What was the most important moment in Jerome Powell’s post-Fed meeting comments this week? I believe it was when a reporter asked about the Fed staff removing recession from their forecast. Powell responded, “It is hard to see a recession when one looks at the data.”

Last quarter began with the so-called blue-chip consensus of economists predicting 0 percent growth; actual growth was 4.9 percent. That announcement didn’t seem to matter, and the narrative on Wall Street remained that we must go into recession because of interest rate hikes. Earnings have been much better than expected with 78 percent of companies outperforming expectations. That didn’t faze the narrative, however, and only 38 percent of companies have seen their stocks rise on earnings. The broken records that have been wrong for this whole cycle kept insisting that gloom and doom are right around the corner.

Then Jerome Powell said, “It is hard to see a recession when one looks at the data.” Maybe, just maybe, reality will trump narrative just this once. If so, the market should rally for a while. I know most people either do not pay attention at all or if they do, it is just to the S&P500, which most in the media refer to as the stock market. That index, which is heavily skewed by a handful of extremely large technology companies, is down approximately 8 percent from the beginning of 2022. However, global markets as a whole are still down almost 20 percent. We have become accustomed to the market dropping rapidly and then bouncing back rapidly, but this bear market dropped, then had several false starts on rallies, but has stayed down.

What is frustrating about this is that company earnings and the economy as a whole have not stayed down. Stocks are supposed to forecast roughly six months in advance, yet stocks bottomed after the two quarters in a row of negative GDP growth in 2022, which was mysteriously not declared a recession. Since then, the real world has been slowly recovering. Company earnings as a whole have re-entered growth – slow growth, but growth. The GDP growth numbers have been between 2 and 5 percent every quarter since, yet the market continues to stay depressed.

While most pundits focus only on the S&P500 whose value is skewed by a few very large companies, most stocks are priced for a recession while we are actually growing at 4.9 percent. Banks are priced as if we are in a crisis, and we are not. Energy companies are priced as if oil were at $40, and it is above $80. Utilities have acted as if no one in America is paying their bills even while we have less than 4 percent unemployment. I could go on and on.

Perhaps this is finally the time where the market wakes up and realizes that it has gone too far to the downside and stayed down too long. We had the recession already; we are not going into a new one. We will keep our fingers crossed. If the rally fails once more, then we just have to stay patient. I’m sure that some pundits who have seemingly risked their careers on the persistently wrong calls for a recession will stay at it. However, some may have actually listened. Recession is hard to see for anyone who is actually looking at the data.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Listen Carefully

Which will you believe, your sense of reason or your sense of sight? Galileo took two balls, one heavy and one light, and dropped them simultaneously from the Leaning Tower of Pisa to see which would hit the ground first. Before Galileo and his fellow pioneers of observational science, the leading theory belonged to Aristotle, who simply used reason to suggest that a heavier object will fall faster than a lighter object. That makes sense, but that isn’t what happened…and the science of physics was born.

Today we continue to hear that higher interest rates are going to slow down our economy. It makes sense: higher rates make home mortgages and car loans more expensive. Rates on credit cards will be higher, so it must have an impact, right? Logic may say yes, but observation says no. The Atlanta Fed GDPNow data reported through October 2 shows GDP is growing at 4.9 percent, which would be far and away the best growth we have seen since the first quarter of 2021.

The pundits who predict gloom and doom will point to high oil prices and now the longer-term interest rates that have risen rapidly. We recently pointed out that oil and interest rates were simply trading in a range, and what happened in the last few months is that they went from the bottom of that range to the top of that range. This has held true for oil thus far, however, interest rates have broken through the old high of 4.3 percent on the 10-year Treasury. They are now up to 4.7 percent, and this is scaring the market.

The same pundits that have been predicting recession for what seems like forever are still at it, and everything is selling off. Rates are up which means bond prices are down, and stock prices are dropping with it. Will this continue, or will we get a rally until year-end? It depends on whether the market sides with Aristotle or Galileo: reason may tell them that high interest rates equal bad economy, but it just isn’t working out that way in reality.

This leads to what is one of the most frustrating years in the market that I can remember, as narrative is trumping reality. We thought we had moved past this and the market was in rally mode, but here we are again with two negative months in a row and a horrible start to October. This market drop is happening as inflation continues to decline and the economy is growing faster – in other words, it doesn’t make sense.

