By David R. Guttery, RFC, RFS, CAM
President, Keystone Financial Group-Trussville Al
Thirty days ago, and two weeks before the last Fed meeting, I suggested to your viewers that I believed the Federal Reserve would find itself with latitude to just simply blink. Not pivot, not pause, and certainly not cut, but rather to be less hawkish with what remains of their strategy for tightening.
Indeed, that is what Chairman Powell indicated in his post meeting press conference, and also reiterated in the release of the minutes from the meeting. I believe that global markets have overly priced the thought of blindly hawkish central bankers, into nefarious assumptions regarding the potential for a deep and long recession.
Until recently, it seemed that 90% of the world’s central banks were following the same patterns of tightening, and the assumption was that this would continue without regard for economic deceleration.
Last month I said that in my opinion, the Federal Reserve is not trying to control inflation. Nothing about the previous four 75 basis point rate hikes has had a material impact on the cost of living, and you can argue that it’s made the cost of shelter even higher.
The Federal Reserve is trying to disincentivize lending and borrowing, and over time, this will have a muting impact on inflation. We’ve heard since birth that inflation is too many dollars, chasing too few goods. The Fed is trying to create an environment of fewer dollars chasing as many goods. If they’re not careful, in the process of disincentivizing lending and borrowing, they might disincentivize production as well, which would leave us in an environment where we have fewer dollars chasing fewer goods. This is the definition of stagflation, and the Fed is trying to avoid this.
Let me give you a high level example of what I mean by this. I’m an entrepreneur, and I want to manufacture a widget, and bring it to market. I must determine the amount of money to borrow, to build the plant, buy the capital equipment, and hire the people to run the machines, with the materials that I need to purchase, to manufacture and distribute one million units, at $1.50 each, to realize an internal rate of return of 8%.
Then the Federal Reserve changes the equation by raising the cost of my capital from 2% to 7%. Now I have to re-work my assumptions, and then realize that I must either raise the selling price of the widget to $2.25 in order to maintain the same internal rate of return. However, at that price, I may not sell one million units. If I keep the price at $1.50, then I’ll have to be happy with an internal rate of return of 2%. The Fed just disincentivized me from borrowing.
They are also disincentivizing banks from making new loans. There are fewer dollars in the lendable supply, and as such, each new subsequent loan is made with greater risk if there are fewer dollars to lend. Lending restrictions are increasing, relative to where they were in November of last year when tapering began.
So, the Fed isn’t directly trying to control inflation, but rather control the supply and velocity of money, which over time, should have a negative impact on inflation. I thought the idea of a haphazard Federal Reserve, tightening without regard for economic impact was absurd, and thus, why I believed they would find the latitude to be more gradual with pursuing targets of tightening. Thirty days later anyway, it would appear that this was a correct assumption.
Last month, I also suggested that if indeed the Fed were inclined to be more judicious with pursuing targets of tightening, that among other things, we may well find ourselves with the dollar showing weakness, at a time when it had been unusually strong.
Indeed, on the Friday, the fourth of November, following the conclusion of the Fed’s meeting on Wednesday, the second, the Dollar Index had its worst day since December of 2015. If a stronger dollar has caused markets to negatively reprice the risk of lower revenues resulting from products being purchased with weaker foreign currencies, then I thought the opposite would be a positive catalyst, if the dollar relented from historically high levels of strength. In my opinion, that seems to be playing out now.
I also drew reference to a graphic last month that juxtaposed the current cycle of tightening, against other major cycles of tightening seen over the previous 35 years. Clearly, this cycle is the most restrictive that we’ve seen over that time. Because of that, we have areas of the economy that are showing significant weakness.
Mortgage rates are over 7% for a thirty year amortizing mortgage according to Fannie Mae, and this is up from 2.50% in February. Rising bond yields, that have resulted from the Federal Reserve unwinding its balance sheet, have caused these mortgage rates to rise. This cycle of tightening appears to have begun just as real estate was peaking, and we can see the visceral response since establishing that peak.
The assumption that the Federal Reserve wasn’t cognizant of such metrics as they pursued targets of tightening was not justifiable in my mind. A less hawkish policy stance may cause negative trends in housing for example to ease as well, and therefore cause the markets to reprice the risk that maybe previous assumptions were wrong.
Housing is just one, major economic area where we can see the impact of Fed policy.
As for the manufacturing side of the economy, we are a gnat’s eyelash away from contraction territory.
I could give you many examples of metrics citing economic deterioration. These are just three of the more important macro-economic metrics. I believe that a less hawkish Fed signals to the market that it is indeed aware of the degree by which the economy is struggling to expand, or by which it is contracting, and because I believe the Fed wishes to avoid stagflation, I believe such data will weigh heavily on future actions by the Federal Reserve, and the market is reacting positively to this development.
