Footnotes is a monthly publication which summaries our “First Friday” webinar presentations each month. The goal of the Footnotes publication is to capture our “First Friday” presentation’s most important data points, which will make it easier for The Abernathy Group Family Office members to make intelligent decisions based on facts and data – as opposed to potentially conflicted opinions from the mainstream media.
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Commentary from the August “First-Friday” meeting:
In our last webinar, we discussed the difference between looking stupid and being stupid.
We discussed the fact that avoiding the noise and following the signals may make you look stupid from time to time because it takes time for the signals to impose reality on the capital markets. However, intelligent investing is an exercise in probability analysis. Consistently ensuring the odds are on your side will deliver attractive results.
It is uncomfortable when you watch others speculate on trendy, overpriced investment themes – taking unintelligent risks by participating in markets which make little sense and still come out ahead, while you remain conservatively diversified with the odds in your favor in solid investments which pay significant dividends. Fortunately, you avoid the short-term noise from the talking heads who continue to scream day and night about (“ABC”) stock which went up today, making it seem as if investing is a contest, or a game.
Never-the-less, it really makes you feel stupid for not joining the fray.
History is littered with fragments of those speculators who think investing is a game and believe they can beat the market by listening to the current narratives and overpaying based on the hype – yet confronted by an uncertain future.
We want to ensure all of the families we counsel are constantly reminded that intelligent investing at times looks stupid for not participating in the narrative du jour…
Yet looking stupid and being stupid are different.
By remaining invested in a well-diversified portfolio of reasonably priced, dividend paying, well managed companies and growing your wealth intelligently – over generations, while sleeping well at night in the process may look stupid at times. Yet Warren Buffett would probably tell you, listening to noise and participating in the alternative – is the definition of being stupid. And you should have little interest in the “being stupid” alternative no matter how it makes you look or feel over the short-term.
Today, we want to discuss some of the alternatives available to intelligent investors and remind Family Office members what the signals are telling us, while answering several of the questions we hear most often. I am going to turn it over the Matt to tell us the questions we are going to discuss today and to make sure we stay on topic to leave room for questions at the end of today’s discussion.
As a short reminder to each Family Office member, The Abernathy Group Family Office has now sponsored 20+ “First Friday” webinars. All of them are available on our website and “YouTube” Channel if you would like to go back and see how we have interpreted the economic signals, while doing our best to cancel the noise over the last year plus. Our goal: to help you spend less time making intelligent financial decisions, by focusing on causal, predictive data (signals); and ignoring the clamor of biased, irrelevant data (noise).
Matt Daley:
Today’s environment is riddled with the noise that accompanies uncertainty.
At any instant, you can hear a number of narratives which seem topical today, yet in a week will be forgotten. These momentary narratives are noise.
It is our job to remind everyone that to continue to be successful you must be able to ignore the noise – the information with little value on what’s ahead – and focus your attention on the signals – which offer information about the future, supported by reason and logic. Signals stack the odds in your favor. Noise distracts you, and is often the genesis of a momentary costly decision.
Slide 3
The 3 topics we are going to discuss today are:
First – Why is the stock market performing so as well despite the risks facing our economy which are right in front of us? What are the real risks we should be spending our time preparing for?
Next – The rate of inflation has decreased, yet we still have inflation. What are the implications of 3% inflation target vs a 2% inflation target?
- The capital markets are placing over 90% chance that interest rates are going to be cut in September
- Is this a political rate cut or is it a cut because our economy needs this cut?
- What happens if there is no rate cut?
Finally – What are the indicators (signals) I should watch for to give me information about whether to increase or decrease my risk exposure?
Let’s jump in and discuss these 3 main topics so we can have some time for questions at the end of our discussion.
So first – Why is the stock market up so much and what are the risks which are most important for intelligent investors to remain aware of and prepared for?
Slide 4
Steven: Matt it’s a good question and it’s really is the one most asked. I must admit it is difficult to see the stock market move up the way it has over the last year or more, and think there is anything wrong with our economy.
However, that is not what the data tell us.
And while I know most people don’t have the time to devote to this kind of research, if they did have time to go back over the historical ups and downs of the economy and the capital markets, they will find there are more times than you would think when the markets and the economy significantly diverge, and in most cases, the economy wins the tug of war.
Today, the risks we face are the same ones we have been warning about for more than the last 6 months.
