“Bad News is Good News”

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Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

February 3, 2023 – DJIA = 34,053 – S&P 500 = 4,179 – Nasdaq = 11,816

“Bad News is Good News”

 

Bad news is good news.  This has become the rally cry of a lot of Wall Street bulls.  The logic is that economic bad news will mean that the Federal Reserve will stop raising interest rates, reducing their balance sheet and other restrictive monetary machinations sooner.

Fortunately for the bulls, when it comes to bad news, they have had plenty of ammunition. Recessionary economic statistics, falling consumer confidence, widespread layoffs, and tumbling corporate profits are some examples.  While many would apply common sense and conclude that these signals are a negative for the financial markets, the current investor attitude is that this will force the Fed to back off and then it is back to party time.

This mentality has helped stabilize the stock market in recent months after a horrible first half of 2022.  It further assisted a strong stock market rally in January 2023.  The Nasdaq Composite jumped 11% in January which is the best start to a year in over 20 years.  The S&P 500 climbed 6.2% in the month.

At risk of raining on the bull’s parade, it might be useful to look past the intense emotional state of the capital markets.  Taking a glance at the financial fundamentals, it shows an extremely overvalued condition.  This may not matter in the short term, but it will likely be a headwind if it continues.

At the end of December 2022, the S&P 500 P/E (price to earnings ratio) stood at 28.7.  To put this in perspective, the 50-year average of this number is 21.  So, if there is any type of reversion to the mean, it is a bad binary outcome.  The S&P 500’s price has to tumble while the earnings stay the same.  Or the earnings number does a rocket launch which will reduce the multiple.

Unfortunately, recent earnings reports and the guidance for 2023 does not foretell any material increase in earnings.  But if things like 0 days-to-expiration options (0DTE) and similar trading strategies continue to squeeze prices higher, maybe it buys enough time for the Fed to back off.  This seems like a low probably outcome but so did an 11% monthly increase for the Nasdaq.

 

 

Copy of the 3rd Quarter Review Letter

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KERR FINANCIAL GROUP

KILDARE ASSET MANAGEMENT

45 Lewis Street, Lackawanna RR Station

Binghamton, NY  13901

Phone: 607-231-6330                                              email: [email protected]

 

The following is a copy of the 2022 3rd quarter letter sent to clients. It reviews the markets and the client account’s activity and performance for the 3rd quarter of 2022.

 

The Federal Reserve (the U.S.’s central bank) was formed in late 1913.  The main purpose was to strengthen the banking and monetary systems after some damaging financial crises.  The Panic of 1907 was an especially deep and destructive recession (perhaps depression) which included bank runs and closures.

 

Despite their efforts at reinforcing the financial system and smoothing out the business cycle, our central bank’s report card is far from honor roll material during its 110 years.  In addition to numerous recessions, the U.S. economy was ravaged by the Great Depression, suffered through widespread inflation and recession in the 1970’s and early 1980’s, the Dot.Com stock market bubble, and the mortgage and financial crisis of 2008-2009.  And there are many critics who believe that the Fed had a hand in each of these or, at a minimum, made them worse. 

 

Regardless of this mediocre performance, the Fed’s influence in the capital markets has grown.    Over the past 40 years, the Fed’s role has mutated past strict monetary policy to become intertwined with the capital markets.  Consider that before 1994, monetary policy decisions were not formally announced.  In the 21st century, the investing world stops whenever our central bank finishes their FOMC meetings and release the accompanying statement.     

 

One of the important components of the Federal Reserve’s operations is controlling short term interest rates.  The Fed has raised this rate (the federal funds rate) six times in 2022 and it has become one of the biggest news stories of the year.  Our central bank tells us higher interest rates are needed to battle inflation which has jumped to 40-year highs. 

 

Rising interest rates and higher inflation signal a new and different environment for investors.  For the past 15 years the Fed have been supportive of the economy and financial assets through low interest rates and easy monetary conditions.  This is changing and it is upsetting the markets. 

 

Stocks are having their worst year since the financial crisis of 2008 – 2009.  Bond investments have also fallen with losses in many fixed income indexes in the mid-teens for the first nine months of 2022.  This double whammy has been especially painful as bonds and stocks have hedged (moved in different directions) for each other in recent years.  With rising inflation, higher interest rates, and a restrictive Federal Reserve, the markets are facing headwinds that have not been seen in decades.

 

Here are the major indexes’ performance numbers for the 3rd quarter and year-to-date ending September 30th.

 

Using a size weighted average, here is how the average Kildare Asset Management – Kerr Financial Group client’s account performed. This is calculated after all fees and expenses.

 

There were some notable market developments during the 3rd quarter.  Stocks bottomed in July and rallied into the middle of August.  It began to look like a significant turning point had happened and Wall Street become more optimistic.

But interest rates, which had drifted lower, reversed, and started climbing again.  These interest rates were the longer-term ones that the Fed can’t directly control.  At that time a growing crowd was pushing the belief that the Fed could soon be done rising rates.  When the long-term interest rates, led by treasury bond yields, began to rise, it rippled through the capital markets and the turmoil continued.

