Q1 23 has ended with gains, with the NASDAQ index rising a robust 17%, the S&P up 7% and the DOW nearly unchanged for 2023. This is the second consecutive quarter of positive results as the S&P has moved from 3678 on 10-2-22 to close at 4109 on 3-31-23. This upswing is another step in the process of the bear market that began 15 months ago. See The Wall Street Journal markets page for a complete recap.
Joseph De La Vega’s “Confusion De Confusiones”, is the earliest known book on the trading and market behavior of practices of a stock market. “The expectation of an event creates a much deeper impression … than the event itself.”—de la Vega.
The market has been in an environment that perceives good news to be bad and bad news to be bad also, but better than good news. Slowing economic activity or “bad news” is what the federal reserve is looking for to reduce inflation. We are now over a year into the current rate increase cycle. The Fed has increased the Fed Funds Rate to 5%. The average fed funds rate since 1954 is 4.6% according to data provided by The St Louis Fed. The market is becoming hopeful that the rate increases may be nearing an end.
The rate increases themselves do not necessarily portend bad times, it is the uncertainty and expectations of additional bad news that elevates investor anxiety. Economic activity should adapt to higher rates and progress forward.
Bank failures and instability are definitely bad news. We have seen an inflection point of banking stress in the current interest rate increase cycle. The collapse of Silicon Valley Bank has sent tremors through the financial system. Banks serve numerous functions within our capital markets and these activities cannot persist without confidence and trust.
The rapid increase in interest rates has placed the fundamental institutions of the banking system in a vulnerable position. A wide range of banking strategies had been constructed in the post 2008 era of persistently low interest rates. The threat of inflation was always lurking, yet some bankers remained in a strategy for a low interest rate environment that had persisted since 2008. The pandemic then resulted in a new brand of disruptive inflation.
Removal of cheap money is now the primary challenge to markets and the economy. The Federal Reserve strategy of rapid rate increases is running into the fundamental plumbing of money. We all know what can happen when plumbing malfunctions.
The progress that has been made on raising rates is substantial. This is positive in the sense that we are reverting towards the average historical level of interest rates. There are significant arguments to be made that zero interest rates are a very difficult thing to transition away from. Cheap money has had dramatic consequences, most recently the parabolic upswing of general price levels and financial assets during the pandemic.
Bank failures may be an inflection point in the recent cycle of inflation data driving the Fed to take vigorous and rapid actions to push rates faster than anyone could have planned for. This singular focus on inflation will now be complicated by the potential for systemic instability.
The Fed cannot blast away without regard to the reality that normalization post-pandemic is a very difficult proposition for the economy. The extended period of below average interest rates is likely to take much longer to normalize than previous rate increase cycles given the nature of the long-time span of cheap money.
It is unfortunate that the Fed has pursued this path of blunt action after such a long period of the opposite. The narrative may now shift to one of rising criticism that the Fed has created a crisis with it’s aggression. This is all part of the challenge that central banks must face as the tools of policy are blunt and subject to unintended consequences.
There is now a “bailout” cry and accusation when it seems to be much more of process of backstopping the banking system. Banking architecture is built to protect itself against these problems that can disrupt confidence in the system. The solution is based on FDIC insurance and the added strategy of the banking system pooling the costs that are beyond the $250k insurance cap. This money is to protect depositors, and the system as a whole. It has been a stark demonstration of the depth and resilience of American banking.
There will be accusations and maneuvers for political advantages as the simplistic slogan of “no bailout” is much easier to broadcast than the nuance of defense against systemic panic. The actions taken for depositors of the recent failures are a legitimate cost to the banking system. The alternative is unknown, but likely dire.
For investors this should be viewed as part of the messy process in getting back to an economically viable interest rate environment. Ultra-low interest rates create distortions that allow too much money chasing supply. The mortgage rate that creates a balance between the cost of money and economic activity is unknown but sub 3% home financing is well below historical averages.
The Hedonic Treadmill is the psychological tendency for the human brain to return to a baseline level of contentment regardless of major positive or negative events. Life changes, promotions and loss are all subject to adaptation. This is a human strength that has likely evolved and permitted man to prosper in the face of relentless setbacks throughout our existence.
For investors, the human hedonic bias to take as given the higher and higher portfolio values of upswings drives all manner of irrationality. Overreaction to downswing, chasing exciting new ideas and frequent trading can all be behaviors initiated by the urge for numbers to grow ever higher.
