Ode to the Short Term and Long Term

Markets are getting noisy with the stories of how a Federal Reserve policy pivot is getting close. However, it is my view that the SP500 will make a new, lower low (3.3k), before a new bull market begins.

We have not yet seen a material reduction of the year over year inflation rate (headline or core). The odds of another 75bps Fed rate hike in November are high, in my mind.

Add on how global equity markets are still in a down trend (lower highs, lower lows), and the current bounce in US stocks looks like a bear market rally. Of course, stocks should have some rally. Stocks had been sold quite hard, down to important technical levels and shorts thereby might cover some of their positions and enjoy a profit. Plus, some of the players trained to buy the dip over the last 12 years, are still keen to catch the “imminent” fed pivot and feel the euphoric high associated with gains, on their increasingly scarce speculative capital.

One of the big question marks right now is corporate profits. They have been somewhat strong, however, as of June 2022, they are no longer accelerating higher. We are still in the midst of earnings season, so more data to come. However, we can start to see some executives beginning to guide down investor expectations with recession talk. It’s also very common for executives to unleash a barrage of bad information, guidance, losses disclosures when environmental conditions outside of their control give them an easy out to “throw the kitchen sink” at a quarterly result that was going to be negative anyway; So that could still be ahead as a negative catalyst for equity prices.

It is my view that the negative feedback loop that weakens the economy is in progress. Housing is well known to be an important economic driver. New residential construction and sales have become weakened. High mortgage rates and healthy levels of inventory are deterring builders from building spec homes and are now having builders negotiate on price to move sales across the finish line. This is step one, step two is that these conditions persist and we actually begin to see layoffs in the homebuilding and peripheral sectors of the economy. This would likely occur just after damage to homebuilding profitability, including outright losses is realized (which as of writing has not happened). This is the pain that J. Powell (Fed Chairperson) thought would be necessary to reduce inflation.

It’s worth noting that high quality money market funds are yielding near 3% these days. As this yield rises each passing week, cash becomes more interesting to hold; especially in light of the potential downside in stocks and stocks comparably paltry dividend yield (about 1.6%, on the SPY as of writing).

Adding to the headwinds for positive stock market returns are profit margins. Let’s face it, energy is the economy. No energy, no economy. If the cost of energy is going to be higher, then corporate profit growth will be more difficult to sustain at current, ahistorical levels. We still have not seen the world grow oil production to a level that exceeds the peak in 2018. I think we need to seriously ask the question of whether or not we have just lived through peak oil. Peak oil is when you can no longer grow your total oil production. Peak oil is not running out of oil, it’s an inability to grow production. Further, the easiest oil to access is generally being accessed. It’s the harder to get, more expensive oil that remains. Corporate profit margins have been super fat for 20 years. With energy costs rising, capital destruction from unproductive investments (zombies), and social tensions intensifying, might we see companies under stress from a profit margins perspective? In my view, Yes, the probabilities are rising.

The biggest risk to my view continues to be fiscal policy. US treasury spending has stabilized at a high level and is exhibiting a positive rate of change. I think it is possible that accelerating levels of government spending could stave off the most severe, short term, stock market outcomes.

Thinking longer term, I believe we need to have an awareness that the rules of the game are going to change. The development of Central Bank Digital Currencies are telling us that the policy makers want more granular control of how the money system works and more flexibility in how they implement monetary and fiscal policy. The choice to favor capital over labor for 40 years has contributed to social trust at low levels. The deterioration of legacy institutions, in a world of fast paced, technological reliance is introducing systemic fragility. Should we even be surprised if countries began to broadly nationalize private assets within 10 or 15 years? It would be wise to observe these dynamics, assign some probability to them and attempt to manage the risk associated with them.

Finally, I think now that the War in Ukraine is off most of the front pages, it would be easier to forget, for a moment, that the world is in conflict. I claim no special insights here. I am not a political or military analyst and even if I was the amount of propaganda surrounding the affair makes it hard to understand what reality is. What can be known; however is that the economic pie is no longer growing. Yes, it is growing on a nominal basis thanks to central banks creating currency on an as needed basis, but it is obvious that while the global standard of living is making nominal highs, real standard and quality of life is declining. This, in my opinion is why the level of social tension is so high. Social tension is high because our social narrative is out of sync with our lived experience. My best sense of our social narrative is: We are going to grow our collective standard of living (consumption) and that is going to deliver us to prosperity and give us the positive emotional states that our successful ancestors enjoyed. Since the real economic pie is not growing the focus has shifted to, how to divide a stagnating pie. This is a more contentious conversation, with winners and losers. Those dynamics evoke tribalism, spite, distrust and possibly various forms of violence or conflict.

Whatever happens, it is clear that over the long run there is a growing understanding that wealth is not Federal Reserve notes; Wealth is houses, health, agricultural products, clean air and water, relationships with mutual consideration, and real assets with productive capacity. That means that constructs like stocks, real estate, digital assets, traditional luxury goods (which mark social status), and generally anything that is more scarce than dollars is likely to rise in price, as measured in dollars.

Thank you for reading. Stay tuned for an upcoming post where I’ll share my recent experience opening a “Self-Directed” IRA in which I buy and own digital assets like Bitcoin. This structure also allows for the purchase of Real Estate within an IRA.