The stock market gave back the 3rd quarter gains and continued to slide into the end of September, finishing that month at year-to-date lows.  The inflation and interest rates challenges that were facing the economy began supporting worries about an upcoming recession.  Also, corporations started to present lower sales and earnings guidance.

Your accounts weathered this turbulence reasonably well.  The hedging that we’ve used your accounts throughout 2022 has been effective.  This hedging has been in the form of inverse mutual funds, put options (for those accounts who allow that) and some selective short sales.  These strategies attempt to balance portfolios and manage risks.

As I stated in the 2nd quarter client review letter, I am cautious and will continue to position defensively.  I believe that a recession is a very large possibility.  Further, I expect the Fed to keep raising rates as they fight inflation.  Unfortunately, I worry that they will lose that battle as inflation is now deeply embedded throughout the economy.  This is a terrible situation and could result in a deep recession that our government and bureaucratic leaders will not be able to fix.

Despite my expectations, there will be opportunities in the long term.  At some point I will be active in unwinding the defensive strategies and changing to the bullish approaches.

Please contact me with questions or comments.  I’m happy to explain what I think is going on within these volatile conditions.  As always, thank you for your support and confidence in Kerr Financial Group

 

“Operation Break Stuff”

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Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

October 17, 2022 – DJIA = 29,634 – S&P 500 = 3,583– Nasdaq = 10,321

“Operation Break Stuff”

 

The economy has a large influence on the financial markets.  This “joined at the hip” relationship makes sense as economic growth helps increase corporate earnings which then leads to higher stock prices.  Looking at the upper part of this food chain, there are countless influences on the direction and breadth of economic activity.  Such things as fiscal policy, inflation, foreign competition, the regulatory environment, labor conditions, and monetary policy affect the economy.

The degrees of impact of these and other factors vary over time.  There have been times where things like foreign currency levels and international trade conditions have an outsized influence on the economy.  But fiscal and monetary policy are probably two of the biggest things that affect the economy, and, during the past 15 years, monetary policy has been a huge boost to the economy and the markets.

The monetary policy tailwinds have been a significant support of the capital markets since the financial crisis of 2008 – 2009.  The Fed chopped short term interest rates to zero and pumped money into the banking system.  The interest rate cuts are easy to understand.  The Fed controls the overnight inter-bank lending rate which impacts other interest rates in the bond market.  By reducing the Fed Funds rate to 0%, interest rates across the spectrum also went down.  It was hoped that these lower rates would spur increased business activity.

The liquidity injection was a different operation.  The Fed would buy bonds and fixed income securities from Wall Street banks.  While this is a simple straight forward transaction, there was some nuanced components to this operation.  First, the Fed would magically create money.  Most of us get money via getting paid for our labor or selling a something that we own.  In this quantitative easing policy, they would hit a button and create dollars and electronically send them to the financial institution for the bonds or mortgages.

While the Fed has this limitless ability print money, it does record its activities on a balance sheet.  It reflects the totals of their purchases and sales.  To offer some perspective, prior to the 2008 – 2009 financial crisis, the Federal Reserves balance sheet totaled around $800 billion.  In early October 2022, it exceeded $8 trillion.  That’s a lot of money created out nothing and sent into the financial system.  Unquestionably, it helped the stock and bond prices for the past decade.

The Fed has not been the only host at this party.  The Bank of England, the European Central Bank, and the Bank of Japan have all participated in quantitative easing through their operations.  Here is a chart from Torsten Slok, Ph.D. the Chief Economist at Apollo Global Management.  It shows the total central bank asset purchases since 2008 and estimates the future reductions.  Keep in mind that this is purchases at different times and doesn’t reflect the summation of entire period.  That is shown in the Federal Reserve’s balance expanding from $800 billion to $8 trillion.

This has been a chaotic year in the financial markets and many historical indicators and correlations are changing.  The Fed has been raising interest rates which has significantly harmed the bond market.  For the past couple of decades fixed income securities offered some diversification from stock market risk.  This year both markets have been battered.

On top of raising interest rates, the Fed has announced that they will be reducing its balance sheet.  This is taking the form of not reinvesting the proceeds from the maturing securities that they own.  The guidance from the Fed is that starting in September $90 billion per month will run off from their balance sheet.

Here is a chart from the Fed’s website showing the progress so far.  The blue line represents the total assets held by the Fed.  It clearly peaked earlier this year.  The red line is the S&P 500’s price which peaked on January 4th.  Also of note, the S&P 500 has declined much faster which is a function of many things but certainly the interest rate hikes as well as the prospects of a reduction of the Fed buying bonds are playing a role.

 

While the Fed has decided that higher interest rates and reduced stimulus are necessary to fight inflation, there are many who question that they can navigate the journey without inflecting systemic damage. A common phrase being used is Operation Break Stuff. Some are replacing “Stuff” with another word that begins with “S”.

The combination of higher interest rates and the removal of the markets punch bowl into an economic recession can easily lead to widespread complications across the markets and the global economy. We recently saw upheaval in the British government bond market as the market plunged and many overextended financial institutions were impaired. The Bank of England scrambled to rescue the markets. They have calmed down – for now.

