Henry Kaufman and hitting the market in the face

Henry “Dr. Doom” Kaufman, former Goldman economist, still working (in his own firm) while his personal odometer approaches three figures, was perhaps the most important Fed interpreter on Wall Street during the Paul Volcker era.

In a “recent” interview with the Financial Times, published yesterday, Kaufman compares Jerome Powell’s performance as head of the Federal Reserve unfavorably with that of Volcker in the early 1980s. The former, in Kaufman’s view, has so far only slapped the financial markets on the hand, in a situation where the latter did what was needed and punched them in the face.

Ultimately, no one is going to buy fixed income instruments unless they, at a minimum, preserve the real value of the owner’s purchase. As Kaufman put it, interest rates need to be higher than inflation. Yes, the 10-year Treasury yield has moved from 1.6% on New Year’s Day to as high as 3.5%, before a recent decline to around 2.9%. That’s a long distance from its March 2020 low of 0.54%. Fed Funds are at 2.5%. But headline inflation is at 8%. Therefore, either inflation comes down or rates have to go up.

I think this last is exactly correct. If we imagine that the long-term inflation target is 3%, then the 10-year should end up somewhere in the 4%-5% range, depending on what investors determine the real return should be.

I think the current situation is substantially different from the 1970s, however. So while a stern expression and a harsh voice may be needed, I wonder whether a punch in the face is the wisest course.

The differences I see:

–for the 1970s as a whole, yearly inflation averaged just under 7%. This strengthened the belief back then that inflation was an enduring phenomenon. Certainly, a lot of loony things happened in the late 70s, as inflation began to accelerate–like lots of industrial companies borrowing heavily to buy gold mines (thinking the real value of fixed-rate debt would decline while gold would only rise) or to explore for the newest super-metal, molybdenum. Yes, this was really stupid, but it shows how panicked even the adults in the room were about accelerating inflation. In contrast, the great macroeconomic fear of the past two decades has been that the Fed’s best efforts have been unable to get inflation to rise as high as 2%

–consumer ideas about future inflation are substantially different now than in the 1970s, when large yearly price rises, accelerating into double digits, were commonly expected to occur. In contrast, the NY Fed’s consumer surveys indicate people expect current inflation to gradually shrink to just above 3%

–the 40x rise in the price of oil, a global situation made worse by the US decision to protect an inefficient, gasoline-guzzling auto industry, was a key factor in both inflation and in setting inflation expectations. Today, “peak oil” no longer means the day demand will outstrip supply, however, but the opposite

–a decade of politically expedient too-loose money and the failure of the country to modernize the industrial base after WWII–not to mention Watergate–meant that by the end of the 70s the rest of the world had lost faith in the US. The Treasury was forced to issue bonds in German marks and Swiss francs to attract foreign buyers who feared accelerating inflation and a declining dollar. Today, in contrast, a strong dollar has attracted lots of foreign buyers–meaning they don’t see a parallel between today and the 1970s–and that’s despite the January 6th coup attempt, which makes Watergate look like a schoolyard prank.

recession, Walmart (WMT) and ZipRecruiter (ZIP)

recession?

I’m not sure where the idea that two consecutive quarters of real GDP decline is what makes a recession. It’s what I learned early in my career. I don’t know when it was abandoned. But it makes sense to put it in file 13 in the present US, since maximum sustainable (meaning non-inflationary) real GDP growth is currently 1%-ish. Not a great deal of difference between that and being in the minus column. This is very different from the 1990s, when US real GDP exceeded the 4% growth mark six times and the worst year was +1.2%. Back then, being in negative territory would have meant a huge economic disruption.

I look a bit differently at where the US is currently rather than through the recession/expansion lens. If we take real GDP at the end of 2018 and project forward at a 1% annual growth rate, the economy should be about 4% larger now than it was back then. It’s actually about 6% bigger. That’s despite the pandemic and the Russian invasion, and because of some combination of our own resilience and the massive Biden stimulus.

