October 21, 2022
Over time this space has been used to provide an unusual view of the economy for typical readers. Sometimes arcane information, but really the basis of good financial planning.
During some recent downtime, I was contemplating the reasons why this information that I watch is considered so arcane. Why potential readers may or may not be interested in interest rates levels, and M2 money supply, corporate profits and the level of employment. The answer that I have come up with is that we have been hoodwinked.
Of course many others have highlighted that markets, managers and individuals are now focused on metrics that are short term, but that really isn’t the issue. The issue is that we are almost completely unaware of the important parts of investing. Another adage comes to mind, and that is the wise farmer. The oft caricatured owner of a swath of land, chewing on a piece of grass, or holding a cow, or a farm implement who doesn’t see the world changing and how futile things are for mucking about.
Like all caricatures, there is truth in that image, but the fact remains, that a farmer knows when to plant and when to harvest. They plan to protect their herd or their crop, they realize what they can control and invest accordingly and what they can’t and try to find protection against those threats.
The modern investor is largely beholden to the latest flashy thing, and may be missing the big patterns.
The current investment world is horribly out of whack and has been since 2017, when the previous president of the United States took office. Before then it was just really off kilter with the knock on effects of the Bush and Obama rescue plans for the ‘Great Recession’ of 2008-2009. To repeat the information, the US economy alone has been flooded with about $1.4 trillion per year over the past 14 years to support the economy. The bulk of that money (about $16 trillion) was done in the last two years of the previous (US) administration. The money was not added evenly and some of it has been added as a matter of policy, but the money has shown up in the economy.
Of course there were reasons. In 2008-2011 it was the Great Recession, then it was the ‘taper tantrum’, then it was election angst, then it was COVID. It wasn’t just the USA either, it was many major economies. And investors keep making significant gains. The chart below is one of my new favourite charts, “Corporate Profits After Tax”.
It shouldn’t be any wonder, given the exponential rise in profits that investors have priced in a continuation of this pattern. Most valuation ratios (price/earnings, price/sales, price/earnings to growth, etc. all assume that earnings will continue as such indefinitely.
If this space was arcane before, then this is going to be annoying. Exponential growth is really hard to do. The earnings chart above shows exponential growth. Exponential growth happens in the physical world very rarely. It happens in the financial world very rarely. It always comes to an end and the reason is always a lack of resources. Not enough molecules, not enough energy, not enough material, not enough people. Otherwise the ‘thing’ growing exponentially consumes everything and it dies.
Money supply has also grown ‘almost’ exponentially until earlier this year. The exponential growth in money supply is also coming to an end (chart below).
This all leads to a return to ‘old ways’. society will need to find ways to create value rather than just reaping marginal gains from large pools of capital. That is a big statement which isn’t covered here, but the reality is that productivity of labor doesn’t even come close to the gains in money supply or profits. The gains are, to use a term bandied about by the gold and crypto crowds, fiat. They are more than completely accounted for by the increased money supply.
The net effect of all of that is that the profits shown above are unsustainable and expectations should be seriously curtailed. Despite all of the criticism for central banks raising rates and reducing their balance sheets (quantitative tightening), the process is necessary to avoid collapse. (The last three weeks in the UK are a clear warning for countries who change course.)
The weak hands are going to be laid bare. How much, how long, how distributed those individuals, organizations and even nations are remains to be seen because much of the risk in markets is poorly understood due to the outsized influence of the noted easy money. This space has repeatedly recommended staying clear of markets with new money until those tail risks (unpredictable things) are either more clearly understood or they have knocked markets down to a discount where the risk makes sense again.
Where is that level? That’s the hard question. Most North American markets are off 20-30% and normally that would be a really big drop. Unfortunately the tightening and the withdrawal of capital is only just beginning. Taxes will still need to go up and profit misses are not yet happening, so the risks haven’t been completely priced into the market yet, at least by the assessment here.
Last year this blog offered up 3,300 on the S&P as a good level to consider as a short term bottom. A place to reassess the risks and perhaps make investments again. The reasoning is based on the chart below. It shows the level that the S&P was at, the last time interest rates were at the level shown. Note the first chart below is from February.
In the past 8 months, the yield on the 10 year treasury has DOUBLED from about 1.9% to 4.2% and the Federal Reserve continues to signal there will be more rate hikes (note that the Federal Funds rate is still at ~3.25% and the 4.2% yield noted above takes the signals from the Federal Reserve into account.)
Where was the S&P 500 the last time interest rates were at 4.2%? That was around mid-2008 and the S&P was just starting it’s long decline (the Great Recession), but rested in the 1,400 range. That’s 60% lower than the current 3,700. It is very pessimistic to predict a 60% decline from here, but it would be extremely optimistic to think that equities will rise substantially from here over any reasonably long period of time.
The world is changing so fast, there is a lot more to draw conclusions from, but the best overall advice remains to stand aside of these markets until more of the pain comes to the surface. The cracks are clearly showing in many places, but the markets haven’t broken and importantly, the reaction of central banks if they do break is a bit of a mystery at this point.
Easy money is going to be very hard to get for the foreseeable future, so be like the farmer. Save when you have excess, protect what you can, and avoid the big mistakes.
[A little bit of extra information here. The caveat that there is plenty of money to be made by the quick and insightful on bear market bounces should be reiterated.
A number of stories this weekend have highlighted that professional managers are starting to move away from buying protection for a collapse, and instead, paying for opportunity on a rebound into the end of the year. This is not far fetched. These trends can last for months and a 10-15% rebound is a distinct possibility if nothing ‘breaks’ in that time.]