Expectations are for the stock market to increase earnings by more 10-15% per year over the next 5 plus years. We do not believe this is a likely outcome. And by the way – if we are wrong and the public companies making up the U.S. capital markets are able to grow earnings by 10-15% per year for the next 5+ years, investors will have little or no return for those 5 years. Why? Because the current prices are already pricing in the expectation that earnings will grow at 10-15%. This is why we are so cautious. Investors who are investing in companies without significant dividends and who are counting on investment appreciation to satisfy their investment goals will likely be displeased. In short, if your investment portfolio is counting on appreciation rather than on dividends and income – there is a very good chance you will be disappointed – and either way, you will have suffered through some pretty volatile periods without any return over the next 5+ years.
Matt:
Ok then, what are the risks you believe intelligent investors should be aware of and incorporating into their risk analysis?
Steven:
Investors tend to focus on what is directly in front of them. The risks most investors are trying to deal with are those within our American economy. These are what we call “first-order” risks. While we admit these are real risks, most often, the markets have already priced in those risks. History will support, it is the second and third order risks that continually surprise us.
First order risks: Interest rates – are they going up or down. Inflation – is it receding or stalling. Is the U.S. going into a recession or are we going to beat the odds and successfully slow our economy while avoiding a recession? Our budget deficit is close to 7% and both parties are planning no changes. What is the impact of this ever increasing budget deficit? (Our U.S. operating deficit is a polite form of insanity and is absolutely unsustainable. Yet no one is planning to deal with it.)
The U.S. along with several other dominant developed countries, will have to embrace significant “Structural Reforms.” And note – structural reforms require upfront pain, before the ability to embrace any level of success. Does the U.S. citizenry have the willpower to reduce social security? Medicare allowance? Tax increases? Educational system?
And while its true – these first order questions will impact our investment returns over the near term, these variables are more influential over the short term and may be forgotten within months afterward.
The risks we should be focusing on, are the ones that keep me up a night – they are the geopolitical risks confronting our global economy – because these risks – if they become reality – will change the world in a way that will leave a lasting impact on our way of life, our standard of living, and maybe the future of the earth itself.
The political environment in the U.S. is sharply divided and is becoming violent. The U.S. political environment looks more like a 3rd world country than at any time in recent history, and our next campaign is just getting started.
On the global front we are living in an increasingly dangerous geopolitical environment. We have at least 2 hot wars, each of which has nuclear power. And while I am not trying to be a sensationalist, at least one of the wars, if not both, have the ability to become a nuclear problem because of the fundamental hatred which may only be quenched by a complete annihilation or eradication of the opposing side.
This is very serious – and no one that I know outside of The Abernathy Group Family Office has diversified their investment portfolios to survive this kind of potential geopolitical conflagration. It is an incredibly significant challenge with a very small chance of happening, and most investors don’t know how to price this into their future.
Please keep in mind we are not saying this is going to happen. We pray it does not. We are just reminding every person that there is a non-zero chance of these wars in Ukraine, Armenia, and most likely in Israel, to become a much larger problem than they are today, and we have not even mentioned the China/Tiwan commentary, which is not significant today, yet which could become more significant in the future.
In summary – Expectations for future earnings are too high. At the same time, valuations in the stock market in many sectors are too high. Also, there are more short-term risks than are currently being priced into the stock and bond market – making current valuations largely unappealing.
However, the longer term risks are the sleeping bear we do not want to awaken, and every investor on this call that is not diversified to weather the long term risks will be sorry if any of these geopolitical risks escalate.
Matt: Slide 5
The inflation rate seems to be coming down, and if it continues, it will be in the 2-3% range sooner rather than later.
The market sees this and as a consequence of higher interest rates imposed by the U.S. Federal Reserve and is expecting a reduction in interest rates by the U.S. Federal Reserve at the next meeting in September. Is this rate cut warranted or is it a political rate cut?
And secondarily, what happens if there is no rate cut?
Steven:
We believe a rate cut is warranted, yet our reasoning may not be similar to the reasons most believe there should be a cut.
Inflation and recessions are both undesirable outcomes. When you compare the risk of inflation vs the risk of a recession, we believe (and history supports) inflation is the least of the two bad outcomes.
The reason – if we move into a recession, tax revenues decline by 4-9% which will increase our already significant budget deficit to over 10%. While this will add a huge amount to our already intolerable U.S. sovereign debt load of $35 trillion, it may signal to the rest of the world that the U.S. is again acting as if it’s a 3rd world country. This would mean that we may start to lose our status as the global currency, or it may signal that if the rest of the world wants to lend the U.S. money it will take a higher interest rate to convince the world to lend us money for our reckless spending. This would be a game changer for the U.S. because the interest payments alone on our debt have become our largest expense.
