September 16, 2022
By Steve Blumenthal
“The process starts with inflation. Then it goes to interest rates, then to other markets, and then to the economy.”
– Ray Dalio, Founder, Co-Chief Investment Officer, and Member of the Bridgewater Board
The process is in motion.
Over the last several years, I’ve been writing that inflation is kryptonite to Fed policy. It forces the Fed to raise interest rates, and higher interest rates ultimately cause stock prices and most asset prices to move lower. My best guess is that, next week, the Fed is going to raise interest rates by another three-quarters of a percent to over 3.00%.
If you study the history of the Fed’s interest rate cycles, you learn that bear markets end after the Fed stops raising rates and starts cutting them.
Three Steps and a Stumble
Edson Gould, a legendary technical analyst active from the 1930s through the 1970s, developed a simple rule about Federal Reserve policy that has an excellent track record of foretelling a stock market decline. The rule states that, “whenever the Federal Reserve raises either the federal funds’ target rate, margin requirements, or reserve requirements three consecutive times without a decline, the stock market is likely to suffer a substantial, perhaps serious, setback” (Schade, 2004). CMT Association
It’s a simple rule, and it’s not perfect, but it should not be ignored. So far this year, the Federal Reserve has implemented four consecutive interest rate hikes, including two giant rate hikes of 0.75% in June and July, respectively. The Federal Effective Funds Rate at the end of August 2022 was 2.33%.
Earlier this week, the latest inflation numbers surprised to the upside, and stocks sold off by more than 4%. Mortgage rates rose above 6% this week. I’m going to go out on a limb and predict that the Fed will raise rates three-quarters of a percent when they conclude their meeting next Wednesday, and it will be their last interest rate hike. I could be wrong, but all signs seem to point to a hard landing ahead.
Dalio put out another LinkedIn post this week. He explains how the system works in a way most people can understand. In the post, he describes his logic and sets some targets for inflation, interest rates, and equities.
Dalio concludes, “The upshot is that it looks likely to me that the inflation rate will stay significantly above what people and the Fed want it to be (while the year-over-year inflation rate will fall), that interest rates will go up, that other markets will go down, and that the economy will be weaker than expected, and that is without consideration given to the worsening trends in internal and external conflicts and their effects.” You’ll find the full post next. It’s excellent.
So, grab your coffee and find your favorite chair. This morning it was a Dunkin Donuts regular blend with extra hot oat milk for me. Then a second. Same favorite chair. Same obsession with figuring out how this will all play out. It starts with inflation (check). It goes to interest rates (check). Then to other markets (check—that’s happening now). Then to the economy (coming soon). Read on. You’ll also find a few of my favorite stock market valuation and forward return charts through the end of August. (Reminder, this is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only).
How It Works – It Starts With Inflation
By Ray Dalio, Founder, Co-Chief Investment Officer, and Member of the Bridgewater Board
It Starts With Inflation: How Inflation, Interest Rates, Markets, and Economic Growth Relate to Each Other and What That Means for What’s Ahead
In this post a) I will very briefly explain how I believe the economic machine that determines inflation, interest rates, market prices, and economic growth rates works, and b) work with you to apply current circumstances to that machine to come up with our expectations for the future.
How It Works
Over the long term, living standards rise because of people inventing ways to get more value out of a day’s work. We call this productivity. The ups and downs around that uptrend are mostly due to money and credit cycles that drive interest rates, other markets, economic growth, and inflation. All things being equal, when money and credit growth are strong, demand and economic growth are strong, unemployment declines, and all that produces higher inflation. When the opposite is true, the opposite happens. Most everyone agrees—most importantly the central bankers who determine the amount of money and credit available in reserve currency countries—that having the highest rate of economic growth and lowest unemployment rate possible is good as long as it doesn’t produce undesirable inflation. What rate of inflation is undesirable? It’s a rate that creates undesirable effects on productivity; most people agree and central banks agree that it’s about two percent for reasons that I won’t now digress into. So, most everyone and most central banks want strong growth and low unemployment on the one hand, and the desired inflation rate on the other. Since strong growth and low unemployment raise inflation, the central banks deal with the inflation-growth trade-off which leads them to pick the greater problem and change monetary policy to minimize it at the expense of the other. In other words, when inflation is high (above 2 percent), they tighten monetary policy and weaken the economy to bring it down. The higher the rate is above their target, the more they tighten.
