<August 23, 2023>
I had breakfast with an old friend last week. We talked about family, work, and sports—the usual stuff. He asked me how business was going, and I explained our strategy and positioning. He looked up from his breakfast and said, “You know, scared money don’t make money.” I responded, “That’s funny. Did you pull that from a Matt Damon crypto commercial?” He said he wasn’t sure but wanted to push my buttons regardless.
I drove back to the office thinking about the quote and how well it fits the current market cycle. After researching the quote, I learned it originated from the rap song, “Scared Money” by Young Jeezy and Lil’ Wayne. The Matt Damon quote I was thinking of, “Fortune favors the brave,” has a similar meaning—take risk and don’t be a wimp. And if name-calling humiliates you into taking risk, make sure you buy what’s being promoted, and don’t forget to hit the ask!
Given the current backdrop in financial markets, we believe more money should be scared. But it’s not. It’s carefree, bold, and fearless, just as Young Jeezy and Lil’ Wayne would have it. A recent Bloomberg article on fund manager sentiment noted, “Investors are the least pessimistic on stocks since February of last year, before the Federal Reserve began one of the most aggressive tightening cycles in decades.” Another Bloomberg article highlighted investor speculation, saying, “About 1.86 million so-called zero-day contracts tied to the S&P 500 changed hands Thursday, making up a record 55% of the index’s total volume.”
In our opinion, it’s one heck of a time to speculate and invest without concern. Equity valuations are extraordinarily expensive, especially based on metrics that smooth earnings, such as price to sales, market capitalization to GDP, and normalized earnings yield.
As equity valuations reach near-record highs, business fundamentals are showing signs of fatigue. After years of excessive fiscal and monetary stimulus, earnings growth is slowing. Interest rates are rising as the maturity wall of corporate and commercial real estate debt approaches. With the cost of borrowing increasing, more companies are favoring debt reduction over stock buybacks. The consensus view that interest rates will decline in 2024 is at odds with trillion dollar fiscal deficits, bulging debt issuance, and a structural shift in wages, productivity, and corporate pricing philosophies. Nevertheless, faith in the Federal Reserve and the return of easy money is providing investors with the courage to chase equity prices higher. Scared money? We don’t see it.
We recently completed our quarterly analysis of our 300-name possible buy list. Our bottom-up review supports our belief that the economy is slowing. The inflation rate is also slowing, but accumulated inflation remains a serious concern, especially for middle to lower-income consumers. Economically sensitive companies continue to work through healthy backlogs built during the stimulus-loaded years; however, new orders are less robust. Inventory destocking has reduced growth and put pressure on transportation and packaging companies. Employment trends are becoming less certain, with temporary employment firms reporting recession-like conditions, while many businesses are reluctant to fire full-time employees. Housing has stabilized even as affordability continues to deteriorate with higher rates and home prices. And finally, consumer companies are reporting mixed-to-weaker results, with consumables and the higher-end outperforming discretionary and the lower-end.
Based on our bottom-up analysis, it is becoming increasingly clear that there are two very distinct economies. There’s economy #1, driven by sharply higher asset prices, and there’s economy #2, driven by employment and wages. As economists and investors debate whether we’re heading for a soft, hard, or no landing, we believe the verdict is already in—economy #1 is booming and economy #2 is in recession.
Many of the companies we follow frequently discuss the two different economies. In its Q2 2023 conference call, Tempur Sealy (TPX) said its top-end customers were doing very well, while the lower end was experiencing sales pressure. Management emphasized, “The strength of the high-end customer was everywhere we looked,” and, “The low-end market is just not there right now.” Ralph Lauren (RL) had similar comments noting that they were “mindful of macro inflationary challenges facing our more value-oriented consumers” and that they were “more than offsetting softness from this cohort with growth in our full price businesses.” Pool Corporation (POOL) confirmed these dynamics, stating high-end pool construction demand remained solid. However, on the lower end, “higher interest rates and uncertain macroeconomic conditions continue to weigh on new pool construction.” In summary, economy #1 is sleeping well, sporting new designer threads, and relaxing in their luxurious pools! Economy #2, not so much.
In the two-economy system, a growing number of workers are beginning to realize they’ve gotten the short end of the stick this cycle. Wage growth has significantly lagged asset prices and the cost of living. It shouldn’t be surprising the working class is frustrated and disruptions related to inadequate wages and skilled workers are increasing. As workers attempt to regain the large amount of purchasing power lost over the past several years, strikes and wage concessions are increasing.
The rising cost of housing has been particularly troublesome for many workers living paycheck to paycheck. On August 17th, Bloomberg noted housing affordability reached its lowest point in nearly four decades! In The Wall Street Journal article, “Striking L.A. Workers Want Hotels to Help Build Affordable Housing,” the financial hardships of service employees were highlighted, including the ability to afford housing. The union believes they are “the tip of the spear” of the movement to take housing affordability into consideration when negotiating worker compensation. In other words, this is just the beginning.
Just as labor makes strides in regaining lost purchasing power, the Federal Reserve and Wall Street have been busy constructing another disinflation narrative. The narrative focuses on the recent decline in the rate of inflation while ignoring the large amount of inflation accumulated to date. Of course, one of the reasons the disinflation narrative even exists is how hot inflation was allowed to run a year ago (easy comparisons). Economy #1 approves. Economy #2 does not. Disinflation is still inflation and doesn’t help the working class pay the bills.
While the Federal Reserve says it remains committed to bringing inflation down to 2%, Chairman Powell recently signaled the Fed is open to cutting rates before its target is reached. Specifically, during his July 26, 2023, press conference, Powell said, “That’s the way I would think about it—you’d stop raising long before you got to 2% inflation, and you’d start cutting before you got to 2% inflation.” Economy #1 approves. Economy #2 does not. Bonds don’t appear in favor either, with 10-year Treasury yields increasing 43 bps since Powell’s press conference.
Scared money don’t make money. Maybe, maybe not. We’ve found it usually depends on where we are in the market cycle. Based on the rumblings in the bond market, we believe the bigger risk isn’t that scared money won’t make money, it’s that there's too much money! We’re reminded of another rap song (possibly the Fed’s theme song), “Mo Money Mo Problems” by The Notorious B.I.G. The Federal Reserve’s policies have been used time and again to promote financial stability (aka asset inflation), bailout the overleveraged, and forgive investors that overpaid. Whether it’s the bond market or economy #2 revolting, there are growing signs that mo money isn’t the solution, it’s the problem. Assuming this recognition continues to proliferate in the bond market, we expect and welcome a meaningful increase in scared money and opportunity.
Eric Cinnamond
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Definitions:
Wilshire 5000: The Wilshire 5000 Total Market Index, or more simply the Wilshire 5000, is a market-capitalization-weighted index of the market value of all American stocks actively traded in the United States.
S&P 500: The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
GDP: Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period.
Earnings Yield: Earnings for the most recent 12-month period divided by the current market price per share. The earnings yield can also be calculated by using the inverse of the P/E ratio.
Shiller P/E: A valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.
The ask: the price a seller is willing to accept for a security.
Basis points (bps): A basis point is a common unit of measure for interest rates and other percentages in finance. Basis points are typically expressed with the abbreviations bp, bps, or bips. One basis point is equal to 1/100th of 1%, or 0.01%.
Zero-day contracts: Zero days to expiration options, or 0DTE options for short, are options contracts that expire and become void the same day that they’re traded.