Of course, it doesn’t have to make sense, at least not in the short term. As Keynes so famously said, “The market can stay irrational longer than you can stay solvent.” We believe this will pass, and as soon as companies begin to report earnings and let Wall Street know that the world is not ending, then the rally should resume. That is what the data tells us should happen; if it doesn’t, then we will need to be defensive. It is good to be correct, and we have been for this entire cycle thus far, but one cannot fight the market.

Hopefully, the market sides with Galileo and starts to actually observe what is happening in the economy. That would lead to a lot less gloom and doom and should lead to a strong rally into year-end. Last week a friend of mine said something that pretty much sums this up: He said he could go home and turn on the news to learn about how horrible the world is with catastrophes looming on the horizon, or he could go outside and see first hand how wonderful the world is and how fortunate we are to be here. In other words, we can all be a little like Galileo and just observe the world around us, or we can sit a listen to the Aristotles, who never let their lack of vision get in the way of their logical narrative.

We’ll choose the former.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Aristotle vs. Galileo

Vinyl has made a comeback. My almost 13-year-old daughter, like all the other cool kids, has a record player in her room and is collecting actual albums – lots of classics; she loves the Eagles (like her father), but new music too. I don’t think she has scratched any of them yet, but as soon as she does, she will be introduced to that wonderfully annoying repeat of the last note: the sound of a broken record.

Wall Street is also a broken record today. The Fed met this week and held rates steady, but indicated that they will keep them where they are for longer than they previously thought. The market reacted negatively, and the pundits are back out once again yelling, “Recession is coming, recession is coming!” But is it? They have been wrong for more than 18 months now, but could they be right this time?

We are not in a recession now, that is for sure. The Atlanta Fed’s GDPNOW tracker says that, based on data thus far this quarter, the economy is growing at 4.9 percent. At the beginning of the quarter, the “Blue Chip” consensus view of economists was that we would grow at 0 percent; the most optimistic economist said we would be growing at just over 1 percent, while the most pessimistic said we would be shrinking with worse than negative 1 percent growth. As the quarter has gone on and data has come in – the data that indicates we are actually growing at 4.9 percent – the consensus has been forced to creep upward and is now just under 3 percent. There is more data to come, and it could bring down the 4.9 percent, but it would have to be pretty horrific to take it all the way down to 3, let alone the 0 where they started.

This has been the same pattern for a year now, on the heels of two negative quarters in a row of GDP growth…which, for some reason, was determined by the pundit class to not be a recession, even though that was the very definition of a recession forever. I tease, but this is an important point. I truly believe this denial of the recession that took place last year is what makes this otherwise intelligent group seem so incompetent. They look at the interest rate environment and believe that means we must have a recession; they just fail to admit that we had it, when in fact we had two recessions within two years, which is quite unique and not good.

Today we are still recovering – slowly for sure, but we are in the recovery phase of the economic cycle, and this is being ignored. The other thing that is being ignored is the growing evidence that central banks, including our Fed, simply do not have the power over the economy that they once did. Our economy today is driven by technology and services. These fields do not require the large-scale borrowing of money that the old manufacturing economy required and therefore are just not as sensitive to interest rates. We spoke about this in Episode 2 of our podcast.

Yes, the Fed was too slow to act when inflation began to rise, but the Fed had been historically loose with monetary policy for almost 20 years at that point without triggering inflation. It was the return to Keynesian stimulus through extraordinary government spending which caused inflation to spike, as it had done in the 1970s. It is energy policy, not interest rates, that is causing the high price of oil, as it did in the 1970s.

The focus on the Fed is misplaced. We need to focus on Congress, who needs to get its act together and actually pass a budget. If we do end up in yet another recession in 2024 it won’t be because of interest rates; it will be because of irresponsible fiscal policy.

In the meantime, the market should get back to being focused on what is actually happening in the companies whose stocks make up the market. While the S&P 500 index looks expensive, it is because of the undue influence of seven mega-companies. The price-to-earnings ratio for the S&P 500 is 22.6, which is expensive, but the price-to-earnings ratio for our core portfolio is 16.6, which is pretty normal. The majority of stocks in the market are not overvalued. A growing economy means growing company earnings, so reality indicates we should be moving up. Why aren’t we?

