where–I think–we are now (ii)

Just after I clicked the Publish button yesterday, I saw the monthly CPI figure release. CPI rose by 0.1% month-on-month vs. a consensus expectation of a 0.1% mom decline. Core CPI (meaning ex food and energy) rose 0.6% mom vs. an expectation of a 0.3% rise. The S&P 500 immediately dropped by 2.5% on the news; NASDAQ lost about 3.5%.

In a bull market, investors would likely have shrugged off the announcement as bad forecasting by Wall Street economists or as being inside the margin of error of the CPI calculation itself (which the result isn’t, but a fine point that any bull would ignore). My initial reaction is that the sharp decline is the work of trading bots. It will be particularly important, if unlikely, though, to see whether any buying emerges later in the day, which I would take as a bullish sign.

As it turns out, the decline yesterday was relentless. I find it very difficult to believe the financial press explanation that the CPI number was the cause of the market’s sharp fall. The trigger, yes, but it strikes me as pure magical thinking to say that the Fed would declare victory and stop aggressive rate increases if it say inflation at a “mere” 7.9% or so. So, in my view, the cause, no.

What I find most interesting about Wall Street now is how negative sentiment is. One venerable market cliche is that a bear market doesn’t end until the last bull capitulates. Another, similar, one is that the markets act so as to make the greatest fools out of the largest number of people–that is, figure out what the consensus market belief is and figure out some way to bet against it.

A very eye-catching example of potential capitulation is celebrity commentator Mohamed El-Arian’s advice a week ago on CNBC that investors should flee the “distorted” stock and bond markets for the safety of cash or short-term fixed income. Yes, this run-for-cover message would have been brilliant last December, when the S&P was 20% higher, NASDAQ 25% up, and the 10-year was yielding 1.5%. And, yes, it’s not as apocalyptic as saying buy canned goods and a cabin in the woods. But it’s also a far cry from saying become defensive, find steadily growing, dividend paying stocks and short duration bonds.

Veteran brokerage house strategists are also preaching caution today. My sense, reading between the lines, is that they’re thinking (hoping?) stocks made their lows in June but worry they’ll will revisit those mid-year depths during the mutual fund selling season that starts around now and runs through mid-October.

True, market sentiment has been gloomier, even this year. The mid-June lows are a case in point. Back then a considerable number of companies, most of them recent issues, were trading at or below their net working capital. That’s crazy low. Not quite 2008-09 lows, maybe 1974-ish lows, but definitely lower lows than any other post-WWII recession. Many issues have bounced very sharply since then. But the sheer depth of the June lows is why I think we won’t see those prices again.

Nevertheless, universal gloom is typically a bullish sign.

What to do now?

…what we always should be doing, only in a lower key, namely (in descending order of importance):

–trying not to let worry trick us into doing deeply stupid things

–doing nothing, and, if possible

–upgrading the portfolio by buying stocks that have been pummeled too severely, getting the money by selling iffy stocks that have held up (maybe un-)reasonably well. Early in my working career, I began to notice that my eye always seemed to skip over the worst clunkers in my portfolio, unless I tried really hard to see them. Finding these stocks (I’m convinced everyone has them) and eliminating them while other, better, stocks are still cheap is probably our most worthwhile task.

where–I think–we are now

The economic part, as least as regards the US, is pretty clear.

The Fed is in the process of raising domestic interest rates to the point where holders of fixed income instruments will be receiving protection from inflation plus a real yield. If we assume the targeted level of “acceptable” annual price rises (i.e., inflation) is 3%, then the ultimate target for Fed Funds is something just north of that, and for the 10-year, a tad above 4%.

The current Fed Funds rate is 2.25% – 2.50%, with one-month T-bills going for 2.57%. Next week, the Fed is likely to raise Fed Funds by 0.75%, meaning the FF rate will be at 3.00% – 3.25%, with one month bills at 3.30% or so. This will presumably put the 10-year at around the 4% mark, or pretty close to the ultimate finish line.

The comparable figures on the first trading day of January were: one-month money at 0.05% and the 10-year at 1.63%. Ytd (including next week), then, we’re up by over 300 bp on the short end and 250bp on the long side.

But there’s still a ways to go. The big economic question is how far.

