October 1, 2023
The long hot summer we experienced did not transfer over to the stock market. After hitting a12-month peak in July, the S&P500 proceeded to drop over the next two months ending the third quarter down 3.6% on September 30, 2023. With dueling forces bombarding all markets, it is harder than ever to read the tea leaves. In the presence of more than usual uncertainty, the markets showed their displeasure by dropping.
Bonds: We often waste more “ink “on the stock market, when it is the bond market (which is thrice as large globally) that leads. We witnessed this in spades in September when the 10-year treasury note rose a dizzying 0.48% for the month, ending at 4.57% on September 30. Although a move this size would go unnoticed in the stock market, it is massive for a market that measures change by a basis point (0.0001). Pundits cite the rise in the “long” end of the bond market as a start in normalizing the relationship between short term and long-term rates, called the “yield curve”. Logically, long rates should be higher than short rates as investors demand more compensation for committing capital for longer periods. This gives the yield curve an upward or positive slope. The yield curve became inverted when the Fed began raising short term rates aggressively 18 months ago while long rates held steady. We pay attention to inversion as it is often considered a precursor to a recession. With the Fed funds rate now at 5.25-5.50% at the short end, we have a way to go before long rates are high enough to result in a positive yield curve.
The big move required for the yield curve to normalize has created a parlor game of predicting whether long rates go up or short rates fall. Earlier in the quarter, the odds were stacked for short rates going lower through Fed cuts early in 2024. Although the Fed paused in September, Chair Powell signaled it may have one more raise in its back pocket. This is one of the reasons cited for the stock market sell off in September. It was the realization that rates were likely to stay at a high level for longer. The imbedded assumption of a rate drop in early 2024 was pushed to the end of 2024 and perhaps into 2025.
Another reason we believe rates will stay high is that the Fed is not buying treasuries as it did during the Covid years. Further, it is not replacing the treasuries that are maturing at the same rate as in the past. This reduces demand for treasuries. Also affecting demand is that other countries, like Japan and China, faced with similar monetary situations, are not able to buy our treasuries as they have in the past. Lower demand means lower prices and higher yields.
Goodbye TINA hello TIA: With T-bills and money market funds now at or above 5%, who needs stocks? Investors are answering with their feet, moving large sums from low paying bank accounts to these instruments. A new term “cash sorting” describes this phenomenon. Investors have also pulled funds from other volatile segments because now There Is an Alternative (TIA). In contrast, for the duration of the past bull market, TINA (There Is No Alternative) ruled. Cash is once again queen.
*We sprinkled a few references to song titles from Taylor Swift’s expansive catalog. Her talent as a singer-songwriter is legendary. By no means a “Swiftee”, I admire her business acumen and the courage it took for her to stand up to the music industry as a young artist.
Labor: Economic statistics indicate a robust and still tight labor market. Despite the layoffs at large companies that made the headlines, unemployment remains stubbornly low at 3.8%. Importantly, job openings are about 20% above 2019 levels, even after the post-Covid rebound. Further, labor force participation (LFP), the share of Americans working or looking for work, is 62.8% and predicted to keep rising. For context, the highest LFP was 67.3% in January 2000. Employers have reduced the impact of tight labor by improving productivity due in part to, you guessed it, AI.
There is a rolling contagion of labor unrest that started with the writer’s strike. In Michigan, we are ultra-attentive to the UAW strike and its ramifications for our economy. To quote colleague Anne Nichols, “this is not your father’s UAW, it’s more like your grandfather’s!”. Regardless of the apparent bad blood between the UAW and auto executives, there are signs the parties are edging towards an agreement. The olive branch is just beginning to sprout buds.
Inflation: August’s Personal Consumption Expenditures (PCE) index was 3.9% annualized, dropping below 4% for the first time in two years. The Consumers Price Index for August, which includes food and energy, was up 3.7% for the year, down from 9.1% a year ago. While the inflation dragon is wounded, it is not slain yet. As we know all too well, higher interest rates and restive labor are not good for inflation longterm. Add oil now at $100 a barrel to the mix, and we are dancing with our hands tied.
Stocks: Despite the third quarter swoon, the S&P 500 is up over 11% for the year to date through September 30, 2023. When in doubt, strategists look to market history, which in this case is on the side of the angels. September is generally the worst month in the year. Then we begin again with a robust bounce in the fourth quarter culminating in a Santa Claus rally. This is the kind of history we would be glad to repeat.
