The market doesn’t know what to make of an optimistic Fed. Last week the Federal Reserve’s Federal Open Market Committee (FOMC) met and raised interest rates by 0.25 percent as expected. Then, something strange happened: Jerome Powell started talking and was actually optimistic. The Fed recognizes that the “disinflationary” process has begun. Inflation is still high, but the rate is coming down.

This is happening without the economy going into a recession. In fact, last Friday the Employment Situation Report revealed the economy created 517,000 jobs in January. Powell was clearly stating his optimism that inflation can come down without a job-killing recession. The stock market rose on the news, and if all one ever looks at is the headline index return, then all is well.

However, as I have often stated, the real story is not in the headline number – it is in the action underneath. The stocks that rallied were the large technology stocks that the market now sees as defensive. Traders buy these stocks because they believe the economy will be weak, and these companies are believed to be able to grow even if the economy is weak.

The bond market followed suit, with interest rates on longer term Treasuries dropping. In other words, while Powell gives the most optimistic speech since his “inflation is transitory” talks, the market takes this as a signal that we are heading to a recession. This makes no sense, as the data show the very opposite.

Enter the spin machine. This week the pundits have come up with another story: They now say this market reaction shows that the market believes we are headed for a low interest rate, low-growth environment, and that is why longer rates dropped and tech stocks led the way.

The only issue with that theory is that with all the positivity, Powell was clear on one thing: The Fed is not stopping its rate hikes. “Further Fed rate increases are needed,” he has said repeatedly. We are not about to enter a low-rate environment unless the Fed cuts rates after inflation is back down to its target of 2 percent.

I suppose the idea here is that the Fed raises rates to get inflation under control and once that job is done, they will then lower them back. That makes sense, except it never happens that way. Granted we have had more experience over the last 30 years with the reverse – the Fed lowers rates to fight a recession, and once the economy is growing again, they go back to “normal.” That hasn’t happened – they never go back to “normal.” In fact, that not happening is part of why we are in this inflationary mess: the Fed pulled out all the stops during the reaction to the pandemic and never went back to “normal.” This was after a decade-plus of not going back to normal after the 2008 financial crisis.

If we get the slow-but-steady growth that the pundits are now calling for, then the Fed would have exactly zero incentive to lower rates. They never raised rates simply because the crisis was over; why would they lower them just because the crisis is over? The only way rates are coming back down in the future is if the Fed goes too far and puts us into a recession.

So, what is going on? I can’t really tell you in regard to the bond market; they are usually the smart ones, and their actions over the last week are puzzling. It may be as simple as we tend to read too much into the predictive power of longer-term rates.

The stock market is clearer to me. Tech stocks are the most beaten up, and if people believe we are finally in a lasting rally, then they are likely to bounce back first. If that is the case, then it will not last. What leads the way down almost never leads the next bull market.

It is early yet, but most economists are predicting negative GDP growth this quarter. The Atlanta Fed’s GDPNow, which is based on actual current data, says we are growing at a little more than 2 percent. There is still too much negativity in the market, and they either do not believe Powell or think he is wrong to be optimistic (fair enough, given his track record).

So where does all this leave us? While I personally find this saga fascinating, the confusion and mixed signals are really just reminders that the prudent way to make investment decisions is from the bottom-up. It is much easier to predict a positive future for a specific company than it is to figure out when the next recession will come and what interest rates will be ten years from now.

Still, it is amusing to see the pundits get it wrong and then change their tune as if they had never said what you just heard them say. Markets often act strangely in the short term, but they tend to get it right over time. Powell’s optimism was the only thing that made sense last week. We still have a long way to go, but so far so good for 2023.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Strange Reaction

Every market strategist seems to have the same outlook going into 2023: The market will struggle in the first half of the year, then rally toward the end. There is some difference in the degree and actual year-end estimates for the value of the S&P 500 index, but directionally, this is the forecast from every strategist we have heard.

This groupthink alone should be taken as evidence that there is a high probability of this forecast being wrong. When everyone on Wall Street agrees, then usually that means everyone is wrong…but not always. Just because it is the consensus doesn’t necessarily mean it is wrong. So, let’s try to figure this out for ourselves.

The almost universal reason for this forecast is the belief that we simply must have a recession in 2023. The argument goes that because the Fed is raising interest rates, the economy must go into a recession.  If we go into a recession, then corporations will make less money; therefore, earnings estimates need to drop, and when they do, the stock market will fall. This has been the steady drumbeat of market strategists for at least nine months now. The only change is that they keep getting frustrated by the fact that analysts’ earnings estimates are not dropping, or at least not dropping fast enough.

