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.