With inflation well above what people and central banks want (e.g. today’s CPI report showed a monthly change in the core CPI of 0.6 percent, which equates to an annualized rate of 7.4 percent) and the unemployment rate low (3.7 percent), it’s obvious that inflation is the targeted problem, so it’s obvious that the central banks should tighten monetary policy. Everything will flow from that. Tell me what the inflation rate will be down the road without the central bank pushing interest rates and money and credit growth rates around and I can pretty much tell you what will happen.
So the process starts with inflation. Then it goes to interest rates, then to other markets, and then to the economy.
It starts with inflation. Since the price of anything is equal to the amount of money and credit spent on it divided by the quantity of it sold, the change in prices i.e., inflation is equal to the change in the amount of money and credit spent on goods and services divided by the change in the quantities of goods and services sold. This is primarily determined by the amount of money and credit and the level of interest rates that the central bank makes available, though it will also be influenced by the supplies of goods and services available e.g., supply disruptions.
Then it goes to interest rates. Central banks determine the amount of money and credit that is available to be spent. They do that by setting interest rates and buying and selling debt assets with money they print e.g., quantitative easing and quantitative tightening. Interest rates relative to inflation rates i.e., real interest rates have a big effect.
Then it goes to other markets. Interest rates rising relative to inflation causes prices of equities, equity-like markets, and most income-producing assets to go down because of a) the negative effects it has on incomes, b) the need for asset prices to go down to provide competitive returns i.e., “the present value effect”, and c) the fact that there is less money and credit available to buy those investment assets. Also, because investors know that these things happening will slow growth in earnings, that will also be reflected in the prices of investment assets, which affects the economy.
Then it goes to the economy. When central banks create low interest rates relative to inflation rates and when they make plenty of credit available, they encourage a) borrowing and spending and b) the selling of debt assets e.g., bonds by investors and the buying of inflation-hedge assets, which accelerates economic growth and raises inflation (especially when there is little ability for the quantity of goods and services to be increased). And, of course, the reverse is true i.e., when they make high interest rates relative to inflation and make the supply of money and credit tight, they have the reverse effect.
Where these things settle will be around the levels that are most tolerable, all things considered i.e., if one thing is intolerable e.g., too high inflation, too weak economic growth, etc. it will be targeted by central bankers to be changed, policies will be changed, and other things will change to bring that about. So, the process of figuring out what will happen is an iterative process, like solving a simultaneous equation optimizing for a few things that matter most.
Applying This to What’s Now Happening
Now, let’s look at what that means for inflation, interest rates, the markets, and the economy. By plugging in our estimates of the determinants, we can estimate the outcomes.
As explained, it starts with what the inflation rate will be. Pick your number based on what you can see ahead. Right now, the markets are discounting inflation over the next 10 years of 2.6 percent in the US. My guesstimate is that it will be around 4.5 percent to 5 percent long term, barring shocks (e.g., worsening economic wars in Europe and Asia, or more droughts and floods) and significantly higher with shocks. In the near term, I expect inflation will fall slightly as past shocks resolve for some items (e.g., energy) and then will trend back up towards 4.5 percent to 5 percent over the medium term. I won’t take you through how I arrived at that estimate (which I’m very uncertain about) because that would take too long. What’s your guesstimate? Write it down.
Next, we need to guesstimate what interest rates will be relative to inflation. Right now, the markets are discounting 1.0 percent for the next 10 years. That’s a relatively low real yield compared to what it has been over the long-term and a modestly high real rate given the recent past. What is your guesstimate? My guesstimate, based on the amount of debt assets and liabilities outstanding, what the debt service costs would be for debtors, and what the real returns would mean for creditors, is for a real interest rate of between zero and one percent because that would be relatively high, but tolerable, for debtors and relatively low, but tolerable, for creditors.