Regardless, a healthy economy will allow the stock market to shake it off and proceed upward. The continuing strength of the economy in the face of 18 months of Fed tightening is impressive to behold. An article published in Barrons on September 30, 2023, entitled “What the Job Market’s Baffling Strength Means” attributes “...generous fiscal stimulus, unexpectedly strong labor-force participation, a rebound in immigration, a boom in small-business creation...” as some of the factors that account for the strong labor market. It will help us achieve a soft landing and avoid a deep recession.
At Fern Capital, we are focused on the end game. We are paying more attention than ever to basics in this period of greater market uncertainty. Our clients are at or below their target allocation to stocks as treasuries are paying us as we wait. Diversification is importantbetweenassetclassesandbetweenstocksectors. Wecontinuetoreplacematuredbondpositionswithshorttreasuries that offer risk free yields north of 5%. We will extend maturities once it is clear the Fed is done tightening. For stocks, consistent earnings growth matters more when the economy is slowing. In periods of high interest rates, we prefer companies that carry relatively low levels of debt that are also able to fund their future growth through their own cash flow.
July 4, 2023
Like the two characters in Samuel Beckett’s play “Waiting for Godot”, we have been anticipating a recession that has not arrived yet. Although we had two consecutive quarters of declining GDP in the first half of 2022, it was not deemed a recession officially due to strong labor metrics at that time. With the Fed having raised interest rates by 5% already since March 2022, we wonder why we haven’t had a recession yet, and what, if anything we should do to prepare for it.
Inflation is the obvious villain in this reality play. There are some signs that inflation is slowly moderating, but it is still much higher than the Fed’s stated target of 2%. The Fed’s favorite inflation gauge is Core Personal Consumption Expenditures (PCE) which excludes the more volatile food and energy costs. The annualized increase year over year for PCE was 4.6% in May versus 4.7% in April. This, and softening in other data could have been the reason the Fed paused raising rates in June, but still warned of potential rate increases to come. Market consensus now is that there may be 2 more raises before the end of the year if inflation data justifies them.
One wonders if the 2% inflation target should be moved higher. In the past several decades, the US economy was able to keep a lid on inflation by shifting production to countries with the lowest labor cost. China was a primary beneficiary of this move to globalization. With growing tensions between our two countries, multi-nationals are scrambling to establish plants in other countries like India. Replacing Chinese production is a costly move, which may be passed on to consumers. Some, enticed by incentives to bring back production to the US, are contemplating just that. As we know, labor costs are high here, and workers are hard to find at the low end of the wage spectrum. So, a higher inflation level is likely to be here to stay.
Labor related indicators are still strong. The unemployment rate ticked up to 3.7% in May but is still low by historical standards. Although mass layoffs at big corporations are announced at increasing frequency this year, small business, the bedrock of the American economy, is still looking for workers. If the “Help Wanted” signs posted on restaurant and store fronts are any indicator, the June jobs reports due out at the end of this week promise to be strong as well.
The labor force participation rate of 62.6% in May is now just 0.7% below that of the February 2020 level for all people over 16. The good news is the May rate for people in their prime earning years of 25-54 has returned to pre-pandemic levels. It also appears the participation rate is getting closer to the historic average of 62.84 as measured over the years 1948 to 2023, leaving little slack in the labor market.
Manufacturing has dropped to 46%, its lowest level since May 2020, as measured by the Institute of Supply Management Index, signaling a contraction in industrial activity. The service sector is seeing a little softening as well. The US Services Purchasing Managers Index dropped slightly in June to 54.1 from 54.9 in May.
Housing data in the U.S. is mixed to say the least. Per HUD and the Census Bureau, new home sales in May were up 20% from a year ago, although the median price paid for a new home fell 8% in the same period. New homes are picking up the slack as the inventory of existing homes for sale is at historically low levels. Existing homeowners, loathe to give up their ultra-low mortgages, are staying put without enough price incentive to move.
Bonds have been signaling a recession for almost a year now with an “inverted yield curve”, where short term interest rates exceed long term rates. Though not all inverted yield curves forecast a recession, it is often associated with one. So, we are still waiting for Godot. The low rates we enjoyed during the extended bull market post-2008 were kept artificially low by an infusion of cash after the Great Recession. With inflation at historic lows (some thought it too low at the time), the Fed did not feel the urgent need to unwind the easing. The massive stimulus during the Covid years on top of the previous surfeit of cash sparked ultra-high inflation in 2022. We expect the yield curve to normalize eventually, with both short- and long-term rates stabilizing at higher levels than in the past, more in line with historic averages.