Last month, I drew reference to a chart, that depicts emotional states of being across the economic cycle. I suggested then that I thought we were drawing near to the capitulation phase, and thirty days later, I believe we have increasingly greater, quantifiable evidence that suggests this may be the case.
All of this is important, because if we are indeed coalescing around a bottom, and you’re not in the market, then in my opinion, you run an even greater risk that comes with talking yourself out of participating in the recovery when it occurs.
So, what quantifiable data do we have today, that wasn’t so clear even thirty days ago? In last months’ article, we talked about stochastics, and how this at a high level, is the art of observing patterns of behavior, connecting those dots, to form patterns, or Bollinger bands, from which insight may be gleaned.
So, let’s take a stochastic look at the market. I didn’t draw this chart. The market participants drew this chart with their actions. You’re looking at the same data, expressed in two different ways.
The top chart reflects rolling, smoothed periods of time for relativity, and the bottom chart is a linear depiction of the same data. At the bottom of this chart, it appears that we’ve bounced off the same Bollinger band, four times, in February, May, July, and again in September. This is where markets are telling you that it collectively feels that risk is adequately priced at these levels. If you see a double bottom, its encouraging. A triple bottom is exciting. If you see a quadruple bottom, pay attention.
I’ve had the feeling lately that the world had collectively priced more risk into market valuations than which was rational. I believe markets had priced into themselves a long and deep recession, caused by global central banks blind to the economic impact of their actions. If this is indeed the case, then I have to ask, as we bounce from the same Bollinger band for a fourth time, how would the markets positively retrace these losses if indeed reality turned out to be different from those assumptions, and hence why the Fed was a critical piece to that puzzle a few weeks ago.
This graphic that seems to suggest that we’re experiencing one of the worst bear markets, if not the worst bear market, 176 days into the cycle, that we’ve seen since 1929. Now, in and of itself, this isn’t an actionable piece of data. But when viewed collectively, with evidence of a weakening dollar from record strength, and seemingly holding the same support on four occasions this year, and where we are relative to all bear markets, you start to get the sense that maybe markets have overly priced nefarious assumptions into themselves.
So, now we start to look for evidence of capitulation. To me, this is evidence of the average investor wringing their hands and metaphorically saying I’m done, lock in the losses and get me out. Well, I believe we had that in September.
This chart is busy, but what it depicts is the amount of fear that was priced into the month of September. The open put to call ratio hit its highest point for the year, and a high not seen since the economy shut down over Covid in early 2020. Below that, you see the bull bear ratio, at a low point in September not seen since 2008, and the Great Recession. We didn’t have this in July.
Furthermore, mutual funds outflows spiked sharply in September, which is usually a characteristic of the capitulation we’ve talked so much about.
So, let’s recap. By the end of September, only three percent of the S&P 500 Index was trading above its fifty-day moving average. We bounced off the same Bollinger band for a fourth time, as the open put to call ratio was setting its high for the year, and bearish sentiment was thicker than at any point since 2008, with a spike in mutual fund outflows, and with near record dollar strength causing markets to reprice risk of repatriating dollars producing lower than expected revenues.
This is why you never want to give into the capitulation compulsion. If you did at the end of September, then you likely missed the best month of October that we’ve seen in 45 years. For context, I was in the second grade the last time we had a month of October that was this positive.
So in conclusion, regardless of the period of time, or the state of the economy, the achievement of long-term goals is predicate on the consistency with which you meet the implementation of the strategy. The composition of the investment accounts will change to reflect current periods of time, but the approach, dedication, and commitment to the strategy should be unwavering. Even missing a few years, with the thought of letting a volatile period of time pass you by, can have a detrimental impact, 40 years down the road, on the potential success of long-term plans. I know that everyone is weary of this strange and unique year, but I believe that we’ve seen a point of inflection, and now is the time to have conviction, and intestinal fortitude, to continue working through periods of time such as this, and avoid the risk that comes with riding the emotional roller coaster.
(*) David R. Guttery, RFC, RFS, CAM, is a financial advisor, and has been in practice for 31 years, and is the President of Keystone Financial Group in Trussville. David offers products and services using the following business names: Keystone Financial Group – insurance and financial services | Ameritas Investment Company, LLC (AIC), Member FINRA / SIPC – securities and investments | Ameritas Advisory Services – investment advisory services. AIC and AAS are not affiliated with Keystone Financial Group. Information provided is gathered from sources believed to be reliable; however, we cannot guarantee their accuracy. This information should not be interpreted as a recommendation to buy or sell any security. Past performance is not an indicator of future results.