Why the disconnect between the earnings estimates of Wall Street analysts and the views of Wall Street strategists? I believe the disconnect comes from having very different perspectives. First, some translation into English would be helpful.

A strategist on Wall Street is someone who uses economic and market data to project the big picture of where the market (usually defined as the S&P 500) is going. They are often (though not always) trained economists. They look at the financial world from the top-down.

An analyst on Wall Street is someone who studies companies. Usually, they will follow every company in a specific industry. They look at each company from the bottom-up.

The strategist community sees the current situation as driven by the actions of the Federal Reserve. The theory goes that the Fed raising rates will cause economic activity to slow down, and the economy will go into a recession. When that happens, companies will make less money, and their stock prices will fall. They believe this will occur in the beginning of this year, and when it is over, the stock market will rebound.

This argument seems logical, but it ignores a significant factor and makes some assumptions that might not hold true. First, it ignores the fact that the market has already dropped well into bear market territory in anticipation of this very event; this seems to not matter to the strategist. Bad news should be priced into the stock market already, but strategists deny this. Secondly, it assumes that Fed actions have a significant impact on the real economy. There simply does not seem to be much evidence for this belief.

Let’s think this through. The Fed’s actions have been to raise interest rates. How much of your personal consumption is impacted by interest rates? Hopefully, none of our readers are borrowing money for monthly expenditures. If one is in the market for a new car or a house, then interest rates would have an impact, but most of us are not borrowing money to buy a new shirt or go to a movie.

How does the increase in interest rates impact companies? There are two possible ways: 1) If they sell a product that requires most customers to use financing. Housing and the mortgage business are certainly hurting with higher interest rates, but most businesses do not sell products that are so expensive that their customers must finance them. 2) If it has to borrow a great deal of money to run its operation. The interest expense on that debt would cause earnings to go down.

In the 1970s and 1980s when we last dealt with high inflation and an aggressive Fed, our economy was based on manufacturing. Manufacturing requires big warehouses and factories with lots of expensive equipment, which were usually financed, and therefore companies carried significant amounts of debt and were sensitive to the cost of borrowing money. Today our economy is based on services. Most companies do not carry a large amount of debt and interest expense is a relatively small item.

This brings us to the view of the Wall Street analysts who keep frustrating their strategist colleagues by not lowering earnings estimates enough. They view the world from the bottom-up. They are looking at individual companies and saying that the actual companies are doing just fine. They are not blind to what the Fed is doing, but most companies just are not seeing a significant impact, so the earnings estimates remain far more positive than the top-down strategists believe.

Who is right? Truth be told, neither group has the best track record, but if forced to pick one over the other, I will go with the ones who see the world from the bottom-up; that is how prudent investing is done – analyzing each investment on its own merits and not guessing where the entire market is going.

Our view is that 2023 may get off to a rough start (though the first two weeks would not indicate this) simply because so many on Wall Street believe the first half will be rough. We believe that by the second quarter, the realization will hit home that the most-forecast recession in history isn’t going to happen, or if it does, it will be so mild that no one will notice. Then we rally for real. If anything, we may be too pessimistic. I for one will be very surprised if 2023 is not a good year for investors. Happy New Year!

Warm regards,

Chuck Osborne, CFA
Managing Director

~2023: What to Expect?

‘Tis the season. If you are a student, a parent of an exam-taking student, or young enough to remember being a student yourself, then you know what I mean:  It is time to finally open up that textbook and do a semester’s worth of learning in one caffeine-fueled all-night cram session. It is the pre-holiday ritual known as final exams.

The market has tests as well. This quarter we have rallied off of the September lows right up to the 200-day moving average. We hit that at the end of November, and since then have been negative. Getting over the 200-day moving average is a big test, and thus far the market has failed.

Some translation to English may be in order. The 200-day moving average is exactly what it sounds like:  Every day there is a value or price for the various market indexes. For this discussion we will use the S&P 500. Every day, one could look at the prices of the S&P 500 for the last 200 days and calculate the average price. The next day one could do the same thing, and the oldest day would fall off and the current day would be added. Then, one could place those 200-day average prices on a chart and see the trend of the S&P 500. Currently that trend is down, as we have been in a bear market. The trend will eventually move up, but for that to happen, the current price has to be higher than the 200-day average price.

What is the real significance of all this? Probably nothing, except there are enough believers in this kind of analysis to make it a self-fulfilling prophesy. Getting meaningfully over that average is the first step in a lasting recovery, and this is often the point where bear market rallies fail. So, will we pass the exam, or will we fail? The former moves us forward, while the latter does the same thing it did in school – it forces us to take our course all over again…down once more before rebounding.