The downside to vinyl records is that they are easy to scratch, and once they do, my daughter will soon learn that they get stuck and keep repeating until we manually move the needle. September is a historically bad month, and no one has the courage to move the needle, so we keep listening to this broken record. But October will come, and the needle will get moved. Until then, patience is in order.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Broken Record

Right now the market is “…Home on the range / Where the buffalo roam / And the deer and the antelope play / Where seldom is heard, a discouragin’ word….” Okay, that is probably the limit on this analogy. We hear lots of discouragin’ words from the pundits, however, we are frustratingly range-bound.

The recent worries have been about interest rates. The ten-year Treasury has climbed to more than 4 percent, and this has markets in a worry. After a rally in July, when the market finally broadened out from its AI craze, we entered earnings season with 80 percent of companies beating expectations, which is higher than the 77 percent average. The market has reacted by going down.

The bears are back and they sound like a broken record. “We are heading to a recession.” “Inflation is back, just look at oil prices.” The Fed is done (or almost done) raising rates, “…but they are going to keep these rates too high for too long.” Finally, they remind us that Fed policy has “long and variable” lags.

We know now that these experts have been dead wrong for a year and a half, but are they right now? Let’s take these points one at a time.

Are we headed to a recession? Through August 16 the Atlanta Fed’s GDP Now, which is a real-time measure of GDP based on the data that has been reported thus far, is saying that the economy is growing at 5.8 percent. Once again the “blue chip” consensus of economists predicted that we would grow at 0 as of the beginning of this quarter; they now have raised their estimates to 1.5 percent. This begs the question: How long can “blue-chip experts” be this wrong and still be referred to as “blue chip”?

Will GDP growth end the quarter at more than 5 percent? Not likely. There will be data points that come in weaker than that as the quarter goes on, but there is very little probability that we sink all the way to 1.5, let alone actually go to 0, as these experts projected. More importantly, in our opinion, than the astounding 5.8 percent number, is the trajectory: Data keeps getting better. The economy is improving, not going in the other direction.

Why are they so wrong? In my opinion it is because they are still denying that we had a recession last year. We had two quarters in a row of negative GDP growth – if that had been labeled a recession (as it had been every other time in economic history), then we would understand that we are in the recovery stage of the business cycle. It is a muted recovery, largely due to bad policy (that is for a future Perspective), but it is a recovery nonetheless.

What was supposed to bring on this recession in 2023? The Fed raising interest rates. This may be one of the most controversial views I possess, but it seems clear to me that the Fed does not have the power that so many just blindly believe they have. For more on that please watch or listen to our podcast episode 2. Anyway, as inflation has been dropping, the pundits grabbed onto oil prices rising this summer to argue that inflation is still rising and therefore the Fed, which has accomplished nothing by raising rates over 5 percent, will send us to recession by going another 0.25 percent.

There are two problems with this nonsense. First, the Fed largely ignores energy prices. They stubbornly cling to “core” inflation measures, which do not include energy or food, as those prices are very volatile. This argument was really grasping at straws. However, even if the Fed did look at oil prices, they are simply trading in a range. They have basically been in the $70s for some time now. They will drop to the high $60 range and creep to the low $80 range, but that is it. This summer oil moved from the low of this range up to the high and now, sure enough it has evened out, and if anything looks to be going back down. Oil isn’t going anywhere, it is trading in a range.

In light of this, will the Fed keep rates high? Probably, because as we have pointed out before, the Fed doesn’t have a good track record of returning to “normal” after a crisis. However, if their policy isn’t slowing the economy now, why would it do so later?

Their answer would be, “Milton Friedman taught us that Fed policy has long and variable lags.” This means that it is hard to predict the impact of Fed policy and that there is a delay in the impact taking place. Milton Friedman proved this. What they don’t say is that Friedman came up with that phrase in 1962, and it was based on research of the economy from 1890 until 1950.

To take the lag argument seriously, one has to believe that our economy in 2023 moves no faster than it did in 1950. Sorry, but that is absurd. If there is any lag at all in our modern economy, it is most certainly faster than in the past.

