Daniel Shainberg
October 11, 2018
With the recent growth spurt in the economy, combined with tight employment, the Fed is predicting the recent wave of labor related inflation to increase. That is it. It’s not about politics. They have a dual mandate to keep employment and inflation in-check. If employment is tight and inflation starts taking off too much, they aren’t doing they’re jobs properly.
The truth is that Fed is not acting “reckless” as President Trump stated. He just needs an outlet to blame the sudden shock of equity losses onto someone else prior to the important mid-term elections.
Guggenheim’s CIO Scott Minder likened the current economy to the Titanic, “full steam ahead with an iceberg.” It’s tough to disagree. While we have been forecasting this volatility and market selloff since the newsletter began last month we were focused on a few very simple concepts. There are a ton of speculators commenting on fancy charts and research. But it’s quite simple.
What is the truth?
The truth is that for the past decade post-crises the Fed has been in an accommodating stance, and the phrase “don’t fight the Fed” worked for bulls. But as balance sheets expanded and the flood of liquidity made its way into market caps and the general economy, employment tightened and inflation began ticking up. The genie is always harder to put back in the bottle, so in anticipation of a major liquidity crises, which may happen anyway, the Fed is starting to be responsible. There are some like Peter Schiff who think that the level of monetary stimulus has totally corrupted the economy to the point where there is no turning back, and the U.S. dollar is doomed.
If we take the Fed at its word, for those of us without such a hyperbolic stance, the story is quite simple: The truth is that it all boils down to math. When the risk-free 10-year yields 1-2%, holding such paper won’t beat inflation. So you as an investor throw your capital into art, stock in Tesla, bitcoin, cyclical equities, real estate, iPhone apps and cannabis frauds. You may even pay 20x EPS through your Betterment account to own the S&P 500 because why wouldn’t you earn a 5% yield.
But once rates start rising all of those hyped up nonsense “investments” get scrutinized more. Do you really want to risk your capital in these bubbles and unproven momentum stories when you can actually earn a risk free return on your capital?
Even if you answer yes, the required return still rises because of the alternative return offered to you. When the S&P 500 trades at 20x earnings which is where it was for the past few years, you are essentially earning a 5% yield excluding growth. That represents a decent spread to compensate for elevated risks relative to risk-free government bonds.
Gundlach expects the 30-year to rise to over a 4% yield. Why would anyone buy the S&P 500 at or near cyclically peak earnings for only a 100bps spread? They won’t. And that repricing of risk is what the market is digesting currently.
While there are always buyers to step in short term, I’d expect this regurgitation to continue in the coming quarters until the equity spread increases sending the S&P 500 multiple towards a more reasonable 15x earnings level. That would call for another 20-30% correction in the markets.
October 11, 2018
- President Trump blames the Fed for the market drop
- Economists largely agree the Fed is making the right moves
- Some economists argue the Fed is actually too late in raising rates
With the recent growth spurt in the economy, combined with tight employment, the Fed is predicting the recent wave of labor related inflation to increase. That is it. It’s not about politics. They have a dual mandate to keep employment and inflation in-check. If employment is tight and inflation starts taking off too much, they aren’t doing they’re jobs properly.
The truth is that Fed is not acting “reckless” as President Trump stated. He just needs an outlet to blame the sudden shock of equity losses onto someone else prior to the important mid-term elections.
Guggenheim’s CIO Scott Minder likened the current economy to the Titanic, “full steam ahead with an iceberg.” It’s tough to disagree. While we have been forecasting this volatility and market selloff since the newsletter began last month we were focused on a few very simple concepts. There are a ton of speculators commenting on fancy charts and research. But it’s quite simple.
What is the truth?
The truth is that for the past decade post-crises the Fed has been in an accommodating stance, and the phrase “don’t fight the Fed” worked for bulls. But as balance sheets expanded and the flood of liquidity made its way into market caps and the general economy, employment tightened and inflation began ticking up. The genie is always harder to put back in the bottle, so in anticipation of a major liquidity crises, which may happen anyway, the Fed is starting to be responsible. There are some like Peter Schiff who think that the level of monetary stimulus has totally corrupted the economy to the point where there is no turning back, and the U.S. dollar is doomed.
If we take the Fed at its word, for those of us without such a hyperbolic stance, the story is quite simple: The truth is that it all boils down to math. When the risk-free 10-year yields 1-2%, holding such paper won’t beat inflation. So you as an investor throw your capital into art, stock in Tesla, bitcoin, cyclical equities, real estate, iPhone apps and cannabis frauds. You may even pay 20x EPS through your Betterment account to own the S&P 500 because why wouldn’t you earn a 5% yield.
But once rates start rising all of those hyped up nonsense “investments” get scrutinized more. Do you really want to risk your capital in these bubbles and unproven momentum stories when you can actually earn a risk free return on your capital?
Even if you answer yes, the required return still rises because of the alternative return offered to you. When the S&P 500 trades at 20x earnings which is where it was for the past few years, you are essentially earning a 5% yield excluding growth. That represents a decent spread to compensate for elevated risks relative to risk-free government bonds.
Gundlach expects the 30-year to rise to over a 4% yield. Why would anyone buy the S&P 500 at or near cyclically peak earnings for only a 100bps spread? They won’t. And that repricing of risk is what the market is digesting currently.
While there are always buyers to step in short term, I’d expect this regurgitation to continue in the coming quarters until the equity spread increases sending the S&P 500 multiple towards a more reasonable 15x earnings level. That would call for another 20-30% correction in the markets.
Dan Shainberg
#DanShainberg
#RecessionResister
@DanShainberg
@DanShainberg
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