One of the oldest rules on Wall Street is that a bear market isn’t over until the last bull capitulates. In the past, the obvious questions have been: how we can know who the last bull is and how we can tell that he/she has finally given in to despair and sold. Arguably, the identity doesn’t matter that much and we see the capitulation through a selling climax–meaning a dramatic market decline on huge volume.

During the past few market cycles, the investing world has changed so that it is no longer the resolve of professional portfolio managers that is crucial. Rather, panic selling has become a group affair, with individuals holding shares in mutual funds, mostly no-load, doing the damage. (During one big downturn when I was managing a load fund, for example, I lost about 5% of my assets to redemptions. A comparable, though somewhat weaker, no-load competitor from Fidelity lost something like a third of its.)

Today it seems to me that if there is a last bull it’s Cathie Wood. If I understand her behavior correctly, she’s responded to the loss of two thirds of her asset value over the past year by increasing her portfolio concentration. This is the opposite of what conventional portfolio management wisdom would prescribe, though one might argue that hers is mainly a move out of the group’s least liquid names. In any event, my guess is that Ms. Wood herself won’t capitulate.

Does the bear market go on forever, then? No. Capitulation will likely come through ETF holder redemptions, especially in the ARK arena. As far as I can tell, this hasn’t happened yet.

A second, equally venerable, rule is that the stock market acts in a way that makes the greatest fools out of the largest number of people. For a portfolio manager, this implies: read/hear the financial news, try to figure out what the consensus opinion is …and then set up a portfolio based on the premise that the opposite of these consensus beliefs will play out.

The underlying assumption is that information flows from companies to a cadre of professional securities analysts, who know the companies well and also gather data from government and industry sources. After they have informed clients of their conclusions and given time for them to to act, the analysts typically begin to release their findings to the financial media. By the time media personalities, who tend to have no stock market knowledge or experience, begin to weigh in, the developments they are talking about would have already been pretty well already factored into stock prices.

So this indicator seems to be giving the opposite signal.

The issue I see is that in the cost-cutting the big financial firms undertook following the financial crisis of 2007-09, most/all brokerage firms decimated their stock research staffs (many mutual fund companies had done something similar with their in-house analysts a decade earlier, becoming radically dependent on sell-side research). This has eliminated the most important information source–a cynic would say the only one–for the financial media.

The result is what we see in the offerings of today’s financial media–highly emotionally-pitched gibberish. Lots of emotive performance, lots of jargon, lots of reaction to company or government data announcements, but no anticipation or analysis.

As for myself, I think the ideas of inflation and recession have been more than beaten to death in the stock market media. But because the essential link of the analyst community between press and portfolio manager has been lost, it’s hard to judge whether the current media near-hysterical pessimism extends beyond the broadcast studio. If it does, that’s a good sign, not a bad one.

I’m not sure I’m a 100% fan of Paul Krugman. On the other hand, he is an expert on international economics, he has won a Nobel Prize, and he has been a round for a relatively long time. So he’s worth paying attention to. He’s also written several recent opinion pieces for the NYT that I think are important.

–in one from June 14th titled “How America Lost Its Edge,” recent international travel has caused him to observe that the US seems to be at best in the middle of the pack among the wealthy countries of the world, and in important ways falling behind. My sense is that this is right, even though the US is being compared with places like Europe and Japan, where the population is significantly older–a significant advantage for the US. In a sense, the Ghost of Christmas Future is turning into the GoC Present.

Washington has long had an obsession with industries of the past. Add in the Trump tariffs and his decision to shrink the domestic workforce and you have a recipe for continuing stagnation. And that’s without the coup attempt.

As an investor, this all seems to put a premium on companies that, while incorporated and traded in the US, have strong intellectual property, global sales and limited plant and equipment in the US. It also argues for rooting through the current tech rubble.

–two others are more important for the near-term stock market, I think. From the past few days, they are “Is the Era of Cheap Money Over?” and “Wonking Out: Hot Economies and High Prices.”

In the first he addresses the issue of a decade of low nominal interest rates, which some are arguing has produced an epic stock market bubble over the past couple of years that can only be cured by much higher rates in the future. Krugman points out that the mother of recent stock market excess, the Internet bubble of 1998-2000 happened when real rates were 4%, or 8x what they’ve been during the pandemic. He also suggests that today’s low rates are more a function of an aging population and lack of population growth–Japan is an extreme case of this, and, I think, a harbinger of the fate of an anti-innovation US–than anything else.

In the second, he observes that most commentators on inflation, even in the academic world, don’t have much of an idea about what inflation actually is. For one thing, on the most basic level, they mix up one-time price increases with inflation, which is a steady, years-long rise in prices. In particular, over the past year crude oil has gone from, say, $70 a barrel to $110. Is this a one-time event, or do consumers (and the stock market) expect inflation in the oil price–that crude will be going for $140 a barrel in 2023, $170 in 2024 and $200 in 2025 (and that no one is going to buy an electric vehicle)?

Also, doomsayers on inflation often refer to the Phillips curve, a generalization from the original empirical observation that at low employment rates prices tend to rise. In the 1970s, economists noted that at low employment rates, not only do workers expect prices to rise today but also for prices to continue to rise for years afterward. In other words, the idea of inflation quickly becomes imbedded in consumer expectations.

From this comes the idea that the money authority must raise interest rates to a level where unemployment rises significantly, so that inflation expectations dissipate.

