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A Weekly Commentary
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What is Going On in The World of Finance?
Some Statistics…
QUOTE OF THE WEEK “I am grateful for what I am and have. My thanksgiving is perpetual.” – Henry David Thoreau TECH CORNER First let me give you some statistics: According to the Bureau of Labor Statistics the Consumer Price Index for the month of October came in at 2.6% year over year. On a monthly basis, costs went up 0.2% which matched the last three months and inflation is coming down so this is a good number. The Federal Reserve lowered interest rates by 0.25% down to 4.58%. I believe this rate is too high based on where the economy is headed. The big news was the Employment Report from the Bureau of Labor Statistics that came out at the beginning of November for the month of October. The report showed that the economy added just 12,000 jobs. If that wasn’t bad enough, employment for August was revised down from 159,000 jobs added to 78,000, a decrease of 81,000 jobs. Add to that the September report was also revised down from 254,000 jobs added to 223,000, a decrease of 31,000. Also, the long-term unemployed number kept rising. Not good. The first thing to break when an economy is in decline is the jobs market. The second thing to break is credit spreads which to this point haven’t risen. What we are now seeing is liquidity being drained out of the banking system. Let me explain. After the pandemic, the banking system was over flowing with cash due to the Federal stimulus and people putting those free checks they received into the banks. In the banking system that totaled about $2.5 trillion. Now that excess in down to $155,000 billion and is declining at a rapid rate. When that excess cash is gone the banks will run out of excess money to lend leaving their only source of lending to come from bank reserves. Banks are very careful lending out of their reserves because it messes up their ratios and puts the bank at risk. A credit spread is the interest rate difference between a risk-free rate of return and the interest charged on the loans the bank issues. For example, if the risk-free rate of return on a U.S. 10yr Treasury is 4.0%, any interest above that rate is the credit spread. So, if the bank lends to a business at 9.0%, the spread is 9.0% (-) 4.0% making the spread 5.0%. How this lack of excess money to lend affects credit spreads is that banks will be much more reluctant to lend and will impose a much higher interest rate to businesses if they are going to loan them money. Let’s assume that you are a business that was borrowing money at 6.0% and now you have to pay 9.0% on the loan from the bank. What happens next? You look for ways to cut costs which usually is to cut employees because for most businesses that is the major cost item. So, people are starting to get laid off which by the way is what’s happening now as per the latest Employment Report. This starts a vicious cycle towards a possible recession. When you as an individual are laid off you lower your consumption, which then causes manufactures to cut production, which then causes more people to by laid off causing employment to go down, which then causes incomes to go down. The cycle repeats until the economy reaches a bottom and starts to recover. Now, with the economy in decline banks are even less willing to loan money out of reserves unless they get a much higher interest rate to offset the risk. Historically, when the stock market realizes the employment is declining and credit spreads are widening, the stock market collapses. The stock market has had an unprecedented rise over that last year, and by many historical standards is very expensive. This is based simply of the Price Earnings Multiple with the S&P 500 currently at $26.87 of price for every dollar of earnings. We are now experiencing an event that has only happen twice in the history of the stock market going back to 1929. The two times it has happened before was in 1929 depression and 2000 during the Tech Bubble. What is happening now and two previous times in history is a negative Equity Risk Premium. The way the Equity Risk Premium is calculated is to invert the Price Earnings Multiple. If you put the earnings over the price, you get the rate of return of the stock market. If we put $1 earnings over the price of $26.87, we get a return of 3.58%. Then we compare that return to the rate of interest on the U.S. 10yr Treasury of 4.39% which is considered a risk-free rate of return. If the 10yr risk free rate of return of a U.S. Treasury is 4.39% and the rate of return on the much more risky stock market is 3.58%, why would you invest in the stock market vs the 10yr U.S. Treasury? This is a negative Equity Risk Premium.
