The third quarter ended poorly last week in what has been a very frustrating year for markets thus far. It begins to feel like it will never end. We are in a horrible cycle in which the Federal Reserve, and many in the markets, seemingly want a more severe recession. Every time corporate earnings or economic data suggest things are not as bad as they want it to be, they punish stocks. It seems like we are in a never-ending downward spiral.

It always seems that way right about when the market finally hits bottom and starts climbing. It is impossible to call such things, but this is feeling like a bottom. I would be very surprised if we do not rally from here – that may even be happening this week. The question will then be: Is this another bear market rally or is this one for real? Time will tell.

Meanwhile, times like this remind us to focus on the fundamentals. Prudent investing is done from the bottom-up, and the companies we own – both directly and indirectly through funds – are high-quality companies. I couldn’t be writing this without products from Microsoft. Apple keeps me connected when I’m away from the office. Most of us are still putting gas in our cars, and we all need food on the table.

Market and economic cycles are part of life. This too shall pass, and we will be glad that we were able to buy these companies at these prices. It may not seem like that now, but it is always darkest before the dawn.

Right now, our thoughts and prayers are with those who were impacted by Hurricane Ian. I was in St Simons Island, GA, the weekend before Ian, and was reminded that it is always beautiful right before the storm comes. When the storm leaves, there is damage to be handled, but it is almost eerie how beautiful the weather gets.

Whether in real life or in our financial lives, storms can be unnerving, but they do pass. Right now may seem bleak, but it is time to stay the course. Dawn will come.

Warm regards,

Chuck Osborne, CFA
Managing Director

Authored 10 a.m. Monday, October 3, 2022

~Darkest Before Dawn

“The difficulty lies not so much in developing new ideas as in escaping from old ones.”  ~ John Maynard Keynes

Federal Reserve Chairman Jerome Powell assured us last spring that inflation was transitory. At the time, we suggested that perhaps transitory didn’t mean what he thought it meant. Now he is telling us that inflation must be crushed through pain. He was wrong then, and he is wrong now.

It is as if Mr. Powell, his fellow Fed governors, and the approximately 400 doctorates who work for the Federal Reserve are all fit with blinders. They didn’t see the growth in money supply, or the high energy and food prices, or the incredible increase in housing cost. They could only see short-term supply issues caused solely by our reaction to the COVID pandemic. Those were temporary; therefore, inflation was transitory. They were blind to all the more lasting drivers of inflation, and as a result, they were late in addressing it.

They finally did address it, however, and have now raised rates from 0.25 percent at the beginning of 2022 to 3.25 percent. That is a substantial increase in a short period of time. The impacts of these raises have not even had time to work their way into the economy. Meanwhile, the drivers of inflation that the Fed missed on the way up, are now all on the way down. Money supply, energy prices, and housing are all in declines. The price of oil went below $80 a barrel on Friday for the first time since January. They were blind on the way up and now they are blind on the way down.

They seem to have it stuck in their heads that the only way to beat inflation is to cause a recession. Guess what? We are already in a recession. We have had negative GDP growth for two quarters in a row. The Fed is predicting the GDP growth for 2022 will be 0.2. To achieve that, we would have to grow the second half of this year at a rate of more than 2 percent. Based on where we are now and in light of the Fed’s actions, that is so overly optimistic it is laughable.

Powell, and many other pundits, keep saying we are not in a recession because the labor market is still strong. I understand that; the labor market has long been our indicator as well. It was weakness in the labor market that made us predict a bear market in 2008, although we had no idea it would be as bad as it was. However, it isn’t always the same. We have had two quarters in a row of negative growth; that is a recession. Inflation is coming down; there is no need to make things worse.

If you have not seen it, I would recommend watching the CNBC interview with Jeremy Siegal[1]. Mr. Siegal, economist and professor of finance at the Wharton School, sums up the frustration we all have with the Fed.

Unfortunately, the Fed that was blindly focused on pandemic supply issues seems now to be blindly focused on employment and wages. They believe that they cannot truly cure inflation unless they drive unemployment up and wage growth down. This is an old idea, and in fairness it has some merit. However, there are new factors that they seem to miss: Although unemployment is low at 3.7 percent, we still have a full 1 percent decline in the labor market participation rate from pre-pandemic. If that 1 percent were to rejoin the labor market tomorrow, then unemployment would be 4.7 percent – three tenths of a percent higher than the Fed’s target of 4.4 percent. We have a worker supply problem, not a job demand problem.

Their other focus is on wages. Wages are rising, but that is not driving inflation, it is lagging behind inflation. Real wages are and have been dropping. You don’t need me to tell you that – every person we talk to is talking about budgets being strained, not wallets being flush.