Stocks on the other hand had a “What, me worry?” attitude, as Nicholas Jasinski of Barrons put it. Shrugging off high inflation, the regional bank crisis, and the debt ceiling negotiation, the S&P 500 had the best first half since 2019. The index’s performance was on the backs of the “Magnificent Seven” biggest stocks that now represent 28% of the S&P 500 market cap. Some of these stocks in turn were rewarded for using regenerative Artificial Intelligence (AI) in their products and processes. Like the dot com bubble days of yore, other companies climbed on the AI bandwagon, rushing to explain how they too had AI applications. A new parlor game sprung up during the past earnings season to identify how many mentions of AI showed up in company earnings calls.
The narrowness of the stock market is of concern. The market cap weighted S&P 500 rose 9.65% YTD through May. In contrast, the RSP index that weights all the S&P500 stocks equally, was down -.67% for the same period. So, there is a bubble, but just at the top of the market. Some of it is due to investors seeking the “safety” of well capitalized companies. The other reason is that the move to large cap index funds invariably results in money pouring into the same top seven stocks which are widely held in other indexes. Active managers, reaching for performance, feel pressure to have some representation in these stocks as well. The S&P 500 index will fall if the giants disappoint. The mega caps are trading at such high valuations that there is tremendous pressure for them to exceed expectations in the upcoming quarters. One hopes that this will spur investors to seek diversification in other segments of the market that still have reasonable valuations.
A recession is predicted by the highly regarded Conference Board that tracks several economic indicators and publishes its evaluations for major world economies. In its June 2023 release, they predict the US economy will contract over the third quarter through first quarter of 2024 period, “due to continued tight monetary policy and lower government spending”. Recessions are healthy for the long-term success of our markets, as it eliminates “irrational exuberance” like the kind we are seeing with the current enthusiasm for AI. Prior to the long bull run, we endured a recession every six years on the average. We are overdue one. Given our strong labor markets, the consensus is that if we do have one, it will be mild and short. Godot’s visit will be brief.
At Fern Capital, we start with investing equal weights in stocks that are diversified across sectors, trimming them back when individual holdings get too large or overvalued. We are taking advantage of the stock market run to trim positions where warranted, keeping equity allocations at or below target. Bonds are finally an attractive alternative, but we are keeping maturities short. Currently, the deal of the year are treasuries with maturities under a year yielding over 5%. Our emphasis on investing in quality companies is paying off, as quality matters more when the economy is retrenching, and rates are high. We define quality companies as those who are growing earnings at a steady clip and have strong balance sheets and cash flow. They hold relatively low debt, and do not need to borrow or replace borrowings at higher rates. This positions them to be able to deploy capital in new opportunities, something weaker competitors may not be able to afford. We are well prepared for Godot, whether he shows up or not.
April 2, 2023
The warning “Beware the ides of March” hit the mark or rather, was “all net” this year. The similarity of the markets’ turmoil this March to the havoc wrought on fan brackets leading to the NCAA finals this week has not gone unnoticed. So here are our thoughts on the final four issues we have faced so far..
Bank Shot: The seemingly overnight collapse of the Silicon Valley Bank (SVB), the second largest failure in bank history, and Signature Bank in close succession, sent a shudder of recollection; is this 2008 happening all over again?
The SVB failure will undoubtedly be the subject of future case studies in Business Schools. It was a classic mismatch of strong offense (short term uninsured deposits) pitted against the weak defense of assets invested in long term Government bonds. The latter bought when interest rates were at historic lows dropped to significant loss positions when the Fed raised interest rates from 0 to 5% at the fastest pace since the 1980s. SVB tried to raise fresh capital through a $2.25 billion stock offering to avoid selling the bonds at a loss. However, when it became clear that the offering had failed, and the bank was forced to sell $21 billion bonds at a loss, venture capital firms with deposits in SVB blew the whistle, pulling out their deposits and urging clients to do the same on Twitter and other social media. What resulted was a bank run 21st century style as depositors withdrew huge sums with a tap of a cell phone. The outcome, as they say, is for the record books.
As is usually the case, there is plenty of blame to go around. Bank management, after taking on too much interest rate risk, was reluctant to take action to mitigate it. Meanwhile, regulators having called foul on these issues, failed to exert their authority. Credit rating agencies missed the risks altogether, maintaining their A1 credit rating on the SVB bank deposits until March 10, when it failed.