The truly unfortunate part of this analysis, for Krugman, is that the the 1970s version of the Phillips curve hasn’t held true for any other period in the nearly half-century since it was formulated–and which was also not characteristic of the time before the 1970s, either.

So, if we have headline number for prices as being 8% higher today than a year ago, my guess is we should probably break this out into 4% one-time, pandemic- and Ukraine invasion-related, price rises + 4% “ordinary” inflation. If so, the Fed’s task isn’t anywhere near as Herculean as inflammatory headlines might make it seem. Also, given recent reports that merchants like Target and Walmart have massive excess inventories, we should probably question what scope retailers have to push prices higher.

To my mind, the oddest thing about residential real estate in all the markets around the world I’ve dealt in is that purchase price is not the primary consideration for buyers. Rather, what is top of mind is the monthly payment–mortgage interest + return of principal + taxes and utilities. Typically, people buy the most expensive property they can finance.

In the US, the traditional rule of thumb is that total monthly payment should not exceed 28% of the buyers’ gross income. I’ve shortened this rule to: the interest payment, which is by far the dominant element in the early years of almost any mortgage, can’t be more than 25% of gross income. (Overall, I’ve found over the years that taking a first step of making gigantic simplifying assumptions and seeing what they imply is, for me, the best way to get started. Refining can come later.)

Let’s assume the buyer(s) have yearly income of $100,000. This means maximum interest expense of $25,000. At 3%, the most that can be borrowed is $25,000/.03 = $833,000. This implies a total price of $1,040,000 ($833,000/.8) and, therefore, a cash down payment of $207,000. When my wife and I bought our house long ago (interest rates at 17%), our biggest problem was getting the $8,000 down payment we needed.

Assume rates rise to 6%. Interest expense of $25,000 implies maximum loan principal of $417,000. and total price of $520,000.

In other words, our imaginary buyer(s), who could afford a million-dollar house a few months ago, can only get financing for a $500,000 house today.

The biggest implication–a cooling housing market.

More tomorrow.

Back in the Stone Age, when I was in business school, I took an Econometrics course–on a mainframe! I learned two things: the most accurate predictions came from autoregression, meaning projecting forward the past behavior of a given variable (rather than having a whole bunch of them); and there’s no failsafe warning if you accidentally hit the delete button on the keyboard.

The Financial Times had an article the other day by John Plender arguing a variation of the same thing dominates the world stock markets in the present day–that today’s computer-driven trading, as well as what’s done in traditional fashion by humans, both act as if today’s winners will be tomorrow’s and that recent market direction (right now meaning down) will continue.

The result is to make a trend reversal much less likely than it has been in the past.

I think some version of this idea is actually the case. If so, the question of the current selling trend exhausting itself is less one of market level than one of time and of the pool of potential sellers drying up. The end of the summer?

What strikes me the most about the current economic situation in the US is how complex the inflation situation is:

–the Russian invasion of Ukraine has caused inflation-inducing oil/gas, metals and grain shortages around the world. This is partly boycott, partly interruption of production

–covid-related lockdowns in China are slowing production/shipping of consumer products destined for the US and Europe

–in hindsight at the very least, the anti-pandemic fiscal and monetary stimulation in the US was much larger than needed and therefore requires a greater effort to return to non-emergency levels of government policy.

I see the first two as being external shocks. The orthodox prescription is to let economies make the sometimes painful adjustment to the new reality. (Washington was unique among major country governments in not doing so during the 1970s oil shocks, with long-lasting negative results for the US in general and the auto industry in particular). Recent announcements by Target, Walmart–and most recently by Samsung–that they have excessive inventories suggest that the non-Russia problems are beginning to solve themselves.

Oil is a headline-grabbing issue. Unlike the 1970s, however, we’re seeing higher prices rather than shortages (due mostly to congressional attempts to legislate a “fix” to potential problems). And, putting political hysteria aside, my guess is that in two years prices will be considerably lower than they are now. How we get there is another question. My point, though, is that I don’t think we should think of oil price increases as a chronic issue. In any event, any reasonable Fed action won’t affect prices that much.

This leaves the issue of reversing the pandemic stimulus.

Assume that the Fed’s inflation target is, say, 2.5% (the Fed is still saying 2%; I think FOMC is thinking 3%). If we think the real yield on the 10-year Treasury should be 1.5%, then the nominal yield should be 4.0%. We’re now at 3.5%–up from 0.93% at the start of 2021 and 1.63% this January. So rates are up by 187bp this year and 260 bp in the past 18 months, with another 50bp to go.

If we look at the same numbers in PE terms, the 10-year-implied multiple on stock market eps was 107x on 1/1/21, was 61x this January …and is 28x now. If 4% on the 10-year is the final goal, 25x is the implied multiple (20x if the final goal is 5%). Brokerage house analysts, who are always too optimistic, say that eps for the S&P 500 will grow by 10% this year to about 250/share. The S&P is now trading at about 15x that number as I’m writing this.

If stock market investors were to be looking forward–the essence of a bear market is that they don’t, and discount and rediscount today’s woes over and over instead–stocks would seem to be on relatively sound footing.

Historically, however, the emotional charge of the fear of continuing loss needs a considerable time to work itself out. The Financial Times, however, suggests that this time around AI trading strategies are making the pain more severe that it might otherwise be.

more tomorrow