While the U.S. stock markets are experiencing a historically bad year, it could get worse if the Fed keeps going and does break something. Here is the year-to-date performance for the major averages as of last Friday, October 14th.

 

 

 

Higher interest rates have been in the headlines throughout 2022.  Everyone is aware that rates have moved higher.  Quantitative tightening in the form of Federal Reserve balance sheet reduction was announced in May.  It has gone unnoticed.  If it continues and accelerates, more people will become aware of “Operation Break Stuff” as it as it will inflict widespread pain.

Many on Wall Street are calling for the Fed to stop the rate hikes as well as stop quantitative tightening.  This policy switch is referred to as the “Powell Pivot”.  Our central bank is facing difficult paths.  If they pivot, inflation will continue and perhaps increase.  If they stay their course, they may break things.  Many are looking for a bottom in stock market decline.  Instead, it might not be too late to “pivot” to a more defensive approach.

 

 

 

“So Long Will They Be a Little People, a Silly People”

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Kerr Financial Group

Kildare Asset Mgt.

Jeffrey J. Kerr, CFA

Newsletter

 April 11, 2022 – DJIA = 34,721 – S&P 500 = 4,488– Nasdaq = 13,711

“So Long Will They Be a Little People, a Silly People”

 

The above quote is from the movie “Lawrence of Arabia” as the main character describes the fighting and squabbling among the local tribes and factions in the Middle East during World War I. The movie depicts British army lieutenant T.E. Lawrence and his life in the region during the war. Throughout the plot, Lawrence, being accustomed to the sophisticated British culture, is continually frustrated with the brutal and violent fighting between the divisions in and around the Ottoman Empire.

The above quote was resuscitated recently as talk show host Bill Maher (“Real Time with Bill Maher”) used it in describing the state of our country. Maher, who doesn’t wear a MAGA hat, harshly criticized the lurch to the left that is sweeping the country.

The HBO show host acknowledges that the U.S. has “already lost” to China because we are too busy on “Woke” culture battles. He compared the discussion on Mr. Potato Head’s gender that took place in the U.S. to our global opponents’ attention to teaching their children such things as math, science, history, and literature. He went on to say, “You know who doesn’t care that there’s a stereotype of a Chinese man in a Dr. Seuss book? China.”

The silliness goes beyond cultural issues including developments in the financial markets. Crippling and historic inflation, the Federal Reserve on a path to raise interest rates perhaps as many as 8 times, and the possibility of slowing economic growth. But the greatest silliness it that the dollar is at risk of losing its prominence as the reserve currency which would cause a massive shift in the global power rankings.

During times of emotional chaos, leadership can offer calm and reason. Unfortunately, the current lunacy is being promoted through the actions by our bureaucratic and political leaders. Since the 2008 financial crisis, the Federal Reserve journeyed on a path of unproven policies that involved injecting newly printed dollars into the financial system.

Here is a chart of the size of the Fed’s balance sheet. As shown, the money supply (the total amount of money in the system which is controlled by the Fed) doubled from 2008 and 2012 as the Fed flooded the system in response to the mortgage and financial crisis. It has continued to grow and is approaching an astounding $8 trillion.

In normal economic conditions, expanding the money supply on this scale would cause catastrophic problems. Inflation and a collapse of confidence are typical results as anything that increases that much is cheapened. The U.S. avoided this mainly through the fact that the dollar is needed for all international transactions, so our trading partners bought dollars needed for their economy. This kept the value of the U.S. dollar stable and helped the U.S. avoid facing any responsibility for the poor decisions.

 

 

This confluence of events gave freedom to the silliest Americans which includes our elected government officials. Fiscal spending increased at a record pace as any logic and accountability has been ignored. Our government debt continually sets records, and no elected official is doing anything about it.

As an example, Washington recently passed a $1.5 trillion spending bill with no effort to finance it other than increasing debt to over $30 trillion. (If we add unfunded government liabilities to this debt amount, we are well over $100 trillion in debt).  But as bad as that was, the real insult was that the 2,700-page bill was distributed in the afternoon and Congress passed it in the middle of that night. This means no one read the proposal let alone debated it. We truly have become a silly people.

The markets might be getting its fill of this silliness. Stocks and bonds have been declining this year and the turmoil might increase. Bonds yields have been moving up which translates into lower prices. The 10-year treasury closed last week above 2.7%. Last summer the 10-year’s yield was below 1.2% and the increase is beginning to be reflected in such things as mortgages.

The stock market had its worst quarter in 2 years to start 2022 and the selling has continued in April. Here is the year-to-date performance for the major averages as of last Friday, April 8th.

 

 

Financial asset prices are a function of the expected cash flows from the investment. The second derivative of this is the economic landscape under which the entity operates. Of course, the cultural stability impacts the economy which impacts the earnings potential of business. When a culture is dominated by silliness, it will be a headwind to the conditions of a strong financial system. It is the direction that we are heading and risks are increasing.