If I had any hair, I would be pulling it out. But, we must play the hand we are delt. We are making moves to position portfolios as best we can. The silver lining of higher interest rates is that bonds are beginning to look attractive once more (and I did have hair the last time I could honestly say that). If Powell gets his wish and our current mild recession becomes a more severe recession with global implications, investors will look for quality, and most of that is here in the U.S.

It has been a rough year mostly due to poor policy, and it may now get worse due to even more poor policy, but it will pass. It will indeed be morning again in America at some point. Bear markets create opportunities for long-term investors. We will get through this.

Warm regards,

Chuck Osborne, CFA
Managing Director

[1] This video is available via CNBC Pro with a 7-day free trial. As an alternative, Mr. Siegel reiterates the same position in this clip from “Squawk Box” 09/26/22

~Blinders

You have heard of the madness of crowds… on Tuesday this week, we witnessed the madness of computers. A few years ago, we talked quite a bit about the phenomenon of computer-driven trading. We don’t think of it much anymore, but it is still there, and every once in a while it rears its ugly head.

Tuesday’s Consumer Price Index (CPI) report showed inflation at 8.3 percent – below the previous reading of 8.5 percent, but above the expectation of 8.1 percent. The core reading, adjusted for food and gas, came in at 6.3 percent, which was an increase. The driver on that increase was housing, and it is important to understand that the current methodology for calculating housing cost has an almost seven-month lag. Real-time data suggests that housing has peaked and is heading down in price.

Here is where the computers take charge: They were programed for “miss on inflation = sell.” Had inflation been lower than the published expectation, they likely would have bought. How do I know this? In truth I have no evidence, nor am I going to waste my time researching, as it really doesn’t matter. Logic and experience tell me that no thinking human being with even a modicum of financial sense is hitting the panic button over an inflation reading that is headed in the correct direction – only computers trade like that.

Economic forecasting is not an exact science; in fact, it can barely be called a science at all. The important factor in Tuesday’s number is not whether it is 8.1 vs 8.3. The important factor is that this is the second reading in a row that is heading down instead of up. Thus far inflation, as measured by CPI, has peaked at 9.1, and the next two readings have been 8.5 and now 8.3. That is good news, not bad.

The sudden selloff does reflect the mood. Pessimism is high right now – too high, in our opinion. Pessimistic short-term traders create opportunities for long-term investors. We don’t even need things to be good, we just need them to be not as bad as the pessimists believe. An inflation reading of 8.3 percent is certainly not a good thing, but it is better than 9.1 percent and better than 8.5 percent. Improvement is all we need. Keep it heading in the right direction.

I know it is frightening to many to see the stock market go down 4 percent is a single day. When it happens, it is important to remember that this does not reflect reality. Apple is not a different company today than it was on Monday. The Home Depot will not be shutting down anytime soon. Your Visa card will still be accepted when you need to use it tonight. The real world doesn’t change 4 percent in one day.

This is why prudent investing is done from the bottom-up. We are investors in companies not traders of stocks, and the companies we own, both directly and indirectly through funds, are doing well. To the extent that their business is hurt by inflation, that pain is a little lower this month than it was last. That is what Tuesday’s report says to a rational human being. The computers are frustrating, and can cause havoc in the short term, but in the long run it is still about the companies one owns. This too shall pass, and long-term owners will be rewarded.

Warm regards,

Chuck Osborne, CFA
Managing Director

~The Madness of Computers

College football kicks off this Labor Day weekend. Most of the top teams will have an easy time of it, but there are bound to be some first-week upsets. The upset will, of course, be accompanied by the underdog’s fans chanting, “Overrated…overrated…!”

Have you ever given that any thought? It really doesn’t make much sense, does it? They might as well be saying, “You’re as bad as we are!” How about actually giving your team some credit? Maybe the favorite wasn’t overrated; maybe your team is just that good. Nah, they were overrated.

Football teams are not the only ones who get overrated. In my opinion, the Federal Reserve is hugely overrated. I will be the first to admit that my belief is not the mainstream. I am in a minority here, but I’m okay with that. I also want to be clear, because we live in a world of absolutes: one must be on one side or the other. An idea is either brilliant or evil, there is no middle ground. (That is nonsense; there is always a middle ground, and usually that is where the truth is found.) When I say the Fed is overrated, I am not saying the Fed is without influence.

The Fed has plenty of influence. However, its ability to impact the actual economy is greatly overstated in my opinion. I have a hard time believing that there was an enormous amount of economic activity that will no longer take place because the Fed has raised interest rates by 2.25 percent. Even if rates get as high as 4 percent for the overnight Fed funds rate, that is still lower than it was for much of the 1990s when the Fed was fueling the tech bubble with “low” rates.