Put the inflation estimate and the real rate estimate together and you will have your projected bond yield. If you want to estimate the short rate, decide what you think the yield curve will look like. What’s your guesstimate? Mine is that the yield curve will be relatively flat until there is an unacceptable negative effect on the economy. Given my guesstimates about inflation and real yields, I come up with between 4.5 and 6 percent in both long and short rates. However, because I think that the higher end of this range would be intolerably bad for debtors, markets, and the economy, I’m guesstimating that the Fed will be easier than that (though 4.5 percent is probably too easy).
While interest rates and credit availability will be influenced by what I just mentioned, simultaneously there is the supply and demand effect on interest rates that results from how much borrowing and how much lending there is. For example, the US government is going to have to sell a lot of debt to fund the deficit (4-5 percent of GDP this year) and the Federal Reserve is also going to sell (and let roll off) a lot (~4 percent of GDP). So the question is where the demand to buy this big supply (8-9 percent of GDP) will come from, or how much will interest rates have to rise to reduce private sector credit demand to balance the supply and demand. What do you think? I think it looks like interest rates will have to rise a lot (toward the higher end of the 4.5 to 6 percent range) and a significant fall in private credit that will curtail spending. This will bring private sector credit growth down, which will bring private sector spending and, hence, the economy down with it.
Now, we can estimate what that rise in rates will mean for market prices and economic growth. The rise in interest rates will have two types of negative effects on asset prices: 1) the present value discount rate and 2) the decline in incomes produced by assets because of the weaker economy. We have to look at both. What are your estimates for these? I estimate that a rise in rates from where they are to about 4.5 percent will produce about a 20 percent negative impact on equity prices (on average, though greater for longer duration assets and less for shorter duration ones) based on the present value discount effect and about a 10 percent negative impact from declining incomes.
Now we can estimate what the fall in markets will mean for the economy i.e., the “wealth effect.” When people lose money, they become cautious, and lenders are more cautious in lending to them, so they spend less. My guesstimate that a significant economic contraction will be required, but it will take a while to happen because cash levels and wealth levels are now relatively high, so they can be used to support spending until they are drawn down. We are now seeing that happen. For example, while we are seeing a significant weakening in the interest rate and debt dependent sectors like housing, we are still seeing relatively strong consumption spending and employment.
The upshot is that it looks likely to me that the inflation rate will stay significantly above what people and the Fed want it to be (while the year-over-year inflation rate will fall), that interest rates will go up, that other markets will go down, and that the economy will be weaker than expected, and that is without consideration given to the worsening trends in internal and external conflicts and their effects.
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Stock Market Valuations and Forward Returns
Here’s how to read the chart:
- Median PE is the PE of the one stock in the middle out of all the stocks that make up the S&P 500 Index. Based on actual earnings and not Wall Street future estimates.
- The orange line plots the 58.5-year history (end-of-month data points). The current Median PE as of 8-31-2022 is 22.4. 58.5-year median PE is 17.4. NDR calls that “Fair Value.”
- NDR does something really cool. At the bottom of the chart, they show just how far away the current level is from the 58.5-year median PE number of 17.4. Needed is a 22.4% additional market decline to get to 3,068.08 = median Fair Value.
- But markets don’t generally revert back to Fair Value and stop. They generally decline below fair value. Just keep that in mind.
- As a general rule, if you were to buy in around Fair Value, I think you can approximate forward returns to be in the 8% to 10% range.
Stock Market Capitalization as a Percentage of Nominal Gross Domestic Income
Here’s how to read the chart:
- The orange line in the middle section shows the Stock Market Cap as a Percentage of Nominal Gross Domestic Income. The dotted blue line in the long-term Linear Regression Trendline.
- Note over time how the orange line moves above and below the long-term regression trendline.
- The bottom section shows where we are relative to the trendline. NDR ranks the data into quintiles.
- Note the red and green arrows in the data box upper left-hand corner of the chart. The best 1-, 3-, 5-, 7-, 9-, and 11-year returns when are starting conditions find us in the Bottom Quintile. The worst subsequent returns when in the Top Quintile – that’s where we find ourselves today.
Price to Sales
- Note the orange line in the middle section. Better but still expansive.