So, which is it going to be this time? The Fed has a lot to say about that. They have now raised the Fed Funds rate by another 0.50 percent, which the market fully expected. They also raised their guidance for where they believe rates will end up (the so-called terminal rate) by 0.50 percent to 5.1 percent.

Interestingly, the bond market reacted to this change in guidance with a yawn., which tells me they do not believe the Fed. The 10-year Treasury is trading near 3.5 percent; in fact, the yield is down very slightly since the Fed announced its action. The bond market believes the Fed is going to overdo it, cause a more severe recession, and then have to reverse course.

The stock market is also yawning – it has lost interest in the whole inflation and interest rate story and moved on to the recession of 2023. The question, according to consensus, is not whether we will have a recession, but how severe will it be?

There are a few holes in this narrative. (We have become accustomed to narratives that have holes in them, but I digress.) In this case, the first hole is that the recession of 2023 would be the most anticipated recession of all time. Anticipated recessions have a way not happening. We could have a setup that is overly pessimistic, in which case the market would go up.

Let’s say that the recession does occur. Lots of pundits want to say that our two quarters of negative GDP growth this year wasn’t a recession, but no one can say we did not have a full-on bear market. If that was not in reaction to the recession that shall not be called a recession, then it must have been in anticipation of the recession of 2023. If that is so, then will a recession in 2023 cause yet another bear market?

It is possible, but it is not probable. My educated guess is that the best case for 2023 is things are far less bad than expected, the market passes the test, and we have a good year. The worst case is that we actually have the most-anticipated recession of all time, and while volatile, the market stays roughly where it is.

In the end, all-night cram sessions won’t likely get you many As, but C is still passing. As a doctor friend of mine once told me, “Do you know what they call someone who finished with a C average in med-school? They call him Doctor. (The hers get As and Bs.)”  We don’t need an A; we just need to pass this 200-day average test, and then we can move forward.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Passing the Test

This has been a tough year in the market. Thankfully, the rally we predicted in our October 3 Insight has occurred. We have seen negative results year-to-date even still, but it could be worse: you could have put your money with FTX.

For those who do not follow the financial news, FTX is (or, was?) a cryptocurrency exchange, which has collapsed. Client assets are frozen and possibly wiped out. I say possibly because no one really knows where the money is located. FTX’s new CEO is John J. Ray, who specializes in cleaning up bankrupt companies; most famously he was brought in to clean up Enron. He is on the record saying that FTX financial information isn’t trustworthy; in fact, he stated he has never seen anything as bad as this in 40 years of restructuring companies.

FTX’s former CEO, Sam Bankman-Fried, evidently did not see the need to keep records at all. Why would he? He is a 28-year-old wunderkind who had a crypto empire and was living a hedonistic life in the Bahamas in a polyamorous relationship with anywhere from seven to ten people, depending on which tabloid one reads. Who has time for bookkeeping? That is old-world stuff…he was enabling crypto, “the people’s currency.” It was a bold new world, until it wasn’t.

Needless to say, none of our clients had exposure to FTX (unless they did it separately without our knowledge). The last time I wrote about crypto in 2017, cryptocurrency enthusiasts were explaining that what they were really excited about was not a new form of currency, but the blockchain technology that makes crypto possible. That made no sense, since putting money in crypto wasn’t actually investing in blockchain technology, but at least they understood that a currency backed by absolutely nothing doesn’t make sense.

I wrote that article at the first height of crypto craziness, and crypto did in fact crash from there. Then the narrative changed at some point during the pandemic when people started talking about, and in some cases using, crypto as an actual currency. This is one of those “the emperor has no clothes” moments we seem to be having all the time now.

In the grand scheme of history, it has not been that long since the population of the world decided that we are comfortable with currency simply being backed by our faith in government. It wasn’t until 1971 that the U.S. dollar went off the gold standard for good. We did try to unlock the dollar from gold a few other times but were forced back to the gold standard for the dollar to be worth something. Since 1971, the dollar is simply backed by the faith and credit of the U.S. government (no wonder we have inflation).

Cryptocurrencies, on the other hand, are backed by absolutely nothing and nobody. Still people ask me if we invest in crypto, and my answer is that crypto isn’t an investment. We believe that an investment is just what Benjamin Graham said it was, “An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

Graham spoke of investments needing a margin of safety – meaning they are backed up by something real: assets and cashflows. The crypto universe, like so much in our time, isn’t real. There will be many FTX speculators who are finding that out the hard way.