Let’s also make up some economic numbers for next year. Let’s say current inflation in the US is 8%–and that this breaks out into 4% from energy/food shock caused by one-time, external factors like the invasion of Ukraine and lockdowns in China, and 4% from garden-variety domestic wage-related factors. Let’s also say that external shocks are a net neutral next year. (I have no idea what the actual figures are. My experience is that precision counts for much less than you’d think.) This doesn’t assume anything will get any better, only that things won’t get worse. If so, the “real” inflation the Fed is trying to combat is much less than the headline numbers.

The remaining task, then, is to get 4% inflation to recede to 3%. Btw, Paul Krugman (I’ve recently become a big fan) argues that in the 1990s, non-accelerating 4% inflation was regarded as fine. In any event, I think there’s a convincing case to be made that engineering a return to 2% inflation is not on the Fed’s agenda.

The conventional wisdom seems to be that what’s needed, or at least what will happen is another 75bp higher on the short end, with relatively small upward movement on the long.

As to discounting, i.e., what’s already factored into today’s prices: when market sentiment is bullish, current prices tend to factor in profit possibilities that are one or two, or sometimes even three (this is at the absolute, speculative top) years in advance. When sentiment is bearish, as it is now, the market is stuck in the past, chewing over, again and again, yesterday’s news. That is to say, the market will react to any news (but especially bad news) as it actually happens–no matter how clearly and completely it has been signaled in advance.

There’s a plus to this last, though. If a well-telegraphed Fed move is actually announced and the market doesn’t go down on the announcement, this is evidence that we’re well past peak bearishness, and on the road to the repair of investor willingness to take risk.

more tomorrow

the Mar-a-Lago government documents

I don’t think it’s very clear at all what the significance is of the government move to recover highly secret documents that Trump removed from the White House, apparently illegally, and kept lying around unsecured, apparently also illegally, scattered in different places in his Florida golf club.

Two questions that I think have yet to be addressed are: why the FBI is acting now, as opposed to, say, a year ago; and why Trump is aggressively trying to suppress the investigation, instead of saying, “Whoops. Sorry. I had no idea. Take everything back.”

The “now” part may be purely random, although my experience is that it’s a mistake to make this your go-to explanation.

What comes to my mind: a little more than half a century ago (ouch!!!), I was a soldier in Vietnam, in the mountains in the northernmost part of then South Vietnam. The North Vietnamese military strategy back then was to control key territory by building elaborate bunker/tunnel complexes, incessantly rehearse how to defend these fortifications …and wait for some unwitting foe to come within striking range. Among other things, this negated most of the technological advantages US troops had.

To avoid premature detection by ARVN or US forces, communication in these complexes was mostly through telephone lines. When we found such lines, we would tap into them and listen to the traffic. We’d know we’d been discovered through one of three cues: traffic became inane, traffic stopped completely and/or a large patrol began to walk the line, looking for breaks.

My worry is that this sort of discovery cue has been triggered with the Mar-a-Lago documents–say, one or more sources have gone silent, or are suddenly offering disinformation, or have disappeared. And the idea that this implies that top secret information in Mar-a-Lago documents has already (recently?) been sold or stolen is what has sparked the FBI search. The anger/ferocity of Trump’s response, and his vilification of the FBI, suggest he’s reading the search the same way I am.

In any event, this is the story I’ve made up to explain this situation. The only thing left to do is to monitor for evidence either for or against the hypothesis. I’m not sure what stock market consequences follow from confirmation, other than it would be a huge black eye for the entire MAGA agenda. So, bad for industries of the past, like fossil fuels.

Reaganomics: …the Laffer curve (ii)

The Laffer Curve, a graphical device used by economist Arthur Laffer to explain the idea that economic growth can be stunted by raising tax rates too high, and hence simulated by lowering them from this position.

There is something to this.

I remember being startled to find that in the UK, pre-Margaret Thatcher, the highest personal income bracket was 83%. The highest corporate rate at the time was 40%. So companies routinely compensated executives through vehicles like personal clothing tax shelters rather than pay raises. The clothing scheme worked like this: instead of paying $10,000 to the executive, who would net $1,700 after tax, the company would send him (it was almost always a him in those days) to a fancy tailor who would make $10,000 in bespoke clothing for him. The company would pay and retain ownership of the clothes, getting a $4,000 tax deduction for doing this. It would then rent them for a nominal sum to the executive, who would have had to pay close to $60,000 to be as well-off, clothing wise.

So the government took in less money and the company spent valuable time cooking up tax avoidance schemes rather than making stuff.

Then, there’s the more obvious stuff–like the existence of Switzerland, the Cayman Islands, the Channel Islands, Ireland… where facilitating tax avoidance is a big business.

