In our quarterly letters, we have talked a lot about hope and reality over the past couple of years as we transition through the end of this economic cycle. Bombarded with the latest headlines, it can be difficult to keep a broader perspective, to look past hype, and to examine the evidence that is before us. Hope is what causes otherwise logical people to overlook the evidence that is contrary to the outcome they desire. Reality, on the other hand, is just that, reality. It is based in facts, evidence, and often mountains of historical data. We spend a lot of time studying historical events and cycles because, as humans, we are inclined to repeat the same patterns over and over. Longer cycles tend to happen over the course of 80 to 100 years (the span of a long life), and shorter cycles tend to reset every 10 to 15 years. They happen because of our human nature. Each time the exact story is a little different, but when you zoom out, you can overlay an archetype pattern to see the similarities (how they rhyme) and discern what will likely happen next. Our current situation is no different, though many would want you to believe that “this time is different” – it’s not. I cannot say that enough, therefore, we will spend the bulk of our letter examining our current situation with those from the past and overlay the template so that you can see, given the evidence, what is likely to happen next. It is my desire that it will help you to avoid the hype and be grounded in reality.
2024 Q3 Market Recap
It was a choppy quarter with the S&P 500 declining by nearly 9% in August, regaining ground and dropping again in September before finishing out the quarter in positive territory. The biggest news of the quarter was the Fed cutting interest rates by 50 basis points (½ percent) which led to a bond rally as rates adjusted (fell) to match the Fed (remember for bond yields to fall, the price must increase and vice versa). Also notable is the fact that the 10yr Treasury – 2yr Treasury yield normalized (turned positive) after being inverted (negative) since mid-2022 (the longest inversion in history), which as we have noted in previous letters has been a hallmark leading indicator of economic trouble ahead. Though still at historic lows, the unemployment rate began to rise, doing so at a pace that also historically has foretold of trouble ahead. Additionally, the manufacturing index is declining and has been doing so for the last eight months. A prolonged period where this index is in contraction vs expansion is also a leading indicator of economic trouble ahead. Though the markets continue to abound in the hope of an economic soft landing, the reality of the evidence is stacking up against it. This is the most dangerous time for an investor where the fear of missing out causes them to take on more risk than would otherwise be prudent.
Hope is Addictive, but This Time is Not Different
Hope is an encouraging drug. Hope sells. That is why you will never see the mainstream media promoting or discussing the real dangers until after the fact. Notice the headlines to the right. They both say we will have an economic soft landing (no recession). One is from September 26, 2007, right before the Great Recession. The other is from September 26, 2024, just a few weeks ago. The similarities between these two cycles are uncanny; perhaps textbook. I am not saying that we are about to have another financial crisis, that was just the trigger in 2008. Each time the trigger is different, but the environment in which the “trigger event” happens is what causes the house to fall. However, it is my desire that by studying these two cycles, you will be able to see past the hope and be grounded in the reality that this time is not different. Let’s dive in.
A Case Study of Two Economic Cycles
Studying historical cases allows us to see what patterns repeat and in what conditions they do so. When you see the same patterns repeat over a number of periods with the same results then you can begin constructing a model, an archetype, that you can overlay on similar events or cases and have a decent probability of understanding what will likely happen next. It also allows you to “experience” different situations which have perhaps never happened in your lifetime, or to you personally. That “experience” can prove invaluable.
Notice the two charts to the left. The top is of the 2001- October 2007 time period and the bottom is our present economic cycle (2019-October 2024). For the sake of simplicity, I’ve limited it to three charted items: the S&P 500 as a representative of the market, the Effective Fed Funds Rate (the interest rate the Fed actually controls), and the 10 yr – 2 yr Treasury yields.
