Market Musings Blog

Waiting for the Other Shoe to Drop

Sometimes the most difficult thing to do is nothing. Viewing the stock market over the last several days, maybe it’s easier than usual to do nothing since whatever you buy today is likely to go down tomorrow – but from our perspective, looking at ever cheaper prices it’s hard to pass up the opportunity to “buy low”.

Still, there’s a narrative that argues against our favored potential purchases lately: the housing stocks. That narrative goes like this:

  1. Housing stocks are cheap, yes, but earnings have yet to fall so they can get cheaper.
  2. Demand is strong and housing is underbuilt, yes, but cancellations are rising.
  3. Balance sheets are in great shape, yes, but will get worse before this is over.
  4. Dividends have gone up over the last few years, yes, but are still paltry.
  5. Earnings are strong now, yes, but will get worse.

The last argument needs better illumination from new data. We would like to see what happens to Toll, DH Horton, and others once earnings begin to fall.

So the waiting game is on. And that’s true of many segments of the market. We’d like to own more energy stocks; we’d like to own more industrial stocks; we might want another retail stock. But it’s better to stand out of the way for the time being.

Faith in the Fed?

Ever since the Federal Reserve was founded in 1913 as a result of upheaval in the wake of the 1907 banking panic, it has depended on the public faith to maintain its legitimacy. Yet throughout history that faith has waxed and waned, occasionally sideswiping markets.

What do we mean by ‘faith in the Fed’ and why is it important?

In the early days of our nation’s banking system, bank panics were all too common. These resulted in institutional failures, loss of depositors’ money, and general volatility that made it difficult for businesses to function long term. Banks needed a source of emergency reserves, and the public needed a reason to calm down when panics gripped markets. The Fed provides these benefits. With just a couple of objectives on its docket, it was relatively easy over time to trust that the Fed would be a backstop against crises.

Over time, however, the Fed has experienced mission creep. It is now responsible for price stability, employment, and currency controls – heavy burdens in our complex economy. Occasionally, these aims also become mutually exclusive. Recently history has shown that the Fed’s actions sometimes cause problems that it must then fix. Very low interest rates for long periods of time caused housing prices to de-couple from inflation and become more volatile. A willingness to create liquidity in bond markets muddled price signals and caused investors to take too much risk. And just recently, the Fed called inflation a ‘transitory’ phenomenon, when it wasn’t. The gradualist approach to hiking rates has some merit, but as inflation rages on, market participants are questioning the Fed’s credibility.

Chairman Powell has a chance – albeit slim – to be correct. If he is correct that a measured approach to raising rates will ease price pressures without spurring unemployment, the Fed can regain investor credibility. But if the Fed’s actions plunge us into another recession, its credibility will continue to erode, causing market volatility along the way. The route away from this erosion of trust is a reassessment of exactly what the Fed can and cannot accomplish, and perhaps a reversion to its original goals. Certainly, it should not be burdened with more tasks that its tools cannot allow it to achieve.



Another Leg of the Economy Bites the Dust

Over the last several years, the US economy has benefited from low-priced money in so many ways. One of those is ready capital for start-up companies, which allowed those start-ups to sell products and services at a loss. Uber, DoorDash, Rivian, Carvana… the list is long.

Recently, Uber announced higher prices, which are rippling through the short ride ecosystem. This is just one example of the end of low prices from the host of new companies that provide services that some view as part of daily life. No more can these companies glide along by using cheap capital; they must produce profits. No profits, no access to capital.

These price increases will also ripple into the overall inflation numbers we are experiencing.

If you’re invested in money-losing companies, time to take a long look at those financials. How fast do they burn cash, and how much cash do they have now? Check to see if the company has issued debt: what are the ratings on that debt? What has the trend of losses been – less losing, or more losing? This is just a start. Looking at other competitors who are also hungry for the same business but have deeper pockets is the second round of investigation. You might believe you have a promising stock only to find out that some private company you never heard of is about to take over its market.

In a larger sense, a strangled start-up environment will slow US growth – so this becomes everyone’s problem, not just that of investors willing to speculate by funding these companies. The true test will come from the jobs picture at start-ups: when layoffs come, you know reality is dawning.

What Will Home Prices Do During Today’s High Inflation?

Much of the economy is in flux at the moment, so it’s difficult to find a trend that’s reliable. Stocks have put together several downtrends, interrupted by strong rallies. Interest rates have generally gone up, but this week, rates fell. Consumer spending is up in some venues, down in others. Shortages plague us here, but not there.

One trend, though, is covered nearly daily by the media: rising home prices. Homes are the single largest source of wealth for most Americans, so their prices have a big impact on our economy. With mortgage rates up and homes already so expensive, what can we expect in the future? More appreciation, or … declines?

The best historical example we have is the 1970s, when interest rates ratcheted up to unimaginable highs, and inflation was running rampant. From 1973 through 1982 – the worst period for rising prices and high interest rates that this country has of yet seen – inflation was running at about 9% a year. Home prices matched that rate nearly exactly. In the decade of the seventies, stocks returned roughly 5.5% per year, and home prices rose about 10% a year.

But using the 1970s experience is probably not as sensible as it seems. For one thing, housing became more volatile starting in the early 2000s, and prices decoupled from inflation. Home prices climbed dramatically from the late 1990s up until about 2006, at a rate far higher than inflation. Then, from 2008 through 2012, home prices crashed. It took years for some locales to recover. While inflation marched along, homes were moribund. Another surge began in about 2013 – and from then to now, homes have returned far more than inflation. This decoupling is reason to believe that perhaps the scenario of the 1970s is less relevant today than we might think.

We believe we may be entering a down cycle for housing, or at least a period when prices no longer match inflation. While many purchasers have paid cash for homes and are consequently less vulnerable to foreclosure, that will not prevent a softening in the price of this asset. There are always owners with mortgages dependent on high incomes to cover housing costs, and if a job loss arrives, that home is likely going to market – at a distressed price. Those lower prices affect entire neighborhoods. Even if we escape a recession, higher interest rates generally confiscate value from assets, and this time around, we don’t think housing will be exempt.


Volatility, As Expected

As broadcast well and thoroughly by the Federal Reserve, it has started to hike interest rates for overnight money (called the federal funds rate), beginning with 25 basis points (0.25%) early in the year, and now, because the perception is that the Fed is behind the curve fighting inflation, a full 50 basis points the other day.

This is a good time to review the three most important factors affecting stock prices:

  1. The level and direction of interest rates
  2. The rate of change in earnings
  3. Sentiment

Two of these are against us right now. Interest rates are rising, which confiscates value from stocks; and earnings growth is slowing. Sentiment, while not very rosy now, changes day to day and is not a reliable indicator of value, or even the likely direction of value.

We’ve been asked ‘how long will this last?’ No one knows, but typically bear markets last up to three years. The range, however, is disconcertingly wide. We’ve seen bear markets last three months. It’s likely, though, that after many, many years of great returns from stocks, future returns will be lower, following global growth downward.

For our part, the ‘holding tank’ where we keep prospective stocks that we may want to buy is expanding. On the bond side, we can now purchase tax exempt issues at 4%. We’ll buy at that rate; later we may get a chance at 5%, where we would also buy, and so on. In an economy that has long term trend growth of about 2%, a 4% tax free rate is solid.

Fundamentals matter less in bear markets than behavior. Microsoft is not a different company at $300 a share, where it sold one month ago, than it is at $277 today. It may sell at $150 sometime before this is all over; it is still not a different company. Remaining rational about values and understanding that the downtrend in place can offer opportunities is more important than trying to time the top or bottom of the market – because no one can do that.