I read a whole lot of analysis about the market every week. Lately, much of that analysis has been overwhelmingly bearish. In fact, I’ve read more bearish analysis over the past couple of months than I’ve read over the past two years.
This makes sense, of course, given the swoon in stocks and the ramped-up volatility that has slammed markets in Q1. So, what’s at the core of this bearish thesis? What is the main thread these analyses have in common, and how should investors look at it?
To answer those questions, I’ve enlisted the help of my favorite macro analyst, Tom Essaye, Editor of the Sevens Report. The following guest editorial was written by Tom and edited by me for this publication.
When Will the Fed End the Bull Market?
By Tom Essaye
There’s been a lot of bearish analysis coming my way of late. Most of that analysis assumes that the yield curve is telling us the Fed is about to commit a “policy mistake” and choke off the recovery — and end this bull market.
Now, in general, I agree. At some point, the Fed will hike rates too high (like they always do), and that will choke off the expansion (like it always does) and end the bull market. But what all this bearish research I’ve been reading has been missing is a compelling answer to the question of when this will happen. Most of the research says it’s soon, but none of it does a good job of backing up that assertion with facts.
So, lacking that answer, I went in search of it, and the historical truths I found about curve inversions and the end of bull markets was surprising — and it universally implies that while this bull market may end for any number of reasons in the short term, history strongly suggests that it will not be because of a “Fed policy mistake” or an inverted yield curve (at least not in the near term).
Before I get into my findings, I want to be clear that yield curve inversions have a perfect history of predicting recessions, and they are signals that should be heeded by all investors. However, knowing the yield curve is forecasting a recession isn’t the hard part.
The hard part is knowing when to get out of the stock market, and that’s what I’m trying to address here, because history shows us that the penalty for getting out too early is very stiff in the form of missed returns (e.g. 1998, 2004/2005).
Fed “Policy Mistake” Fact One: Yield Curve Inversions Don’t Mean Immediate Ends to Rallies. On average (going back to 1980), the S&P 500 peaks 10 months after the yield curve first inverts. The shortest period of inversion to peak was three months (1980-1981) while the longest period of inversion to peak was 19 months (1988-1990). The yield curve hasn’t even inverted yet, so based on this historical precedent, the proverbial “end-of-the-rally” clock isn’t even ticking yet.
Yield Curve Inversion Fact Two: There has never been an economic downturn when real interest rates are negative. Right now, real interest rates are still negative. Real interest rates are the Fed funds rate (currently 1.625%) minus the year-over-year core Consumer Price Index (CPI) rate (currently 2.10%). So, 1.625% – 2.10% = -0.475%. Takeaway: The fact that rates are negative strongly implies that the Fed has not raised rates too far.
In fact, according to some JPM research I was sent, there has never been an economic downturn started when real rates were below 1.8%. Now, I admit that we’ve also never come out of a near decade of 0% rates, so perhaps that 1.8% will be lower this time. But the point still is that based on historical metrics, the Fed is not close to hiking rates “too much,” and thus halting the recovery.
Yield Curve Inversion Fact Three: The S&P 500 has rallied in every rate hike cycle since 1980 (where I stopped my research). The smallest gain over those hiking cycles was 4% on three separate occasions (’80/’81, ’94/’95, ’99/’00). The biggest return is this current cycle, 29% from December ’15. Clearly, that corresponds to the pace of which rates are being raised (the more quickly rates rise, the lower the returns for stocks).
So, this research implies that, on a very simple level, equity investors should remain fully allocated until the first “Fed pause” that signals the end of the hiking cycle and, barring a big surprise, we’re not close to that.
Now, knowing that inverted yield curves signal a looming recession isn’t the hard part. The hard part is knowing when to get out of equities and when to get more defensive, and that’s the answer I’m trying to find here.
Going forward, based on my analysis, I am looking for three specific signals to tell us when it’s time to get out of stocks (for medium- and longer-term investors):
- Positive Real Interest Rates (the closer to 1.8% the more cautious)
- An actual yield curve inversion (that starts the clock)
- The first “pause” on the rate-hike parade
Those three signals (generally speaking) should, according to history, tell us when it is time to prepare for a bear market in stocks — and none of those indicators have been elected at this point (or are close to being elected).
Finally, I believe my research only demonstrates that a Fed policy mistake/inverted curve won’t end this rally near term. That does not, however, mean something else can’t end it, including trade wars, military conflicts, political disasters, etc. So, I will remain vigilant to any macro threats, but for now, a Fed policy mistake/inverted curve is not a near-term concern.
ETF Talk: Consider the CurrencyShares British Pound Sterling Trust (FXB)
As part of the series of currency exchange-traded funds (ETFs) offered by Invesco PowerShares, the CurrencyShares British Pound Sterling Trust (FXB) is designed to track the price of the British pound sterling, the official currency of the United Kingdom.
Incorporated in the United States, FXB holds British pounds in a deposit account. Investors also should do their due diligence regarding the fund’s tax efficiency, since any distributions or capital gains are taxed at ordinary income rates, without regard to the holding period.
With $4.76 million in daily trading volume and a tight average 60-day trading spread of just 0.02%, analysts rate FXB highly in terms of trading liquidity. Thus, both large and small investors should be able to trade the fund easily.
FXB, with $197.10 million in total assets under management and an expense ratio of 0.40%, uses JPMorgan as its depository bank. Below is a chart of the exchange rate from British pound (GBP) to U.S. dollar (USD) over one year. The overall trend has been a strengthening in the pound versus the dollar.