The light blue line is the difference between the yield on the 10-year Treasury minus the yield on the 2-year Treasury. Under normal conditions this would be a positive number since you would expect to earn more for loaning out money for a longer period of time. However, under times of economic stress the difference will be negative (meaning you can earn more loaning out money for a short period of time (2 yrs) vs a longer one (10 yrs). This is caused by the Fed’s rate actions. When the Fed changes the Fed Funds Rate (an overnight rate) it affects all other rates. When the bond market’s expectation is that short rates will be higher than previously issued long-term rates the yield curve inverts (is negative). Notice the movement of the S&P 500 (dark blue) and the yield curve as the Fed raises short-term rates (red line). Initially the market reacts negatively to higher rates as it should, then the hope that the Fed will be able to engineer a mystical soft landing, cooling the economy without a recession, takes over and the market advances to higher and higher valuations. The market continues to climb, even past the point of reasonable value due to the fear of missing out. In his book Irrational Exuberance, Dr. Robert Shiller, an Economics Professor at Yale, focused on the phenomenon making the point that markets are often influenced by investor sentiment (herd behavior) and psychological biases (desire for good times) rather than by fundamentals (how much the company earns relative to the price you pay), leading to excessive enthusiasm, or “irrational exuberance,” that inflates asset prices far beyond their realistic values. Sentiment can be focused on many things, but it is often new technology such was the case during the Tech Bubble of the 1990s, or perhaps the AI Revolution of today. This narrow focus blinds investors and turns them into speculators. The speculators buying close to the end at very unreasonable prices are hurt when reality returns and prices fall to reasonable levels. We are entering that phase of the cycle.
In order to study this phenomenon, Dr. Shiller invented a new way to measure the value of the market relative to its earnings and economic conditions, the Cyclically Adjusted Price-to-Earnings ratio (CAPE), or Shiller P/E or PE10 as it has become known. We have looked at it before. It is widely regarded as a robust measure of market valuation (how expensive or cheap the market is) because its construction filters out the “noise” of short-term events and allows us to see when markets are overvalued compared to other times and similar conditions in history.
At the Extremes of Valuation
The chart to the right depicts the CAPE for the S&P 500. As I am writing this the CAPE value for our current market is 39.7. The only time it was higher was at the peak of the 1990s Tech Bubble. Let that sink in – it should give you pause.
The long-term historical average is 17.6, but if you were to just look at the very low-interest rate world of the last 25 years the average has been 27.4, which means today’s market is 31% higher than the recent historical average. Cycles are conditions that move up and down centered around a mean (or average), so there is a strong possibility for a steep market decline from our current values as they revert towards the average. Additionally, higher interest rates make the current value unsustainable for any extended period. Revisiting the chart to the left, we are reminded that when conditions in the past have been similar to today, the archetype indicates the likely next event, a period of slow economic growth – a recession.
I do not know the event or when it will arrive, though I suspect it will be soon, but something will trigger reality.
There are other indicators that, for the sake of space, I cannot fully lay out here. For one, the US manufacturing sector has been contracting with readings in recessionary mode for eight months now. Like most things, it takes time for the effects to show up in other areas. While still very low, the unemployment rate has moved higher in the past few months at a speed which has historically indicated a recession was at hand. Also, as we have noted before, inflation will persist, making matters worse. The chart below is of the M2 money supply, which is a measure of how much money is in the economy. You can see the large influx of cash due to pandemic-era stimulus packages. As we have discussed at length, this is the main cause for the inflation we have experienced the last couple of years. However, notice that it is not draining away. That will keep inflation higher. The concern is that if inflation persists with slow economic growth, it will lead us into a period of stagflation much like the 1970s. That is a very real possibility that is still on the table.
The Fed’s initial rate cut was 50 points, which was a very aggressive pressing of the gas pedal. It was an unusual move, but considering the evidence, perhaps appropriate, but likely too little too late. They are still behind the curve, and they have been from the beginning (remember “transitory” inflation…).
Still Positioned for Growth and Safety
Keeping all of this in mind, we still have our portfolios positioned in such a way as to participate in the current market while defensively awaiting the market decline and the beginning of the new investment paradigm we have talked extensively about before. Meaning we have more cash, cash investments, and bonds in our portfolios than we would normally. It is an “aggressive yet conservative” allocation that feels uncomfortable when faced with flashy headlines of new market highs but will feel very comfortable when the inevitable happens.
I look forward to the day when I can once again paint rosier pictures, but until then, we will continue to work hard to see the reality of the market and avoid the dangers of being swept away by the hope of irrational exuberance. We will strive to see the signal through the noise, remain rational, and invest both for now and for the future.
As always, please let me know if you have any questions. – John