Dear Clients & Friends,
It has been a fast start to the year and hard to believe we are nearing Spring! Feels like we got off easy this year with the weather, and there is a lot to be grateful for. One of the traits of Americans is that we are good at seeing what is wrong with our country and then working to make it better. The flip side of this is that we sometimes fail to see how blessed we are in relation to history or the rest of the world.
At the same time, it has been an amazing three years. With a world-wide pandemic and the resulting shutdowns, one of the most contentious elections in modern history, unprecedented levels of government spending, mask and vaccine mandates, and inflation we have not seen in over 40 years, this has caused much stress in businesses, families and individuals and I want to congratulate you for making it through!
I am getting a lot of questions about a recession, bank runs, etc, which I will cover below, but I wanted to start with a note of optimism. We have been made to be resilient. Our ancestors have been through world wars, epidemics, famines, revolutions, emigration, droughts, and they passed the torch to us, and with a material standard of living that surpasses their wildest imagination. Simple things that we take for granted like running clean water, anything we want delivered right to our front door, controlled temperature, flying across the world in hours… I could go on.
Many of these things were developed in response to massive problems we faced and found solutions to. One can argue that problems are blessings because when we experience a problem, we are also given the ability to find a solution to it, and while the problem is temporary, the solution is permanent.
There are massive seeds of growth in our economy now – here are a few examples:
- Space Travel, Manufacturing, and Mining – This will create a whole new civilization and economy.
- Artificial Intelligence – While this rightfully concerns us now, history shows that we learn to use new technologies to our benefit.
- Robotics – When combined with artificial intelligence, it will enhance our material wealth.
What drives the economy is growth in productivity, and people. While demographics are currently challenged, productivity growth is in the early stages of significant growth. Entirely new companies will drive things forward while also making existing companies better.
Pessimism is easy because there is so much evidence for it (and armchair quarterbacking is easy). Optimism is hard because while the problems are obvious, the solutions have not yet been developed. We must have faith that those solutions will be found.
As a person of faith, I believe God is good and that God is in the future, therefore the future must be good!!
We know this email is long. If you don’t have time to read fully, Here are a few quick bullet points to know:
- Over the last few years, we have seen a shutdown and a deluge of government spending which resulted in historic inflation. This led to record interest rate increases which has caused both bonds and stocks to decrease in value. This tightening has always led to a recession and there are many signs that we are in one now (or close). Stock indexes remain highly valued. This is causing us to want to be more conservative and being cautious with regards to risk. We will eventually have excellent buying opportunities – patience is required.
- Banks are under pressure because interest rates have gone up so much that savers now have better alternatives in short-term bonds, and banks are losing money on their long-term bonds.
- And of course ,I have lots of fun graphs! Read on…
In 2020, there were two things that happened from an economic perspective:
- There was a massive drop in productivity as the economy was shut down. You can see from the graph how much the labor force shrunk by. While people have come back, we are not at the level we were at before that pandemic, let alone the level we were on track for without it.
Source: US Bureau of Labor Statistics
- The money supply expanded at historic rate through Federal Reserve ‘Printing’.40% of all the money that has ever been created in the US was created in 2020 & 2021. This happened by the Fed printing money and buying assets – largely government bonds and mortgage-backed securities. The world has never seen such a wave of liquidity.
When productivity is reduced, and the money supply is expanded, inflation inevitably results... “Too many dollars chasing too few goods.” You cannot print yourself to prosperity! However, the money supply now is negative year-over-year. This means that the Fed is letting its assets mature which results in the money being destroyed.
Above, you can see the total debt of the United States at $31.42T. The latest budget proposal is for $7T of spending, to put this in perspective, before the pandemic it was ‘only’ $4T.
The orange line is the Federal Reserve’s balance sheet. As you can see it is coming down at the same time, as interest rates are increasing at the fastest pace on record. Rising interest rates combined with decreasing the money supply normally brings down inflation, just like rising rates and increasing the money supply will increase inflation.
Some have asked how can the government increase its debt while decreasing the total money? Well, the money has to come from somewhere. To attract the money, government rates have increased to about 5% for short term rates, and 3.5% for 10-year rates. This is ‘risk-free’ and a decent return and so people are moving money from banks and stocks to buy government bonds. It is one of the reasons I am bearish on the broader market is because money must come out to fund bonds.
It is also the reason that some banks are starting to struggle. The banks bought bonds early last year to de-risk from stocks. However, bonds went down as much as stocks. The 20-year government bond was down almost exactly as much as the NASDAQ last year (33%). This is not exactly what they had in mind as safe!
Normally banks make money by lending money for the long-term and paying money in the short term. This attracts both borrowers and savers, but there is a problem. Long-term debt is paying less than short-term right now. This is called an ‘inversion of the yield curve’. You will notice that this only happens before recessions (indicated by the grey vertical bars).
This is causing depositors to move their money out of banks, which makes it harder for banks to loan money, which is causing them to tighten. This is called disintermediation. As you can see from the graph this is also a good predictor of recessions.
Source: Board of Governors of the Federal Reserve System (US)
Historically, the stock market never bottoms before a recession. Therefore, it's possible the market may not have bottomed yet. Two key factors that go into the market are:
- Earnings – how much companies are making.
- P/E Ratio – How much investors are willing to pay for those earnings.
As you can see earnings have started coming down last year but have a long way to go to get to the historical trend line. On average earnings decline by about 25% during a recession (again, indicated by the grey vertical bars).
Sources (clockwise from top left): LPL Research / Ycharts.com / Chaikin Analytics.com
There are a lot of ways to measure this, but as of Q3, the P/E was about 19 times earnings. Recessions almost always bring the PE under 15. Aggregating this together means we have a bit to go until we get to bottom.
When interest rates are low and things are going well, everyone can do well. However, when interest rates go up and there are financial stresses, we start to see those that weren’t doing things right beginning to fail. So far, we have seen FTX fall apart from this and now banks, specifically Silicon Valley Bank and Signature Bank. This is the largest collapse since the 2008 crisis and caused investors to line up to withdraw their funds. As the market opened the Monday after, shock spread and a ridiculous number of bank stocks were halted after losses of more than $70 BILLION, bringing a 3 day total to around $170 Billion. Lucky for account holders, the Fed looks to be making all the depositors whole – even above the FDIC limits.
Banking is typically a sector to avoid during a recession. The yield curve's inversion is brutal on banks as investors move to get their money out and buy treasuries.
As an investor, I am very concerned about the economy and think a pretty bad recession is inevitable due to inflation, interest rate shocks, and a tightening money supply by the Fed and banking system. That said, I certainly DO NOT think it is the end of our civilization, but it will be bumpy and I think we will see new lows in the indexes.
There are a lot of bubbles that need to be washed out, and historically this has created good opportunities to put your extra cash to work.
We keep our eyes on a number of sectors, and as a result, manage a number of unique portfolios. Customizing the allocation of each of them to our client's individual situation and risk tolerance is what's important.
Bear markets try one’s soul because you can go from extreme greed as we saw in January to extreme fear as we saw last week with the failure of Silicon Valley Bank.
We don’t have a view into the future, but we can take the lessons of history and apply them prudently to the present to be prepared.
As always, let me know what questions you have, and I will be happy to help!
I am also eager for your feedback on these newsletters. Reach out and let me know your thoughts!
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