It seems to me there are two plusses to the Laffer Curve theory: it can be explained with a cocktail napkin drawing and it has a veneer of respectability, given Arthur Laffer’s academic career and his former ties to the University of Chicago. It also gives cover to politicians eager to cut taxes for big donors.

On the other hand, there don’t seem to be many professional economists, other than Mr. Laffer, who think current tax rates in the US are anywhere near the inflection point where lowering them would increase revenues. On the contrary, the predominant belief is that raising them from today’s level for the wealthy would bring in more money.

A more important indictment of the Laffer curve, I think, is the parlous state of national infrastructure– roads, bridges, water, electricity …and, of course, public schools. Another major consequence is the worst-in-the-world performance of the US in aiding workers left unemployed by technological change to retrain and find new, productive employment.

If this deterioration is in fact happening, why hasn’t there been a greater negative impact on the domestic stock market, especially given the Trump-driven acceleration of political instability over the past half-decade? I think that if Deng were still (alive and) in charge in China, there would already have been a mass flight of capital out of the US. But Xi appears to be a 21st-century version of Mao. Japan hasn’t had economic growth for thirty-plus years. The UK is crazy. The EU is directly affected by the war in Ukraine, and still dreaming of its 19the century glory days. Latin American and Africa are Wild West-like frontier places. Australia is small, quirky and the original breeding ground for Murdoch hate politics. Canada?

Anyway, my point: saved by Xi, the US is the best of a bad lot.

Reaganomics, junk bonds and the Laffer curve (i)

junk bonds

In 1978, I realized I wasn’t going to get a teaching job I’d accept and, more by accident than design, stumbled into a career as a securities analyst. From the steel analyst a few desks away, I learned that the US was making steel in blast furnaces built during the 19th century. In contrast, Europe and Japan, whose industrial bases were flattened in WWII, were churning out superior products at lower cost from the much more efficient factories they rebuilt with. I gradually learned that many other domestic manufacturing industries were similarly in desperate need of modernization. The biggest stumbling block: CEOs didn’t want to take the risk of revamping, with the lower profits (meaning lower stock price and lower bonuses) and the risk of being fired if things didn’t go smoothly. Better to paper over problems and leave them for one’s successor.

Then came junk bonds.

In the earliest days of Drexel Burnham Lambert, high-yield, aka “junk,” bonds were all about “fallen angels,” that is, once high-grade bonds, already in the market, whose issuers had fallen on hard times. These were typically highly illiquid, and traded at deep discounts to their redemption value. DBL would do equity-style company analysis aimed at finding down-at-the-heels firms that were turning operations around and whose improving fortunes weren’t yet reflected in the bond price.

Under Michael Milken, DBL soon expanded to original issue junk. The idea is that they would substitute for bank loans, in similar fashion to the emergence around the same time of the money market fund as a rival to bank savings accounts.

Junk proceeds were often used to finance the takeover, and modernization, of the kind of sleepy companies described in the opening paragraph. Arguably, this was the kind of tough love American industry needed. And the country’s industrial base certainly was modernized during the Milken era.

Several issues, though:

–corporate raiders often, in my view, took very little care for the welfare of the employees of target companies or the funds put aside for their pensions, creating a chronic unemployment problem in some areas of the country

–in 1985? DBL ran out of economically viable takeover candidates to fund with new junk bond issues. By this time, there was a robust junk bond category of mutual funds, however, happy to take up new deals. So–again, in my view–DBL decided to promote issues that would target companies where chances of the bonds eventually being repaid were not good. The pension plans of firms corporate raiders had used junk bond financing to take private were one class of buyers of these dubious bonds. It also appears Milken used hefty under-the-table payments to induce junk bond fund managers to buy these clunker issues, despite their lack of investment appeal

–mutual fund pricing was not as highly developed in the 1980s as it is now. Typically, funds would outsource pricing to a third party, which, again typically, would use the last trade in an issue as the current value. The problem with junk bonds was that many rarely traded. So the outside service would be using a price from, say, six months earlier, that would not reflect deteriorating prospects with the issuer. And as long as junk bond funds were getting large inflows–“all the capital gains potential of stocks, all the safety of bonds” was the sales pitch–there was no need for any fund to sell

–the catalyst for the inevitable collapse came in the failure of the United Airlines leveraged buyout in late 1989.

So, yes, the Reagan era produced a much-needed modernization of American industry, but at a substantial social cost in callous disregard by both major political parties for displaced workers.

more tomorrow