However, keep in mind that this increase in the value of the British pound comes at a time of a weakening dollar and international volatility. Thus, interested investors are encouraged to do their own due diligence before investing in this fund.
Below is a chart of FXB’s one-year performance, which largely matches the performance of the GBP versus USD seen in the chart above. The fund is currently trading near its 52-week high and has returned 3.87% year to date.
For investors who believe in the strength of the pound sterling, I encourage you to look into the CurrencyShares British Pound Sterling Trust (FXB).
As always, I am happy to answer any of your questions about ETFs, so do not hesitate to send me an email. You just may see your question answered in a future ETF Talk.
What I Wish Mark Zuckerberg Would Say
Last week, Facebook (FB) CEO Mark Zuckerberg was grilled on Capitol Hill. That means it was an opportunity for grandstanding bureaucrats to attack a businessman for his achievement.
You see, the men and women of Congress all have created multi-billion-dollar businesses that have changed the world, so of course they know better than the Facebook creator and CEO about how he should run his operation. Mr. Zuckerberg began his testimony to members of several Senate committees with a statement that I thought was both contrite and accountable for what he admitted was the unintended outcome via the Cambridge Analytica data breach.
I found the Facebook chief’s words to be solid and, of course, understandably apologetic given the vitriol he faces from both sides of the political aisle, as well as from much of the public, over the recent data scandal. That vitriol has caused Facebook shares to fall nearly 15% from their 52-week high set on Feb. 1, an example of what I call the free market policing its own.
Yet that’s not enough for lawmakers. In fact, this whole data breach incident has come with calls for all sorts of government regulation on Facebook (I prefer to call it interference) designed to dictate how the company operates, how it interacts with its users and what it can do with the data it obtains.
Unfortunately, Mr. Zuckerberg seems to have in principle agreed with the need for greater regulation on his company. This is an example that the novelist/philosopher Ayn Rand, one of the most powerful exponents of laissez-faire capitalism ever, called “the sanction of the victims.”
Rand had keenly observed that profit-seeking businessmen, despite conferring huge benefits on society of the sort Mr. Zuckerberg is responsible for, are often the “most hated, blamed, denounced men” in the eyes of much of society, and most particularly the political class. She also noted that these businessmen are complicit in this injustice, as many times they accept their attackers’ moral standards and end up guiltily apologizing for their own productive virtues.
That is what Mark Zuckerberg has done, for the most part, although he stopped short of truly capitulating to his harshest critics. He also largely defended his company and the tremendous good it has created for the world.
Yet I wish Zuckerberg would have gone a lot further in the defense of his brainchild. So, if you’ll indulge me, this is what I would have liked Mr. Zuckerberg to say at the outset of Tuesday’s hearing.
Chairman Walden, Ranking Member Pallone and Members of the Committee,
We face a number of important issues around privacy, safety and democracy, and I know you have your opinions on what the government’s role should be in how Facebook deals with these issues.
And while I am aware of your desire to wield influence on a business that has changed the way the world interacts, I am here to say that you have neither the right, nor the knowledge, nor the permission to interfere with the way Facebook operates.
Facebook is an idealistic and optimistic company. For most of our existence, we focused on all the good that connecting people can bring. As Facebook has grown, people everywhere have gotten a powerful new tool to stay connected to the people they love, make their voices heard and build communities and businesses.
This tool is used voluntarily by those who agree to the terms and conditions of its use before they sign up and create an account. This voluntary agreement allows us to monetize the data that users freely choose to put out to the world on the Facebook platform.
Nobody is forced to use Facebook. Yet if you want the benefits of Facebook, which billions of users around the world have demonstrated they do, then you have voluntarily chosen to allow my company to monetize that data.
Facebook is a for-profit operation. I do not apologize for this; rather, I celebrate it.
Our company has brought into existence tremendous wealth for shareholders, for advertisers and for businesses that use Facebook as a storefront of sorts. That wealth has allowed us to expand our mission and to continue evolving to create even greater value.
Have there been bad actors who have used my creation for nefarious purposes, such as spreading fake news, interfering in foreign elections and promulgating hate speech? Yes, there have. And it is my company’s responsibility to correct this situation, as it has been harmful to our business, our shareholders and to our users at large.
What would be more harmful, however, is for me to accept the premise that my creation is somehow a “public utility” or a “monopoly” that requires the arrogant and uninformed interference of federal lawmakers.
I admit that Facebook didn’t take a broad enough view of our responsibility in this matter, and that was a big mistake. It was my mistake, and I’m sorry for it. I started Facebook, I run it and I’m responsible for what happens here.
It will take some time to work through all the changes we need to make, but I’m committed to getting it right.
I’m also committed to protecting what I and my community of users and advertisers have created from the undue interference of big government.
I thank you for the opportunity to state my case, and with that, I am going to excuse myself from this hearing.
I have a business to run, and shareholders to answer to.
“Never lose sight of the fact that the most important yardstick of your success will be how you treat other people — your family, friends, and coworkers, and even strangers you meet along the way.”
— Barbara Bush
Barbara Bush was known as a tough matriarch who spoke her mind and often reminded her kids to make sure they acted properly, and with an eye toward taking care of their responsibilities. The passing yesterday of the former First Lady reminded the world of her strong character, the classy example she set for others and her many laudable qualities — qualities that we all can learn from.
Wisdom about money, investing and life can be found anywhere. If you have a good quote you’d like me to share with your fellow readers, send it to me, along with any comments, questions and suggestions you have about my newsletters, seminars or anything else. Click here to ask Jim.