The bear arguments carry no weight. We had a strong rally in July, and as is the case with markets, we then take a step back to move forward once more. The economy is doing fine: 80 percent of companies have beaten financial expectations. The rally will resume, we just have to be patient and prudent. Meanwhile, the pundits will continue their discouragin’ words, but we are just stuck home on the range.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Home, Home on the Range

Last week, bond-rating agency Fitch Ratings downgraded the rating of the United States. Instead of the highest AAA, the U.S. now has a rating of AA+. Fitch grabbed some headlines, but they did not have the impact that S&P Global had when it downgraded the U.S. in 2011. I personally would like to thank Fitch for better timing; I was supposed to be on vacation in 2011 when S&P made their downgrade…as it was, my wife and kids enjoyed the beach and pool while I stayed inside working remotely with a better view than the one from my office. At least Fitch had the decency to wait for the Osbornes to get back from their summer vacation before throwing their bomb at the market.

In 2011, the downgrade made a big splash: We were just recovering from our own financial crisis, Europe was still having their financial crisis, and the market was on shaky ground. This time, the market took the news with hardly a shrug. I wonder how much this shrug played into Moody’s decision to downgrade banks five months after Silicon Valley Bank went under in the non-crisis that the financial media tried to create. They did this with the dire warning that it isn’t over.

There is no banking crisis. There is a difficult environment for banks, but a difficult environment is not the same thing as a crisis. One has to wonder about the timing of the downgrade. Where was the downgrade of banks before Silicon Valley failed? Why is the U.S. being downgraded now? The problem with rating agencies is and always has been that they view the world through the rear-view mirror. They react to what has already happened and do not, in my opinion, actually provide investors with forewarning as most investors believe. After their remarkable failure leading up to the 2008 Financial Crisis, it is a wonder anyone pays attention at all to the rating agencies.

How should one measure risk if not by looking at ratings? We believe that prudent investing is risk averse, and that risk is best measured by what Benjamin Graham referred to as the “margin of safety.” The margin of safety is the difference between the value of an investment and the current market price of an investment. Calculating the value is a subject beyond the scope of this Insight (at Iron Capital we use our own research and models to do this), but the end result does not need to be exact – we need to know only that the value is much higher than the price.

How can we do that? U.S. Treasuries and banks happen to be two great examples. The yield on U.S. Treasuries were extremely low in recent memory; for most of the last 15 years, the 10-year Treasury had a yield in the neighborhood of 2 percent. The prices of bonds are inversely related to the yield. In other words, low yields mean high prices, and high yields mean low prices. Treasuries are usually considered “risk free” because, regardless of the rating Fitch or S&P wish to bestow, the Treasury is not going to default on its debt. However, record-low yield means record-high prices, and any time something sells for record-high prices, the margin of safety is low. Sure enough, when rates finally rose in 2022, bond investors had the worst returns in the history of the aggregate bond index – with no warning from any rating agencies.

Banks offered the reverse. When Silicon Valley Bank failed and the pundits kept yelling “crisis,” we purchased two banks. That seems like the riskiest time to invest in banks, doesn’t it? It is amazing how often safety seems risky and risky seems safe. We purchased Western Alliance Bancorp and Truist Financial for appropriate portfolios. I name these for educational purposes only, so don’t just go out and buy them.

Both banks are well run and in solid shape. Both were selling for a price not seen since the Financial Crisis. The margin of safety was high. Western Alliance, which is a more aggressive investment, is up 50 percent in the short time we have owned it. Truist has not been as exciting, and is actually slightly down, but it is paying a 6.5 percent dividend and we are confident it will weather this difficult environment and do well over time. Meanwhile, our clients will gladly collect the 6.5 percent coupon.

Does this mean our timing is better than the rating agencies? Well, timing is a fool’s errand. No one can time the market, including the rating agencies. One can pay attention to price and value and the margin of safety. Prudent investing is risk averse, which often leads to counter-intuitive moments. No one knows the future of Treasuries, but at a 4 percent yield they have a better margin of safety than at a 2 percent yield, regardless of what Fitch says. One cannot predict the future of the entire banking sector, but the margin of safety on individual banks can be calculated and is often the most attractive when investors are the most nervous.

The rating agencies can say what they want. We will continue to invest prudently, and that largely means ignoring ratings.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Timing