Dear Valued Clients and Friends,
The first quarter of 2024 is in the history books (both because it is done, so therefore now history—and because it was a big quarter with a lot of surprises for market pundits). As you go into your Easter Weekend and enjoy the market holiday that is Good Friday, take a trip around the horn as we look at history, market valuations, passive investing, credit, the money supply, financial conditions, and more.
Jump on into the Dividend Cafe …
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The Passing Fad of Passive Investing
With a H/T to Michael Poulos, who perfectly interpreted three different charts he passed along this week, we are currently dealing with a few different phenomena all playing out at once:
- There is a brutally high number of stocks in the total U.S. stock market with a very high P/E ratio (23% of stocks have a P/E over 30x!).
- The median stock P/E is only around 17.5x.
- If the whole S&P is trading at 22x and there are 23% of companies trading at 30x or more, and the median P/E is only 17x, then, well, MATH tells us that it is a minority amount of companies, at a super-size, that are trading at a higher-than-historical valuation.
- Returns amongst stocks within the market are very likely to be less correlated than has been the historical norm in the year (or so) to come.
- Lower correlation is an advantage to active managers over passive.
One might say that, for good or for bad, one way to separate from the index would be to well own less of the big and expensive stuff and more of the not big and not expensive stuff. Just a thought.
With Credit This Tight, Who Needs Tight Credit
The High Yield bond market’s default rate was 11% out of the dotcom crash and 2002 recession. It was 14% when the world almost ended in 2008. It was over 8% in 2020 (largely driven by Energy defaults during COVID). And it has averaged 5% plus change for over 25 years. And what has it done as the Fed has raised rates from 0% to 5.25%, bringing HY absolute rates and spreads up to the highest place they have been in years? It has stayed between 2% and 5% for the last three years and is now flattening even before the Fed has begun to cut rates.
Fed Noise is Loud but Meaningless
A bit of an extraction from the What’s on David’s Mind in DC Today yesterday, but we basically know the following about Q1:
- The major market indices are all up in Q1 a lot.
- We started the year expecting six rate cuts on the year and now expect just three or maybe four (ambiguous odds in the futures market between 75 basis points and 100 basis points of rate reduction by year-end)
- We started the year expecting a rate cut in March and now expect the first one in June at the earliest.
- See #1.
The Fed does not drive markets. The noise around the Fed is unhelpful and pitifully stupid. And this crucial forecast we had for 2024 took one quarter to play out, not the whole year.
Roaring 20’s
The 1920s started off with a global pandemic (Spanish Flu of 1918-1919) and then a mini-depression, but then went into a 500% increase in the Dow (before the Great Depression began in 1929). The 2020s saw a global pandemic and a severe (but short-lived) recession, and the Dow is up 100% from its COVID bottom (now a little bit more than that). So do we have 400% more to go for the 2020’s to mirror the 1920’s?
History is funny in where it repeats, where it rhymes, and where it tells you to stop being a blockhead.
Dialing for the Dollar
The U.S. dollar declined from October through the end of January by nearly -7% against its trade-weighted basket of currencies, and then rallied a few points higher, and has been range bound since then (dropping -2% and recovering +2%). I put no stock in any short-term move in any currency, let alone the dollar, and have no outlook on where it will be against what or when. All I can say is this:
- The dollar’s reserve currency status is not currently under assault, and for those who believe it is, I merely ask, “by which currency”?
- China has no interest in seeing our dollar strengthen against theirs, at least not substantively or significantly. A stable yuan is their policy goal if they are to de-dollarize with their trading partners.
See #1 and #2 over and over again to avoid being radicalized by either extreme of dollar analysis that passes for punditry these days.
The Fed and Inflation
My basic rule of thumb is always and forever that central bankers live to fight off deflation – that everyone knows what has to be done to fight off inflation (as uncomfortable as those things may be at times) – but that deflation has proven in history to be something that can get out of control, very quickly. Debt-deflation spirals are not easily extinguished, and they destroy central banker legacies and sometimes destroy countries. So while “price stability” is a Fed mandate, “deflation” is a central banker obsession. And I believe this to be an immutable fact of life.
Does the Fed believe inflation is coming back up? No. Is it? No. Could it be later? Sure. Will it? I doubt it. Does the Fed worry it might? Not really. Is that because they want to see Biden get elected? Huh? If the Fed made a policy mistake one way or the other it hurts the incumbent President. And even if they do the right thing for policy, but if it hurts asset prices or some form of economic activity, that hurts the incumbent President, too.
Look, the Fed is tasked with doing things I don’t think it should be tasked with doing. In so tackling these tasks, it does things I think it shouldn’t be doing in a way I don’t think it should do them (I think I said that correctly). But they are not pro-inflation. They are anti-deflation. And more than anything else, petrified about becoming powerless to stop it. They may not read me on Japanification, but they do read Japan on Japanification.
The Fed does not believe inflation is going to go higher. And they do believe they are on their way to the 2% target they have set (a target I don’t understand). Some believe they will just say, “We did it!” even apart from a 2% number by actually saying, “Never mind, 3% is our number.” Politically, optically, and in terms of credibility, I would be shocked if they explicitly did that.
I believe the Fed is waiting on the shelter inflation data to come down, and is confident in the massive disinflation in core goods and content to use the core data and not headline so as to remove oil and food from their process. And the Fed knows what politicians have known for years … people don’t mind asset price inflation; they pretend they do, but they don’t. And they don’t notice 2-3% inflation. They notice 4-8%, but not 2-3%.
Speaking of Money Supply
I join the chorus of people surprised at how little attention the decline of the money supply has gotten and how little the collateral damage has been thus far. The Fed balance sheet is down $1.5 trillion from its high and the actual M2 money supply has negative year-over-year growth for the second year in a row. At the same time, the Fed’s reverse repo facility has seen cash on deposit there decline by almost $2 trillion. Money has sloshed around, and the inevitable tightening of those conditions has played out slowly and harmlessly (thus far). The question those whose investment policy relies on continued excess liquidity ought to be asking themselves is: “Are we closer to the point of excess liquidity or to the point of removal of excess liquidity?” I opt for the latter.
Financial Conditions Ain’t Just a Rate Cut and QT
The most underrated aspect of better financial conditions in Q1 was not the reversal of quantitative tightening (they haven’t reversed it yet, even if they hinted at it in the last meeting), and it wasn’t the beginning of rate cuts (they haven’t done so yet and may not do so for several months). It was the clear walk-back from the horrific idea of Basel III capital requirements for banks. Regulation is a policy tool, as well, and the idea of banks having to increase capital requirements by 16%, as the proposed rule changes implied, was monetary tightening on steroids. The clear reversal of this threat in Q1 was a huge reason financials are the leader of the pack, and not seemingly letting up any time soon.
Quote of the Week
“Man is not a rational animal; he is a rationalizing animal.”
~ Robert Heinlein
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Reach out with any questions, and get ready for an exciting Q2.
May it be a wonderful weekend for you all. History has never been the same.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet.
