 
Last Friday, the BOJ intervened in the currency markets (defending the value of the yen).  It turned the tide of markets that day:  stocks higher, yields lower, commodities higher and the dollar broadly lower. 
 
And that has become a trend this week. 
 
Importantly, we discussed the prospects that this intervention could mark a top in the dollar. 
 
That would be meaningful for commodities prices. 
 
And commodities prices have been on the move.  So have commodity stocks.  
 
Let's look at a few charts …
Above is the dollar index.  As you can see, the absolute top of this 20% rise in the dollar this year, was the day the Bank of England intervened to save the UK government bond market.  That reversed a free fall in the pound.  And then the BOJ was in, explicitly to stop the free fall in the yen. 
 
As we've discussed here in my daily notes, historically major turning points in markets come with some form of intervention.  Again, a turning point in the dollar, would mean a turning point in commodities. 
 
Remember, on Friday, we looked at the CRB index of broad commodities prices. 
 
Here's what that looks like now …
The trend in this young structural bull market in commodities is well intact.  And no coincidence, it started a month after the fiscal and monetary bazookas were fired in 2020 (inflationary policies). 
 
A bounce in commodities from this big trendline would align with a top in the dollar. 
 
What does that mean for oil prices?  Higher.  
 
This commodities/dollar relationship comes as the Biden administration's program to drawdown 180 million barrels of oil from the Strategic Petroleum Reserve has come to an end — as of yesterday!  This will remove the downward pressure on oil prices.  And the resumption of the move in oil will be coming from a high base of the mid $80s.

Pro Perspectives 10/25/22

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October 25, 2022
 
As we discussed yesterday, the biggest event for markets, by far, over the next two weeks, is the midterm election (bigger than earnings, bigger than the Fed rate decision).
 
With that, just a month ago, here in my daily note, we took a look at the election betting markets. The oddsmakers were pricing in about a 47% chance of a split Congress, and 33% chance of a Republican sweep.
 
Here's what it looks like now …
As you can see, the bets on a Republican sweep have ramped up since mid (late) September. 
 
What was happening at that time?  Markets were melting. 
 
If we could attribute a market timeline to this change in the midterm election outlook, it would start with a hot U.S. inflation number, then a warning on "worldwide recession" from FedEx, then a draconian message from the Fed on the rate path, then an attack on the Russia gas pipeline, then the meltdown in the UK bond market (a threat to global market stability), and then another hot U.S. inflation number.  Meanwhile, throughout this timeline, mortgage rates jumped from 6% to 7%. 
 
So, was it this destabilizing spiral, over the period of less than 30 days, that may outright flip control of Congress?  Maybe.
 
If so, the Republican Congress would likely go after (i.e. attempt to weaken) the Build Back Better funding (better known as the "Inflation Reduction Act")? 
 
That would be a catalyst to get yields moving back down. 

Pro Perspectives 10/24/22

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October 24, 2022
 
About a fifth of the companies in the S&P 500 have reported on Q3 earnings thus far.
 
Over seventy-percent have beat earnings estimates, and about seventy-percent have beat revenue estimates. And despite the hot inflation, profit margins remain healthy at 12%.  That's above the 5-year average.
 
These are reports from a quarter that the Atlanta Fed's GDP model is now projecting to have grown by an annual rate of almost 3% (that's AFTER effects of inflation).
 
Again, as we anticipated coming into these earnings, the fundamentals don't match the performance of the financial markets.  The fear is outweighing the facts.
 
On that note, no one has introduced more fear into markets over the past seven months than the Fed.  And we will hear from them again on November 2.  
 
But the bigger event for markets, and the economy, by far, comes in two weeks.  The midterm elections.
 
A Democrat White House and Democrat controlled Congress has led to executing of the full Democrat agenda, despite the fiscal and inflationary consequences.  On November 8th, we should get at least a split Congress.  This will bring gridlock, which will bring stability and certainty to the fiscal outlook. That's historically good for stocks.
 
In fact, post-midterm elections, regardless of the outcome, are historically good for stocks.
 
Bancorp did a study on this:  Looking back to 1962, stocks (S&P 500) in the 12-months following a midterm election had an average return of 16%.  That's double the long-term average return.  And over these fifteen data points observed (over 60 years), ALL had positive stock market performance for the twelve-month period following the midterm election.
 
How To Capitalize On A Rebound in Stocks
 
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Pro Perspectives 10/23/22

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October 23, 2022
 
Special note on stock market declines: 
 
During market declines – with the constant barrage of market analysis and opinion on financial television, in newspapers, or through the Internet – it’s easy to get sucked into drama played out in the media.

That tends to drive fear. 

But while the fearful start running out of the store when stocks go on sale, the best investors in the world, start running IN.

The fact is, the best investors in the world see declines in the U.S. stock market as an exciting opportunity.  And so should you.

Most average investors in stocks are NOT leveraged. And with that, they should see U.S. stock market declines as a gift.  The question should be: 'Do I have cash I can put to work at these cheaper prices? And, where should I put that cash to work?'

Billionaire Ray Dalio, the founder of the biggest hedge fund in the world, has said what I think is the most simple yet important fact ever said about investing.

'There are few sure things in investing … that betas rise over time relative to cash is one of them.'  
 
In plain English, he’s saying that major asset classes, over time, will rise (stocks, bonds, real estate). The value of these core assets will grow faster than the value of cash.
 