Maintaining a Conservative Position
QUOTE OF THE WEEK “There are two kinds of gratitude: The sudden kind we feel for what we take, the larger kind we feel for what we give.” – Edward Arlington Robinson TECH CORNER I don’t have much to discuss this week. We still see the economy weakening and are maintaining the conservative position in the portfolios I discussed in the last letter. The big events coming up are the Jobs Report on Friday and of course the election. The Jobs Report will tell us a lot about the direction of the economy. As I stated before, the apparent great report last month when you dialed down wasn’t as great as the headlines. This coming Friday’s report hopefully will give us more clarity. And, of course, the election results on Tuesday will give us the probable direction of the economy and the country for the next four years. I will have plenty to say in the next letter.
Labor Statistics Report
QUOTE OF THE WEEK “Don’t judge each day by the harvest you reap but by the seeds that you plant.” – Robert Louis Stevenson TECH CORNER Last Friday’s Bureau of Labor Statistics Report (BLS) for September came in way above expectations. The Bureau reported that the economy added 254,000 jobs vs an expected addition of around 140,000. The stock market immediately rallied on the news then fell back and then rallied up again all in one day. Today (Monday) the market is selling off. I think we are in for a lot of volatility between now and the election. The stock market can’t seem to make up its mind. On the surface, the jobs report seemed almost too good to be true. Guess what, it was too good to be true. Approximately 75% of the jobs added were in healthcare, leisure, government, and hospitality. Except for government these are not high paying jobs. One little known fact is that the BLS considers any job an addition to the total job report. So, if you are working three jobs to make ends meet, that is considered three new jobs. Multiple job holders are at an all-time record high. On the surface, the report looks much better than it does after you dig into the statistics. The report also reported that the hours worked is at a 14-year low. After the pandemic most employers couldn’t find new employees to fill their openings. What is now happening is that employers are reluctant to lay anyone off, so they are cutting the work week to lower costs. That can’t go on forever because for most companies, labor is their highest cost. Another statistic that caught my attention is that the U.S. economy has lost over 500,000 fulltime jobs over the last twelve months. So on balance the labor market is not really that great. This fact corresponds with other economic indicators that we track. The economy is in decline. We are maintaining our safety-first positions for the portfolios.
Portfolio Change
QUOTE OF THE WEEK “And remember, no matter where you go, here you are.” – Confucious TECH CORNER Last Friday, August 6th, the August employment report came out. At first blush it didn’t seem so bad. New employment dropped to 142,000 new jobs but the expectation was 161,000 new jobs. The stock market reacted by opening up until reality set in. The reality came in the form of the downward revisions for June and July. June was revised down by 61,000 jobs and July was revised down by 25,000 jobs. Then the stock market crashed turning in one of the worst days of 2024, then, rebounded on Monday but is still looking very weak as the value is still below its channel. The Friday employment report also showed that unemployment dropped from 4.3% to 4.2%. However, the Sahm Rule rose to 0.58% Every time the Sahm Rule has been triggered a recession has followed. Remember the Sahm Rule is a real-time indicator that helps economists and policymakers identify when the economy might be entering a recession. The rule is triggered when the three-month moving average of the unemployment rate increases by 0.5 percentage points or more than its lowest point in the previous twelve months. Unemployment is one of the two coincidence “meaning current” indicators of being in a recession. The other coincidence indicator is the widening of credit spreads. A credit spread refers to the difference in yield between a corporate bond and a Treasury bond of the same maturity. What this means is how much in excess the corporate community has to pay in interest to issue bonds or borrow money. If credit spreads start to widen, corporations and businesses have to pay more in interest to borrow money. If interest costs go up that affects the bottom line or profits. If profits go down the stock or business value goes down. Current economic policy is draining money out of the system thus reducing liquidity in the system. When there is less money in the system there is less money to loan. Combine that with a slowing economy affecting business bottom lines, banks are less willing to loan unless they get a higher interest rate, thus interest rates are rising on bond issuance or corporate loans. When credit spreads widen enough, recessions follow. As far as being in a recession we aren’t quite there yet but we are preparing for one. After being defensive for so long, we see an area for opportunity and we are making some changes to the allocation to add some returns to the models. The new allocation is designed to take advantage of what we believe will be a turbulent environment headed into the election and a possible recession. We are still staying in U.S. Government backed bonds to avoid any default risk, but we are extending the duration to boost returns while still protecting us from the downside.