The trauma faced by depositors could have been much worse if the Fed and the Treasury Department had not taken immediate action to try to find qualified buyers for SVB and Signature Bank. Failing that, they had to shut the banks down to allow the FDIC to cover withdrawals regardless of size. To calm the situation further, the Fed created a new lending program enabling all banks to borrow sums equal to the face value of their long-term investments at low rates. This allowed them to hold the bonds to maturity rather than sell them at a loss. These actions were effective in staving off further panic. At the end of March, “bank runs apparently had slowed to a stroll” to quote Randall Forsyth of Barron’s. Indeed, deposits at small banks stabilized at $5.39 trillion on March 22, versus $5.38 trillion in the prior week.
The Fed and Inflation: Tied for second seed and too intertwined to separate, is Fed action related to inflation. Though dropping, inflation is still at a relatively high level. On March 31, the Commerce Department reported that consumer prices rose 0.3% in February over January but was still 5% higher than the year before.
Core inflation, the increase in price without the more volatile food and energy segments was also up 0.3% over January, but increased 4.6%, year over year. Banks are bound to tighten lending, doing some of the Fed’s work in tamping down inflationary spending, making them the sixth player on the team. Consensus now is for one final hike of 0.25% in May. The Fed may not reach its stated target of 2% inflation but could settle for stability at a higher inflation rate to avoid tipping the economy into a deep recession. In fact, the likelihood that the Fed could cut rates in the second half is gaining momentum but is a far cry from a slam-dunk.
Market Sentiment: The first quarter ended on a high note, with the S&P 500 up 6.7%. We believe the market is discounting a pause in Fed hikes after the May raise. There is a 12–18-month lag before rate hikes have their desired effect. It has been 12 months since the first rate hike in 2022, so we could have another six months of pain to go through. As markets generally anticipate the state of the economy six months ahead, the strength we see now is consistent with the sentiment that the fourth quarter could be a turning point for the economy.
The positive outlook is supported by a chart called “Panic/Euphoria” created by Citigroup Investment Research. It tracks statistically driven buy and sell signals to gauge investor sentiment. On March 25, the model was deep in panic territory, at -0.34 below the -0.17 level that indicates panic. This low reading implies there is more than a 95% likelihood that stock prices will be higher in one year.
But there is plenty to worry about before we get there, including whether our economy goes into a recession. First quarter earnings are expected to fall 6.6% according to a Factset report released on March 31. So far, companies have been able to keep their margins intact by raising prices. But there is a limit to how far that can go before demand gets hit. Labor is next on the chopping block. The layoffs announced to date have generally been from big tech companies reducing their white-collar workers. Some wags are using the term “richcession”, where the wealthy are hurt by reduced compensation tied to lower values of their company stock and private equity portfolios. Meanwhile blue-collar jobs, particularly those in the service sector, are still going abegging. The odds of a recession are currently at 35%. The consensus belief is that the recession if it happens, will be mild and short.
Base Line: A low growth economy with restricted lending and higher interest rates, favors the kind of stocks we prefer at Fern Capital. These are ones that have sufficient cash flow from their normal operations to maintain or reduce current debt levels to keep interest expense low. Unlike cyclically sensitive stocks, they do not rely on a robust economy for growth but have products and services that are supported by secular trends. A bonus is that we are finding more opportunities to buy these companies at the prices we like.
On the bond side, we hold portfolios of investment grade bonds with no more than five years to maturity. These bonds are laddered so that some of the bonds mature each year. This gives us the ability to reinvest at the higher yields currently offered. There can be method in this madness.
January 2, 2023
We recognize duality in various aspects of our economy and markets, as we say “hello” to 2023 and “goodbye” to 2022. But will the key concerns of inflation, Fed action, and a possible recession go away with the mere turn of the calendar page? For at least the past two decades we have enjoyed low inflation, and at times even lamented that it was too low. That reversed dramatically in 2022 with a spike in inflation caused by several trends reversing simultaneously in the year. We expect inflation to eventually stabilize but at a higher level, more in line with long term averages than we have enjoyed in the past.