- Also, look at the sales numbers by year in the data box in the lower left. Simply, over time companies grow, and over time that is why it makes sense to invest in stocks.
- It just makes sense to buy them when you get a good value.
Buffett Indicator – Total Stock Market Cap to Gross Domestic Product (GDP)
Here’s how to read the chart:
- The current level remains higher than the peak in 2000 and 2007.
Household Stock Ownership
This last chart simply shows that when U.S. Households are significantly invested in Stocks as a percentage of their total investment allocation, future returns are the lowest (the yellow highlighted area in the lower left-hand corner shows the current state of play).
Average 10-Year S&P 500 Index Annualized Real Total Return Based on PE 10-Year Earnings
Bottom line: Valuations are better but not great. Valuation headwinds remain. A good re-entry target for the stock market is around 3,200 in the S&P 500 Index. We may get there sooner than we think. With Median Fair Value at 3,069.08, let’s call the Fed Pivot Zone somewhere between 3,000 and 3,200. A logical target in my view, but please know I could be wrong.
Trade Signals: CPI Inflation at 8.3%, Food at 11.4%, and Stocks Down 4%
September 14, 2022
S&P 500 Index — 3,932
Notable this week:
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizons, and risk tolerances.
Personal Note – Hard Coaching = Love
Susan’s high school soccer team is now three weeks and six games in, with nine weeks to go.
Three wins and three losses.
I’ve had a front-row seat to her coaching and have been enjoying it immensely. Monday’s game was at the Hill School. Malvern Prep was up 2-0 at halftime. Coach told the team, “I have three concerns: 1) A 2-0 lead should make us uncomfortable. We need to get the third goal.; 2) defending restarts (I.e., a corner kick, or a direct kick given to the opponent after a foul; and 3) player #11. Sadly, those concerns did the team in.
The final score was 2-3. It’s painful to walk away from dominating a game with a loss. But such is the way sometimes.
Susan told the team she holds herself equally accountable for the loss. She could have helped them navigate better. “We fouled too much, allowed our emotions to take over after some heinous tackles to teammates. We need to work on the emotional vicissitudes of the game to keep us playing our best.”
Last night, Susan shared several clips from the game with me. One stood out. Her starting goalie felt he was the reason for the loss. As he walked off the field, head down and in tears, several of his players went to him, put their arms around him, and accompanied him back to the bench. The school’s vision this year is “You are part of something bigger than yourself.” In that moment, they demonstrated it.
I always had a rule with my kids when they were growing up: Pick a team sport and pick a life sport. Team sports can teach us so much about life and prepare young people to be adaptable, competitive, gracious, coachable, and successful. In team sports, we learn how much we need each other. Some teammates we like; some we may not like so much, but we need to come together if we are to achieve our personal goals and team goals. We need our goalie, our defenders, our quarterback/playmakers, and our scorers. So much of what we experience in life happens within tiny pockets of time, as it did in Monday’s heartbreaking loss. And the upperclassman who couldn’t get his emotions under control during the game? He learned from two young freshmen and a sophomore who were the first to lift the spirit of their goalie. What a great moment for all of them.
What about that life sport I mentioned? It is the lifelong enjoyment of a favorite activity, something that can carry you through life. Golfing, skiing, running, walking, tennis, hiking, fishing, sailing, or swimming. And, as I’m learning from clients and friends, pickleball. I really have to give it a try.
“It’s because your coach loves you.” It’s fun watching Susan. More updates as the season unfolds.
Old teammates and friends are meeting tonight for a reunion at Penn State. I’m passing on the event this year, as son Kyle is heading west to begin his career in LA. We are golfing tomorrow morning at Stonewall before he departs. Life sport, indeed!
In case you missed last week’s OMR, here is a link to the audio recording of that post. Titled, On My Radar: The Great Reset September 2022 Update. Click on the photo for the audio version. Listen in your car, on a walk, on a train, on a plane, or with hot coffee in hand. I hope you enjoy it.
Wishing you and your family the very best!
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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Forbes Book – On My Radar, Navigating Stock Market Cycles. Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth. You can learn more here.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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