Ignoring the hedonic urge is key to potential investing success. Our psyche is constantly adapting to gains and subject to the underlying assumption: investing = make money. During this difficult stretch in the market the conversation continuously has been focused on the setback from the high-water mark value. The peak is what our inner Hedone expects to see immediately.
High points in portfolio levels, economic activity and market indexes have historically been succeeded by a correction, downswing or just a time of no growth. Price levels can be pushed higher by overly optimistic demand for equities that often runs into difficulty. The recent cycle was driven by the unique fiscal and monetary support of the pandemic. Ironically, it is post-pandemic that has brought downward pressure.
A recent paper in the Journal of Human Behavior , “Negativity drives online news consumption” explores the natural human tendency to pay attention to threats and all manner of bad news. “News headlines containing negative language are significantly more likely to be clicked on, even after adjusting for the corresponding content of the news story”. This awareness of negative events has been one of the pillars that has allowed humans to survive and prosper. In the digital age, this bias is vulnerable to exploitation.
Modern information flow has a significant component that is locked in a race for clicks and engagement. Advertising supported by social media and television are particularly engaged and aware of how negativity, catastrophizing and fear mongering can build and retain audiences.
It has been said that the WSJ is so negative that if there was a cure for cancer it would sound an alarm regarding the impossibility of caring for so many more in our population. Barron’s, the sister publication of the Journal, has an endless stream of fear for your consumption. The March 27,2023 Barron’s displayed these gems:
“The US Is Scaring Off Foreign Investors. Is It Becoming Uninvestible?
“Stocks Keep Gaining. The Risks Keep Building.”
“The Floor Could Still Fall Out of This Market.”
“A Cash-Bond Mix May Let You Sleep More Soundly.”
“Diesel Drops. It’s an Economic Danger Sign.”
This is all on the home page of one weekly addition. Successful investors have always had to traverse this type of alarmist narrative. Capitalism solves most of the challenges of human economic activity, albeit in messy and unpredictable ways. Uncertainty is the same as gravity. It imposes a constant pull as infinite variables and billions of people make decisions every day. The phase, “things are uncertain now” should always be known without the “now”.
Here are resilient investor responses to this negativity:
The most dynamic, innovative and resilient economy is that of the USA. Avoid it at your peril.
The market has held up incredibly well in the face of extremely difficult post-pandemic challenges.
There is no floor to any prices, markets will do what they always have and anyone who expects stability will be tested. Persistence has historically been rewarded.
Sleeping soundly is based on eating well, getting proper exercise, and learning to quiet the mind. It should not be related to your investment strategy.
Fuel markets are all over the place, this is standard volatility. In the middle and long run it is likely to be noise.
To adopt Mark Twain, the scare is halfway around the world before rational perspective is out of bed.
A particularly stark insight into manipulative media is the current litigation between dominion voting systems and Fox News. The legal discovery has provided a glimpse behind the veil of one of the most successful global media companies. These conversations often are met with a refrain of, “yeah, but CNN.” That is like comparing McDonalds to Wendy’s. Fox has crafted a brilliant media product. Its political ideology is incidental.
Fox Pundit text messages that conclusively demonstrate cynical manipulation of reporting on behalf of “the audience” should be appalling to anyone concerned about the broadcast of noxious and utterly false narratives about our precious democracy and its functional legitimacy. This media business model has had a hand in the development of the new and novel idea of an “election denier”. These Political operators seek to raise money and build political brands without regard to the undermining of confidence in our democratic system.
Fox has an extremely profitable media product that upholds a persistent narrative. The depiction of good and evil is continuously reinforced. The nightly hosts churn out endless punditry that stays consistently within the binary of right wing good left wing bad. This media brings clarity and comfort to a world filled with complexity and randomness. Television is a blunt medium that has little time for nuance or diving deep into the complexities we face as a democracy.
There are many financial media and product marketing firms that seek to earn through exploitation of our bias towards fear, negativity, and the potential for protection. Former congressman and candidate for president, Ron Paul, has been predicting financial disaster for decades. He published a book in 1982 with the title, “The Case for Gold”. He has also merged these dire visions in partnering with newsletter operators and peddlers of gold sold to the public, often at significant markup.