Open vs Closed Markets: In its eerily prescient article “The Long Boom” Wired Magazine published in 1997, Peter Schwartz and Peter Leyden made a strong case for 25 years of global prosperity and integration based on “fundamental technological change and a new ethos of openness”. There is no question they were right on technology, which accelerated change for the better. Technology enabled companies to manufacture more efficiently domestically. Open markets enabled companies to seek and access low-cost labor and materials wherever they could find them abroad. Globalization was a win for emerging economies and a win for us as our consumer-focused economy benefitted from cheaper goods and services. Goodbye inflation.
Communication between individuals accelerated significantly after the iPhone was introduced 10 years later in 2007. Being linked by this and similar devices unfettered by boundaries of country and culture certainly promoted openness, for a while. For a moment we had the Arab Spring. But then we experienced 9/11, regime change in China, the Covid pandemic and this year, the Russian invasion of Ukraine.
Clyde Prestowitz (“Industrial Policy Comes Full Circle” WSJ of December 15, 2022) posits that Covid shutdowns of the last few years have exposed the perils of being too intertwined with countries separated from us by geography and radically different political, legal, and philosophical systems. He cites the example of Germany paying dearly for becoming too reliant on Russian natural gas. The US too, learned from the pervasive computer chip shortage that recently crippled many industries. The new production facilities planned for the U.S is our response. But these chips are unlikely to cost less than imported chips which also benefit from being purchased with the stronger US dollar. Mr. Prestowitz also points out that shipping generates 14% of global greenhouse gas emissions, a cost that is not currently incorporated into the price of the product shipped. If it was, we would be more likely to buy local.
Tariffs have been around in some form for all of our history. Tea anyone? But their magnitude and impact began to accelerate in earnest by tariffs placed on China pre-Covid. These are still in place and expanded with embargoes on Russian oil and other commodities after the invasion of Ukraine. There is a direct relationship between tariffs and the cost of imported goods across the globe. Hello inflation.
Demand vs Supply: During the Great Recession of 2008, the Fed embarked on an extensive and successful program to lower interest rates to stimulate demand for goods and services. During the Covid crisis years, the Fed followed the same game plan, injecting a huge amount of liquidity into the economy. These policies were also supplemented by direct payments to households and loans to businesses to keep them afloat. Those actions helped the country get through the crisis and prevented certain industries like the airlines from going bankrupt when few were travelling. This time however, the problem was supply, not demand. During the Covid years, homebound households and businesses flush with cash had little to spend it on due to supply bottlenecks. There were too many dollars chasing fewer goods and services. Hello inflation.
Mild vs Severe Recession: Yields on Treasury notes with maturities greater than 10 years are now lower than those with maturities under 2 years. This situation, an “inverted yield curve” has traditionally been known to foreshadow a recession. The Fed has insisted that it will continue to raise rates to 5-5.5% from the current 4.25-4.5% if the labor market, the last pin to fall, stays stubbornly resilient. There are indications of softness, with drops in job gains and a slight rise in unemployment projected for December. Those results will be out later in the first week of the year. This time bad news on the labor front will presage good news for markets, as it may stay the Fed’s hand.
Stocks vs Bonds: Markets dashed hopes of a Santa rally in stocks with the S&P 500 down over 19% for 2022. Bonds as measured by the Bloomberg US Aggregate Index also dropped 13% for the year decimating the traditional 60/40 balanced portfolio. In market history, there have been just two other calendar years when both stocks and bonds had negative returns. The consensus outlook for 2023 remains murky for both, with investors expecting a poor first half while the Fed is still in a rate raising mode. Investors expect a rebound in the second half, expecting to eke out a positive year overall.
Active vs Passive: Due to the challenges ahead, 2023 is very likely to be a stock pickers’ market. Investors will have to throw out the old play book to adjust to the brave new world of higher inflation and higher rates. As we have seen in 2022, investors will reward the companies that are nimble enough to adjust their cost structure to maintain earnings growth. Also rewarded will be companies with strong enough brands to raise prices without affecting sales. Good cash flow and solid balance sheets will be more important than ever, playing into the high-quality stocks and bonds we prefer. Goodbye “meme” stocks, hello active management.
Bottom Line: We take comfort from the fact that two back-to-back down years are extremely rare in stock market history. It is also easier to find attractive entry points in a market down 20% than the other way around. Due to the “known unknowns”, we are maintaining clients at the low end of their target ranges for both stocks and bonds. While we wait for stability, however, there is an alternative: U.S. Treasuries with short maturities that are still yielding north of 4%. Instead of choosing between hello or goodbye, “Aloha” seems about right.
*Song title by The Beatles