November, 2024 – I trust this finds you and yours well this holiday season!
We’ve got a little over a month left in the fourth quarter this year and already it’s been full of a few surprises. I’m not sure how many people saw Trump’s sweep of the swing states, but his overwhelming victory was a surprise to many. I personally was expecting some more Supreme Court refereeing, but luckily, we didn’t need that this time around. (Sorry my lawyer friends, maybe next time.)
The stock market certainly appears to approve of the Trump victory, as the so called “Trump Bumb” buoyed the markets by at least a few percentage points following the election. This was to be expected given that his corporate tax plan calls for a 15% rate as compared to today’s 21% rate. The stock market likes lower taxes. No surprise there.
The other big news is that the Fed has started to reduce the Federal Funds rate—the overnight short-term rate that banks use as a benchmark. Generally, when the Fed lowers interest rates, bond prices rise. Remember that bond prices and bond yields have an inverse relationship—so that as prices rise, yields decline, and vice versa. This is simply a mathematical rule.
When the Fed dropped rates by ½ point last month, everyone expected the yields of all the other bonds to follow suit. But they didn’t; they reversed in price and the yields went up! Why would this happen? No one really knows but the two main operating ideas are:
- Inflation is not under control and the bond market believes that rates may need to go back up; or
- The federal government’s debt and deficit are out of control and treasuries are not as safe as they used to be.
Remember when our debt carried a rating of “AAA”? Maybe you remember when that was reduced to “AA” –which caused quite a stir? Is it possible that the bond market is reducing prices (thus increasing yields) in response to poor fiscal stewardship and the increased likelihood of eventual default? Is the bond market saying, “Hey America, you’re no longer “AA”, if you want my money, you’ve got to pay more?”
According to a September 19th article in Barron’s entitled Why Fed Rate Cuts Are Hurting Treasury Bonds:
It looks like the party in the bond market is over.
The Federal Reserve made a bold move on Wednesday, cutting interest rates by half a percentage point instead of starting slow with a quarter point. Stock investors have embraced this move, pushing the S&P 500 and Dow Jones Industrial Average toward record highs on Thursday. Bonds aren’t following suit.
Yields on 10-year treasuries, or government bonds, rose 5.4 basis points on Thursday to 3.739%, after gaining 4.4 basis points on Wednesday. (One basis point is equal to one one-hundredth of a percentage point.) If investors believe a “fair” yield is higher than it was previously, the price of existing bonds in portfolios fall to attract new buyers.[i]
Why would investors be demanding a “fairer” yield?
Could it have anything to do with our $36 trillion debt? Or how about our more than $2 trillion deficit spending with no end in sight? Does anyone really believe that we will ever pay this off? Or even balance the budget? Apparently, the bond market does not.
But I don’t know if I “buy” that argument. If you take a look at our public debt in terms of GDP (or as a percentage of GDP), you will note that our ratio is near 120%. But we are not the worst kid on the block. That honor goes to Japan (among the big economies).
The chart above shows the total debt of both the U.S. and Japan as a percentage of GDP. Even though ours is “high” at 120, Japan’s is over 215! And guess what? They are only paying 1%. So, if the international bond market is worried about solvency or credit worthiness and looking for a yield that would justify that, how can you explain Japan? They are in worse shape, AND their yield is much less!
Besides the growing debt and the unsustainable spending deficit, there is pretty much a universal agreement that stocks are greatly overpriced.
The chart above shows the five main categories economists use to determine where stock prices fall—neutral, undervalued, or overvalued. The colored boxes indicate the averages, or the mean, if you remember back to high school. The red dots indicate the price last year. The blue dots indicate the valuation this year. AND, this is before the election.
In every single instance, stocks are at least 2 deviations above the mean. This rarely happens, and statistical and math experts know the significance. However, there is another indicator that’s been making headlines.
Motley Fool: The stock market has done this only three times since January 1871.
Throughout the year, there have been an assortment of correlative events, forecasting tools, and data points that have warned of potential weakness in the U.S. economy and/or stock market. This includes the first notable decline in U.S. M2 money supply since the Great Depression, the longest yield-curve inversion in history, and the correlative performance of equities when the Federal Reserve shifts to a rate-easing cycle.
However, one historically flawless valuation metric stands head and shoulders above these other tools, and it's doing something right now that's only been observed three times in more than 150 years.