We don’t take pleasure in other people’s suffering, but it is Thanksgiving, and we have much for which to be thankful. In keeping with our tradition, here is my list:

-> I am thankful that we did not speculate in FTX.

-> I am thankful that my wife and I both believe in monogamy and didn’t even know “polyamorous” was a thing (maybe I’m getting old, but that sounds gross and exhausting).

-> I am thankful for our children, who are keeping my wife and me very busy.

-> I am thankful that my son has his learner’s permit and is just one year away from driving solo so my wife can quit her current role of unpaid chauffeur.

-> I am thankful for my family, immediate and extended.

-> I am thankful for all of my friends.

-> As always, I’m thankful for Mama’s pumpkin cheesecake and for my loose-fitting pants, which – while no longer in style – still make enjoyment of said cheesecake possible.

-> Finally, I am thankful for you, our clients and friends. Your trust in Iron Capital is our greatest asset and we value it every day of the year.

Happy Thanksgiving!

Chuck Osborne, CFA
Managing Director

~It Could Be Worse

The one thing I know about British politics is that if I ever get depressed about the state of U.S. politics, I can always pick up a British news story and feel much better. There is a long history here. They created a separate church so the heir-obsessed King Henry VIII could annul his marriages and behead his wives without spiritual condemnation. Is it any wonder we beat them twice, and then little more than a hundred years after the second beating had to save them from the Germans, only to have to save them again some 25 years later from, yes, the Germans again.

There are many lessons to be learned in the shortest run ever as a Prime Minister of Great Britain, and I’m sure there will be books written that will take longer to read than Ms. Truss’ tenure. We are going to focus on two immediate lessons that deal with economics and how markets work.

What got Truss into trouble was her reportedly aggressive tax-cutting schemes. Lesson number one is an economic policy lesson: tax reform is about reducing the government’s influence on the economy, not just cutting people’s taxes. Since the days of Reagan and Thatcher, every conservative politician in the world has preached tax cuts: “Vote for me and you will keep more of your money.” It is often said that what voters want is lots of government programs and no taxes; that doesn’t work so well in real life, but most politicians hope to be out of office before the bill comes.

Tax policy success is like everything else:  the devil is in the details. We seldom get details these days; we just get a declaration that the Truss government was going to cut taxes, usually with some added modifier like “ill-advised,” which makes the article more propaganda than actual news. I don’t know the details of the Truss policy proposals, but I do know a fair amount about what Reagan actually did in office. Reagan was far more of a tax reformer than an actual tax cutter. During his administration, Congress lowered income tax rates and reduced the number of brackets, but they also eliminated many tax shelters.

The biggest economic issue with tax policy is not usually the rate, but the impact of tax incentives on the economy. The big-picture goal is to reduce the influence of government on the economy, not necessarily to reduce one’s tax bill. In the real world, high tax rates are always accompanied by tax loopholes for the politically favored. In this way the government influences the economy, and usually that turns out to be a bad idea. Reform is not about reducing tax receipts; it is about reducing these incentives. My guess is that Truss, like many conservative politicians, oversimplified the lesson and just wanted to cut, then cut some more.

When the markets took a look at the Truss economic agenda, they saw deficits exploding in an already precarious fiscal situation. They reacted by doing what markets do best in the short term:  panic. The value of the pound plummeted and rates on British debt rose rapidly.

This brings us to lesson number two: markets anticipate. An important factor here that has not been reported, at least certainly not enough, is that Truss never actually did anything as Prime Minister. None of these recommended policies were voted on, and even things that did not need parliament’s approval had no chance to take effect. But markets don’t wait for the real-world impacts; markets anticipate, and by the time reality finally hits, they are anticipating the next thing.

This is probably the most important lesson to be learned here. The Biden administration’s first official act was to shut down the Keystone Pipeline and put a moratorium on oil and gas leasing activities in the Artic National Wildlife Refuge. Energy prices started to rise. A logical person could point out that the pipeline wasn’t finished, so it really didn’t change the status quo. One may point out the numerous existing oil leases that are not being drilled for various reasons. The same person could point out that “Trussenomcics” was all theoretical. None of that logic matters to markets.

Market anticipation isn’t always right, and that is what creates opportunities. The stock market this year has been anticipating a severe recession brought on by higher interest rates, yet in reality, in June and again this month, corporations are reporting results that indicate this isn’t happening. We should enjoy the rally while it lasts and hope the market has learned a lesson. We need to stay diligent, however, because today’s reality is not as important to the market as the market’s belief in tomorrow’s reality. Markets anticipate.

Warm regards,

Chuck Osborne, CFA
Managing Director

~The Lessons of Liz Truss