In short, our ability to spend money we don’t have is going to come to an end if we don’t start acting responsibly.
If we cut rates and inflation reappears, it will be a negative. Inflation is a tax on the U.S. citizenry because it decreases our buying power, making everyone feel poorer. Eventually inflation increases the likelihood of violence in the U.S. yet it is politically more acceptable than a recession.
However, a recession creates a harsher hardship on the U.S. population as jobs are lost which lowers tax revenues, AND it increases our debt, while simultaneously decreasing our ability to repay our debt.
Of the two outcomes – clearly the U.S. Federal Reserve will choose to cut rates and deal with inflation, rather than embracing a recession.
Matt – do you have any additional comments on this topic?
Matt: Slide 6
The last topic for today is which are the best market indicators acting as signals as opposed to the many indicators that tend to be noise because of their lack of predictability?
Steven:
This is a topic we have gone over several times, and I don’t want to appear to be redundant. However, the real signals which offer valuable information about what future lies ahead, don’t change very often.
Slide 7
That said, there are many signals today that are giving us pieces of information which gives us the feeling we are headed for a recession if we are not already in one.
The most dominant two signals are the a) yield curve – an inversion signals a recession in almost 90% of all cases; and b) the Conference Board Leading Economic Indicators (LEI).
However, because we have reviewed both several times in former webinars, and both are still signaling a recession to come, we will discuss a few more, which have predictive information in the data, yet are not as accurate.
The first is most often related to the jobs market.
When the jobs being offered start decreasing meaningfully, it is unlikely to be the sign of a healthy economy. And it makes sense. When job creation is decreasing, it is a strong indicator that employment is weaker.
This chart clearly shows the leading edge of the jobs market. It shows job creation, and it has been declining for over 6 months.
This is not a foolproof signal, yet it is one piece of a mosaic that leads us to a picture indicating that corporate America is acting as if the economy may be weaker than the market believes.
Slide 8
This chart clearly shows the next step in the early stages of the employment framework. It shows actual rate of new hires.
As you can see this chart has also been declining for more than 6 months also.
Again, I want to point out that this chart is not an indicator which is reliable enough to be termed a “signal.” It is just another piece in the puzzle, yet it is often a predictive indicator, and it should be noted.
Let’s, take a moment and move on to one of the most reliable indicators, one each of you should always have an eye on, as it is incredibly reliable – because it is causal.
This is an indicator that once invoked by the U.S. Federal Reserve, it always, and I want to repeat, it always slows the U.S. economy because banks slow or stop lending when the yield curve is inverted. Because our U.S. economy is built on borrowing to grow, when banks stop lending, companies stop borrowing and growth grinds to a halt. In over 80% of the instances a recession follows.
Slide 9
This is what the Yield curve is telling us today.
It has been inverted for over 2 years which is the longest inversion in history. This leads many to believe the U.S. Federal Reserve has orchestrated a soft landing – where there will be no recession. We do not believe this to be true.
We believe the U.S. may already be in a recession or will enter one soon because when you subtract the U.S. government deficit spending from the U.S. GDP numbers, you get a negative GDP. As you know the GDP is a lagging indicator, so we don’t actually know we have been in a recession until at least 6-9 months after we have entered a recession.
In summary, the anecdotal evidence about our U.S. economy seems to signal a weaker economy, which should act to lower inflation. However, it is likely to be a deadly indicator for those who are hoping to avoid a recession.
And let me show you why those who believe it is important to avoid a recession believe this to be the most important U.S. economic risk – or said differently – the elephant in the room…
Slide 10
This slide shows our ever-growing U.S. debt load. As you can see, we are at record levels of debt – which means we are at record levels of interest expense on that debt, which means our U.S. government has less available to spend on initiatives which may be able to help us grow and repay this debt.
Without too much rhetoric here, this amount of debt is unsustainable. And although no one can tell you when it will happen, this amount of debt, at some point in the economic cycle will create a problem so large that our society will be challenged.
This ends The Abernathy Group Family Office August 2024 “First Friday” Webinar.
Please let me take a moment to thank you for tuning in and to invite you to either call us with questions or send them along – as we want you to be armed with reliable data which will allow you to make intelligent decisions.