Most investors are probably familiar with or rely on the traditional price-to-earnings (P/E) ratio, which divides a company's share price into its trailing-12-month earnings per share (EPS). The P/E ratio provides a relatively quick way to compare a company's valuation to its peers or the broader market.
A considerably more encompassing valuation tool, and the metric currently making history, is the S&P 500's Shiller P/E ratio, also referred to as the cyclically adjusted P/E ratio or CAPE Ratio.
As of the closing bell on Nov. 13, the S&P 500's Shiller P/E clocked in at 38.18, more than double its average reading of 17.17 when back-tested to January 1871.
But more importantly, the Shiller P/E ratio has reached a reading of 38 only three times during a bull market rally in 153 years. In December 1999, during the dot-com boom, the Shiller P/E peaked at a reading of 44.19. Meanwhile, in the first week of 2022, it very briefly lifted above 40.[ii]
As briefly mentioned at the beginning of the article, there has also been a notable decline in the amount of dollars in circulation, known as M2. History has seen this before.
“As shown by Ludwig von Mises, recessions are often preceded by a mere slowing in money supply growth. But the drop into negative territory we’ve seen in recent months does help illustrate just how far and how rapidly money supply growth has fallen. That is generally a red flag for economic growth and employment.
The money supply has now fallen by approximately $2.8 trillion (or 13.00 percent) since the peak in April 2022. Proportionally, the drop in money supply since 2022 is the largest fall we’ve seen since the Depression. (Rothbard estimates that in the lead-up to the Great Depression, the money supply fell by 12 percent from its peak of $73 billion in mid-1929 to $64 billion at the end of 1932.)[iii]
If CAPE ratios and money supply seem too esoteric to make much sense, then perhaps leading indicators make a little bit more use of common sense.
Think about a neighborhood that is planned for the next year or two. What is the first thing you have to do to build a neighborhood? Architectural plans, zoning, land acquisition, orders for delivery of concrete, lumber, masonry, lighting. Interviewing and hiring of new staff and salespeople, et cetera. I’m sure you can think of many more. Notice how each of these things hints of a new neighborhood to come when not one person has put a spade in the ground—yet.
Well, there are several indicators like this that economists look to for guidance on where the economy is headed. The chart below shows leading indicators since 1970. The grey vertical lines indicate recessions. In every single instance where leading indicators break below 5%, a recession follows, ushered in by a significant market correction.
Note that our current number is -6.3%. Back in September, it was -4.8%. In the last 52 years, there has been a recession 100% of the time when we were similarly situated.
Without a doubt, stocks have been amazingly resilient in the face of the Russia/Ukraine conflict, the middle east fallout with Hamas & Hezbollah, Isreal’s exchanges with Iran, potential escalation with Russia and North Korea—I could go on. It’s almost like the market just doesn’t care.
Imagine yourself an investment advisor with a retiree showing up with her life savings. Would you—could you—buy stocks for her, now, knowing everything I just showed you? But you know this is going on around the country every business day. Whenever we have a down trend that recovers so quickly, that means someone is buying. Who?
And yes, inflation has certainly come down, but that doesn’t mean prices have come down—just that they’ve stopped increasing so much, though they are still increasing. We will have to keep our eye on this as higher inflation could mean a return to higher rates.
The good news is that on certain “bad” market days, the treasuries are rallying as they should, though they are still below the price one would have expected. Obviously, we are watching this situation very closely as it unfolds.
If you have any questions or concerns please feel free to contact me at 404-257-8811 or kevin@magellanplanning.com.
Wishing you and your family a very happy and safe holiday season!
J. Kevin Meaders, J.D. CFP, ChFC, CLU
The views and opinions are those of J. Kevin Meaders, J.D., CFP®, ChFC, CLU and should not be construed as individual investment advice, nor the opinions/views of Cetera Advisor Networks. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Additional risks are associated with international investing such as, currency fluctuation, political and economic stability, and differences in accounting standards. Due to volatility within the markets mentioned, options are subject to change without notice.
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[i]https://www.barrons.com/articles/why-fed-rate-cuts-are-bad-news-for-treasury-bonds-b91b9164
[ii]https://www.fool.com/investing/2024/11/17/stock-market-3-times-153-years-history-what-next/
[iii]https://mises.org/mises-wire/money-supply-growth-hit-23-month-high-and-fed-wants-more