To my mind, this means that to get the country back to a non-inflationary path, we’ve got to shrink GDP by 2%. GDP in 1Q22 was -1.6% and -0.9% in 2Q22. If we did this for four more quarters, we’d be back where we should be. Earnings reports are beginning to tell us, however, that the US economy is starting to shift into a lower gear.

WMT and ZIP

Both companies reported overnight. WMT, the country’s largest retailer, reported better than expected earnings for the June quarter, although it said customers are shifting from discretionary items to food and from brands to private label. The stock is up by about 6% as I’m writing this. ZIP, a large online employment agency, said the new hiring business, especially among smaller customers, began to weaken in June and has stayed soft since. The stock is off its lows but still down by about 5%.

I’m not sure why there’s the performance difference between the two. If I were forced to make something up, I’d say that the WMT results were better than feared, that it’s a known quantity and relatively defensive. ZIP, on the other hand, is a recent listing, is not well covered on Wall Street, and is in an industry that’s perceived as cyclical. Earnings are going to be fine here as well, but if I understand the conference call transcript I read this morning correctly, that’s apparently because the company is going to cut expenses.

a new bull market(?): describing the rear view mirror

I found out on the radio news this morning that NASDAQ is in a new bull market. How so? The index is 20% more expensive today than it was in mid-June. I guess the conclusion, communicated by the cheerfully relieved tone, is that it’s safe to begin investing again.

That may be correct, if a bit tardy, since the lows of mid-June seem to be not only holding but left far behind. (An aside: I was looking at Asana, a stock I don’t own and know little more than the ticker symbol ASAN). It had a high of 141 last November, but had fallen to 16.60 by this June 16th. It bounced off that low three times in the second half of July before rising to the current 29 or so. One could reasonably argue that it has stopped going down. Same story with Peloton (PTON), although the low of 8.22 came a bit later in time. It’s now 13.41. Same story for Roblox (RBLX), a stock I do own, which has gone from 24 to 53. …and for Robinhood (HOOD), another holding of mine. The figures there are 6.81 and 11.05 (although my idea of buying it in the low teens a while ago based on net working capital of 11-ish wasn’t my finest hour). )

Anyway, I think the much bigger story is the extraordinary volatility of prices in percentage terms over the summer. In the case of ASAN it was moving up or down by 10% a week before the apparent breakout. I’ve had it in my mind since mid-June that we’re now going sideways for a while as we sort stocks into ones that have strong long-term fundamentals and those whose strength is mostly a function of the extraordinary economic and stock market environment of 2020-21 and which, therefore, have a limited remaining shelf life.

Do I want to make a big bet on the direction of market sentiment? No. It seems to me that I can either:

–take a value approach and look for firms like HOOD that are trading at discounts to asset value. The two main flavors of value are: with or without a catalyst for change. HOOD falls into the second category, I think, which I find much less risky. ASAN, by the way, has about a dollar a share in tangible assets. Clearly, to me anyway, the bet is on intangible assets I know nothing about.

–take the time to learn more about what I own or am interested in buying: stuff like industry structure, relative market share, barriers to entry …what allows a firm to have higher margins and faster revenue growth. One reason I’ve always liked retail is that I can visit the stores (the best way I’ve found to distinguish between, say, TGT and WMT) and use the company’s products.

the fossil fuel end game

Around 1900, coal began to replace firewood in a serious way as fuel.

Around 1950, oil and gas began to replace coal.

Around now, renewables are beginning to replace oil and, to a lesser degree, natural gas.

This is a complex issue, with many competing global economic and political interests, both inside the US and abroad. If I were still managing money professionally, I’d be torn between having no exposure at all to the traditional Energy sector or having maybe half the 4.4% index weighting. I’d probably choose the second, emphasize renewables and own the bigger names. My idea would not be to gain performance in the sector–too time-consuming for something that small–but rather to limit the damage that ignoring the sector might do. Elementary triage.

basic facts, as I see them

–the big three global oil producers are: the US (19 million bbl/day), Saudi Arabia (10 million) and Russia (10 million). Russia makes something like 4x its oil earnings from natural gas, but oil is much more easily transportable, so it’s still very important.