If the Fed raised rates dramatically as it did in the 1970s and early 1980s when rates peaked at more than 20 percent, then it could cause a severe recession, but that isn’t likely to happen. I believe that the Fed has to move rates dramatically before having an impact on the real economy. It does, however, have enormous influence in financial markets, especially the bond market. In the bond market, a small move in rates equals a big move in the value of bonds. Add to that phenomenon the fact that the Fed basically became the bond market during the financial crisis in 2008 with “quantitative easing” – the actual purchase of government bonds. The easing went on much longer than needed (if needed at all), and the Fed now has an enormous bond portfolio it is in the process of liquidating. No one really knows what the impact of that move will be. Quantitative easing was new ground, and now we get to see what quantitative tightening does.

My guess is that it will have little impact on any of our daily lives, but the market is convinced that it is going to cause a recession. (Of course, we are technically in a recession, but no one wants to admit it.) Some have clarified that the Fed will cause an “earnings recession,” meaning corporate earnings will go down. The issue I have with that theory is that the underlying cause of all of this is inflation. Inflation does not impact all companies the same; some are hurt, but most actually will see earnings rise. The rise is only nominal – the higher earnings from price increases get eaten up in the next period by higher costs, all due to inflation – but nominal earnings is what companies report.

We believe the market is giving too much credit to the Fed and is overstating the threat of a severe recession. The JOLTS job openings were reported earlier this week and there are basically two open jobs for every unemployed person in the U.S. This is after the Fed has raised rates.

This is the problem in the market now: Fed action isn’t causing the real economy to slow dramatically, as the market fears. Every time we get data confirming this, the market, instead of celebrating good news, fears for even more Fed action, which it believes will cause real harm. At some point, good news has to be accepted as good news.

As we have written before, the Fed did not get us into this situation alone, and it cannot get us out of it alone. Meanwhile, one cannot fight the market. We remain defensively positioned, but also cautiously optimistic. At this point, this still could be just a dip in the rally. We will know shortly which way we will go. We hope for the best but stay prepared for the worst.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Overrated!

“Now what are you going to do? You done dropped your gun in the last scene!” ~ Eddie Murphy

I don’t know about you, but I find that there is a reason certain lines from pop culture seem to have staying power. In a meeting just last week, one of my colleagues was discussing a remote probability. Immediately someone (okay I confess, it was me) said, “So you’re telling me there’s a chance?” Everyone laughed. It isn’t because the line is that funny, it is because everyone at that table recognized it as a line from the movie, “Dumb and Dumber.” It is these little things, the inside jokes, that in part make up a culture.

Wall Street also has a culture, and a language. Often times the market does what it does because of a Wall Street script that is known by those who share the culture and know the punch line before it is delivered. There are naysayers, and frankly I’m one of them. There is no actual script; history does not have to repeat itself. However, it often does. Why? I believe it is the phenomenon of the self-fulfilling prophesy. It happens that way because we made it happen that way, because we believed that is the way it was going to happen.

However, every once in a while there are two (or more) possible scripts. We are at one of those moments now. We have had a bear market, and we have rallied off the bottom; but now what? One possibility is that the bounce we have seen over the last six weeks was just a “bear market rally.” Long-lasting bear markets often have dramatic rallies, but they eventually peter out and the bear market resumes; that is possible. Yes, I am saying there is a chance.

It is also possible that bottom is in. We have just seen the first move in a lasting rally; in that script we have a dip, and then the rally resumes. This is the more likely scenario, in my opinion. Earnings have held up much better than the pessimistic consensus view of a few months ago predicted. Economic data has been mixed but employment has held up, the consumers are spending, and inflation may have peaked. This would all lead to a resumption of the rally.

Of course, the thing about the future is that no one really knows what it is. Don’t say that too loudly around Wall Street. The script says that when the Fed raises rates, there must be a recession. Of course, we are in a recession (as defined for the entirety of my career), but those who deny the current data also seem completely certain that a recession is on its way; they keep saying that things must get worse, but the truth is that we don’t know that.

That is why we have to be prudent in our decision-making. The top-down headlines will make one depressed, but the view from the bottom-up is very different. Just this past Friday I met with someone who told me that everyone she talks to is busier than ever; that doesn’t sound like the gloom-and-doom reports we hear in the news. The truth is that it is far easier to project the probable future of a particular company than it is to predict an entire economy.

Some companies are struggling in this environment, but others are hanging in there. To me, this reads like the script where we take a step back and then resume the rally. Of course, we have to keep watching to know for sure. That is why we remain cautious and defensively postured. The key to knowing what to do now, is to think through the different probabilities and have a plan for each scenario. Step one: let’s listen to Mr. Murphy and make sure we don’t drop anything that might be needed later.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Now What?