That comes with one simple assumption. The world, over time, will improve, will grow and will be a better and more efficient place to live than it was before. If that assumption turned out to be wrong, we have a lot more to worry about than the value of our stock portfolio.

With that said, as an average investor that is not leveraged, dips in stocks (particularly U.S. stocks – the largest economy in the world, with the deepest financial markets) should be bought, because in the simplest terms, over time, the broad stock market has an upward sloping trajectory.

 
You don't have to pick the bottom.  Just take advantage of discounts when you see them. 
 
This is the very simple philosophy Dalio follows, and is the core of how he makes money, and how he has become one of the best and wealthiest investors alive.
 
Billionaires Bill Ackman and Carl Icahn, two of the great activist investors, lick their chops when broad markets sell off on fear and uncertainty.
 
Ackman says he gets to buy stakes in high quality businesses at a discount when broad markets decline for non-fundamental reasons.
 
Icahn says he hopes a stock he owns goes lower so he can buy more.
What about the great Warren Buffett?  What does he think about market declines? 

 

He has famously attributed his long-term investing success to 'being greedy when others are fearful.'
 
With this rationale in mind, I've just published an update on two stocks in our Billionaire's Portfolio. 
 
One is the highest conviction stock in the portfolio of one of the great activist investors of the past twenty years.  He has a third of his multi-billion portfolio in this one stock.  It's a vital company in the multi-trillion dollar clean energy agenda.  Wall Street just upgraded the stock, calling for 50% upside over the next twelve months. 

 
The other update was on a technology company that owns the infrastructure critical to the success of 5G.  If 5G is the future, it won't happen without this company. It's the second largest position in the portfolio of a billionaire value/activist investor with a nearly 50-year track record.  Wall Street has a high price target on it 80% above current levels.
 
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Also involved in the stock is the best activist investor in the world.  Both are very influential billionaire investors, with large stakes in the company, and are already pushing company leadership to unlock value in the stock.  Wall Street has a high 12-month price target on the stock more than 60% higher than current levels. 
 
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Pro Perspectives 10/21/22

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October 21, 2022
 
We've talked about the stress that rising global interest rates are putting on the global financial system, all being pulled along by U.S. monetary policy (and U.S. market interest rates).
 
The global financial system continues to show intolerance to higher interest rates, after a fourteen-year period of quantitative easing and zero interest rate policy.    
 
First, it was Europe's sovereign debt market that was breaking, as U.S. 10-year yields were hitting about 3.30%.  The ECB had to intervene to avert a sovereign debt crisis. 
 
Then it was the UK bond market that broke.  The Bank of England intervened to avert a financial system meltdown.  The U.S. yields traded up to 4% when that UK bond market crisis was revealed (yet it was blamed on the new UK tax cut plan).
 
Today it was the Bank of Japan's turn.  They intervened in the currency markets, defending the rapidly declining value of the yen.  
 
This came after a 31% decline in the yen (on the year), relative to the dollar.  And it came as U.S. yields surpassed 4%, and climbed over the past three days, unabated, to 4.34%. 
 
Of course, the weak yen is driven by divergent monetary policies of Japan and the U.S..   Money moves out of Japan (zero interest rates), and into the U.S. for a favorable yield, which also encourages a yen carry trade — borrowing yen (virtually free), selling it and buying dollars and earning about a 4% interest rate spread. 
 
What does it mean for markets?  
 
The BOJ intervention this morning turned the tide of markets on the day:  stocks higher, yields lower, commodities higher and the dollar broadly lower. 
 
This also came with some Fed speak/news on the day, somewhat less hawkish than the drumbeat we've heard since the September meeting.
 
Nonetheless, this dollar chart, as we close the week, becomes very important. 
If the dollar trend is over, it will breathe new life into commodities prices.  

Pro Perspectives 10/20/22

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October 20, 2022
 
The 10-year yield climbed another 11 basis points today, nearly touching 4.25%.
 
That puts it 117 basis points above the Fed Funds Rate (the overnight interbank lending rate set by the Fed).  This signals a bond market that believes the threats the Fed has been making all year.
 
What's the threat?  The Fed is threatening to keep hiking rates until they bring inflation back to their target of 2%.
 
Interestingly, it was just two years ago that the Fed made "signficant changes" to it's monetary policy framework (here).  They adjusted their "target" level for inflation to be, an "inflation that averages 2% over time."
 
This was the Fed's response to an inflation rate that ran persistently UNDER 2% throughout the post-financial crisis period. 
 
They said, "following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time."
 
What happened to this strategy?
 
No one on the Fed is talking about this.  They continue to say, definitively, they will bring inflation back to 2%.  In fact, there aren't even dissenters among the Fed Board of Governors, about the current path, nor the talking points.  That's very unusual, historically, to have a Fed all in agreement, all toeing the line, especially in such a complicated time.
 
Let's take a look at what this "average" inflation number looks like.  
 
Below is the Fed's favored inflation measure, core pce.  You can see it ran about 1.5% on average in the post-GFC period.  Post-covid its run about 3%.  If we narrow it to the Biden administration, it's running an average of 4%.  
 
If we average the annualized monthly core pce dating back to the failure of Lehman Brothers, we get 1.85%.  
With the above in mind, should this inflation be unwelcome by policymakers?
 
As you can see in the next chart, it's doing the job they want it to do.  Deflating the value of a very high debt burden (the far right of the chart, finally declining).