“If I’ve made myself too clear, you must have misunderstood me.”
– Alan Greenspan
by Tony Scherrer, Smead Capital Management
My career started in 1994, which was a stealth bear market for stocks and an outright bear market for bonds. Fed Chair Alan Greenspan hiked rates seven times as he played catch up in response to a percolating economy that rediscovered its sea legs coming off the 1991 recession.
The Federal Funds Rate doubled from 3.00% to 6.00%, and the 30-year bond yield jumped 150 basis points to 7.75%. You lost roughly 25% by owning the long bond, and although the S&P 500 grew operating earnings 18% that year, its price declined around 1.5% while your average stock did far worse.
This Fed era was quite opaque, often surprising the market and offering very little read-through. At times it seemed Greenspan reveled in non-transparency, as the opening quote reminds us. [backc url='http://www.dynamic.ca/leadership/eng/active.html?fund=dreii2f&utm_source=aa&utm_medium=banner&utm_campaign=alts_2019&utm_content=dreii2f']
The contrast today vs. the Greenspan era is massive, both in Fed transparency and how the market attempts to read its cues. The closed-door Fed of the ‘90s caused market participants to have to figure things out on their own, mandating a far more fundamental approach to capital allocation.
This world of yesteryear cultivated an incredibly important factor in the market that is gravely missing today: risk taking. Today there is precious little of it! We now have half of market participants agnostically owning passive vehicles, and another large group playing “risk-on / risk-off” by trading baskets of securities based on the illusion they have been spoon-fed the right answers by the Federal Reserve’s teacher.
Consider the chart below, which shows the various Central Bank programs of “quantitative easing” (economic stimulation), and how the market volatility was squelched after these announced plans were put in place.
The “Fed to the rescue” or the “Powell Put” is alive and well. Ever since the global financial crisis, the market has increasingly responded to Fed talk, and the Fed has increasingly been willing to show its hand.
Ah, if life were really that easy…
The lazy person in me would love to simply get paid by hinging on every word the Fed may dispense. Even Fed chair Powell might be persuaded towards this kind of luxury. This is the most data-driven Fed we’ve ever seen, and they seem to live on that stuff. Last December, Powell said he put his quantitative tightening program on “auto pilot,” only to walk back those remarks in January after realizing the markets saw this as too rigid. Fed to the rescue, again. The markets have rallied more to start this year than any year since 1987 and the NASDAQ started with nine weeks straight up without interruption!
But history tells us there’s a problem with letting the Fed drive the ship of your portfolio. The Fed (and all economists) can only drive by looking in the rear-view mirror. This causes colossal wrecks from time to time. The below chart is full of boom/bust patterns, and should give a clue that markets are far smarter than any central bank management:
This isn’t just a financial markets issue, it is also real world. John Maynard Keynes referred to the benefits when “animal spirits” are unleashed. Today there is a dearth of real-world risk taking in the form of homebuying, mortgage originations, entrepreneurship and other forms of personal risk assumption. This lack of mo-jo, along with renewed expectations of lower-for-longer, offers folks no reason to go looking for it. The loss of primal instincts is easy to see by looking at the velocity of money. Today’s dollar turns over at roughly the pace of molasses in January, which has not been good news for bank lending:
Source: Bloomberg
If the Fed went dark, what would light your way?
We don’t want to pretend the Fed will revert to its former black-box mode, but there’s value to wondering what kind of market views would develop if the approach was more fundamental. After all, the “weighing machine” of the market’s scales are balanced by fundamentals, not the Fed’s tea leaves. A fundamental approach would offer the following observations:
- Key home buying demographics looks like a pig going through a python for the next 12-14 years, as the 35-44-year-old cohort will grow to become materially higher in numbers than it’s ever been before in the United States.
- Today’s millennial will statistically take on 4x the amount of debt balances into their lives over the next decade, if history of the prior four generations is any guide. This is not consumer debt based on spendthrift habits, but rather, debt needed as household formation and homeownership activities increase. These have huge multiplier effects and will cause the velocity of money to grow meaningfully from today’s floor.
- There is ample room to increase personal balance sheet risk. The Federal Reserve Household Debt Service ratio is as low as it’s ever been since it’s been reported going back to 1980. The millennials of today are in way better shape than boomers were when they got their lives started.
- The supply of new U.S. houses has increased each year since it’s 2012 low but is only back up to the lowest point it had ever been at prior to the ‘08/’09 global financial crisis looking back to 1968. That prior low point was 1982, when there were more than 100 fewer million people in the United States than today. On a population adjusted basis, we are at the lowest point of housing supply since 1960.
- The consumer is very strong. Consumer spending is strong, consumer confidence near record levels, nonfarm payrolls are near the higher levels of the past 40 years, and unemployment is at record lows.
- This may sound like a “late cycle” economy with nowhere to go but down, except for the fact that only 60.7% of the population is employed. Today’s employment population ratio is not even back up to the lows seen over the past 30 years. Today it is lower than the S&L crisis that brought a recession in the early ‘90s or the tech-wreck that bottomed in 2003. If the employed population among the U.S. labour force was at a healthier 63%, we could add another 4.5 – 5 million jobs to reach full employment.
- Wage growth is on the rise. This is structural, due to a lack of available labour, due to the surging trends in long-term disability recipients, boomer retirement (outpacing millennial participation) and an increase in former felony convictions.
If the above list looks more inflationary than deflationary, you are thinking about it correctly. The Fed will get its chance to normalize (take higher) interest rates due to economic strength and price inflation as it shows up down the road. It will play catch-up to these new and surprising “data points.” As investors, we need to play the forward view, and avoid the temptation to reposition based on short-term momentum, however palpable it feels at the time. We couldn’t be more excited to see how these views play out and believe investors who lean into them will get rewarded handsomely.
Warm regards,
Tony Scherrer, CFA
The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Tony Scherrer, CFA, Director of Research, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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