–the largest global consumers of oil are: the US (21 million bbl/day), China (14 million) and India (5 million). Other than the OPEC oil producing countries, the US and Canada both use about twice the oil per capita of any other advanced countries

–the global demand for oil is relatively inflexible and the world has limited storage capacity for excess output. So small changes in global supply or demand, which is roughly 100 million barrels daily, can lead to large changes in price. Just look at a chart of the oil price over the past decade

–in the US, transportation takes about 2/3 of the oil we use. This amount is split roughly 60/30/10 among gasoline, diesel and jet fuel. The other third of total use is industrial, with a small amount of that going to electricity generation.

So US oil use is mostly for autos. The domestic auto manufacturing industry has been heavily protected against foreign competition for decades–with the highly predictable result that the “Big Three” are financially weak and technological laggards in fuel efficiency.

The result of this, though, is that passenger cars and light trucks in the US make up about 12% of the world’s daily oil usage. A doubling of the fuel efficiency of the US fleet would clip 6 million daily barrels of oil from world usage, presumably sending the oil price plunging. The Obama administration put plans in place for this to happen by 2025. This would be bad for Russia, bad for OPEC, bad for Big Oil …and bad for US automakers, who would presumably be technologically unable to meet these goals. The plans were rolled back by the Trump administration, however, before being reinstated in somewhat weaker form this April.

more on Monday

Archimedes and the stock market

Archimedes is the ancient Greek who lived in Sicily around 300BC and who is credited with saying that if he had a level long enough and a fulcrum to put it against, he could move anything.

To me the key takeaway for today’s complex and confusing stock market comes from this statement. It’s not the lever part, though. It’s the fulcrum. It’s finding someplace solid to plant your feet and to build a portfolio around.

Thinking in the most general terms, the two important factors in evaluating a stock are concept and valuation. In it’s simplest (and most dangerous) form concept is the dream, the elevator speech you use to explain what a company does and why it’s interesting. You might say” Streaming is becoming the dominant form of entertainment content delivery to homes and ROKU is the leading independent in the field.” Valuation, in contrast, is the current stock price compared with here-and-now measures like book (balance sheet net asset) value, or net working capital (meaning after subtracting long-term liabilities) or net cash.

In bull markets, it’s all about concept. In bear markets, it’s all about valuation. In a typical business cycle-driven market (not the current situation, as I see it), the turn from bear to bull usually comes from a combination of valuation plus the first hints from companies that business is beginning to turn up.

In the middle of June it seemed to me that tech stocks were reaching the kind of valuation lows that typically mark market bottoms. Each market has it’s own special characteristics, though. In the present case it’s that the dual share structure that gives founders voting control over “their” firm is a deterrent to the takeover bids that such low valuations would otherwise trigger.

It’s still my guess that the S&P bottomed back in June (I’m having trouble getting my finfers to type out this sentence, which illustrates my level of conviction),

I’m not going to bet the farm that this is the case, though. I am going through my portfolio, name by name, though, to decide what to do with each. I’m noting my cost basis; I have one or two that are far below my purchase price, but that’s life in the big leagues. For me this is a strong signal to sell–to harvest the tax loss, or at least move into something I understand a little better.

Assuming I’m correct that the bulk (if not all) of the market downturn is behind us, there are still an unusually large number of one-time economic factors influencing the environment–and that I think will have an important influence of the shape the market takes in the coming year.

In no particular order, and probably not a complete list, they are:

–rhythms of post-pandemic life. An example: Marriott is down about 3%, ytd: Carnival Cruise has been cut in half

–the US anti-immigration stance. As regular readers will doubtless be tired of hearing, this cuts the growth rate of the US almost in half and sets the country down the same path Japan embarked on in 1990, yielding in the Land of Wa 33 years–and counting–of economic stagnation

–the end of the fossil fuel era

–the Russian invasion of Ukraine under Putin

–the end of entrepreneurship (called “socialism with Chinese characteristics,” under Deng) in China under Xi

–the legitimation of white racism in the US under Trump, and his attempt to overthrow the government