The “Case for Gold” contains nonsense such as “all the effort and planning imaginable cannot make paper money work”. This was work on the behalf of a political stunt early in the Reagan’s first term to appoint a “Gold Commission”. This group sought to investigate the viability of a return to the gold standard that the US had suspended in 1973. As noted by the NYT, “The Reagan Administration has named a ”gold commission” made up of 17 men – most of them Government officials – who are to begin meeting soon to assess the role of gold in the domestic and international monetary systems, Treasury Department officials said today.”
The result of this effort was nothing, as any notion of Gold as the basis of a monetary system is snuffed by the rolling crises exhibited throughout history when economics are linked to gold metal that comes out of the ground. As the NYT Editorial board noted on 2-17-1982, “Those who argue for a gold standard are like people who think they can give up smoking by not buying cigarettes.”
Arguments for a gold standard have persistently circulated throughout modern economics. It may be wise to consider this empty fear mongering as the US dollar-based system has shown persistent resilience while creating a significant structural advantage for the United States.
During the upswing that ended December 2021, the hope would have been for a plateau in the level of a given portfolio strategy. This is rarely how markets work. “What goes up must go down”, has been disproven by the history of great companies that can continue to become more valuable over time. There are significant periods of challenge, stagnation and external shocks to the economy that produce downswing with frustrating upward moves that cannot hold.
During these periods there can be internal dynamics that are slowly strengthening a portfolio via dividend reinvestments. Share balances can be increased by dividend reinvestment, but they can also suffer in negative environments and are not guaranteed. During severe contraction in economic activity some companies may cut or suspend dividends in an effort to conserve company resources.
Companies like Visa, Starbucks, Costco and many others are the businesses that investors may seek to own long term. These high-quality operators have the potential to grow over the medium and long run. Wealth is likely to be created for the owners of quality companies. Downswings are simply part of the natural ebb and flow of the economic cycle.
The famous prediction of Peak Oil Theory is another in a long line of pessimistic projections that revealed nearly the opposite of their dark forecasts. Many dire prognostications fail to account for innovation and adaptation that always emerges. There is now the possibility that gasoline consumption in the United States has plateaued. The combination of rising fuel efficiency and the promise of electric automobiles is having a significant impact and the amount of oil needed to satisfy US demand.
There is a wealth of data provided by the US Information Energy Administration. Barron’s recently noted, “Americans used about 8.8 million barrels a day of gasoline in 2022, down from 9.3 million in 2019, according to the Energy Information Administration, the research arm of the U.S. Energy Department. The pandemic obviously complicated the picture, but recent stats have made the trend clear. So far in 2023, demand has continued to fall, dropping 1% from last year’s levels over the past four-week period. Increasingly, analysts see little chance of it ever rebounding to its previous highs.”
The opportunity of domestic energy channeled through battery and other electricity-based innovation has the potential to be a paradigm shift. These technologies have a monumental economic cycle ahead in the build out of the electrical grid, along with battery production and technological advancement. This transition will be challenging but the rewards to society are likely to be quite substantial.
According to the American Oil & Gas Historical Society, “American oil history begins in a woodland valley along a creek in remote northwestern Pennsylvania. Today’s U.S. petroleum exploration and production industry is born on August 27, 1859, near Titusville when a well specifically drilled for oil finds it. A former railroad conductor drilled it for New Haven Connecticut investors.”
In the era of petroleum, we have seen the massive creation of wealth by Rockefeller and Standard Oil along with Saudi Arabia and other major exporters. Our modern economy is platformed on oil and coal. The industrial revolution is not over. We may be living in a time where it is difficult to recognize how much development and breakthrough lies ahead. Electrification is likely to be just as impactful as other structural innovations.
Legacy energy generation institutions in coal, oil, and gasoline refining will mount all manner of effort to preserve their economic franchise. There has been significant economic incentive for the dissemination of information clouding the idea that fossil fuel has impacts on our air quality and the larger issue of global climate change.
Tobacco market operators argued for the harmless nature of a product that had adverse health qualities that they knew about for years until it was definitively proven, understood, and publicly revealed that smoking is anything but harmless. These types of narratives will be broadcast in defense of fossil fuels as the economics are exponentially larger than tobacco. Structural transitions are inherently difficult and the infrastructure for petroleum-based transportation systems have been developed and refined for over 150 years.
The rewards of this progress will only be apparent after long periods of innovation, investment and trial and error. In exchange for patience there will likely be great rewards for society, living standards and investors that hold title to ownership in the dynamism that is our capitalist future.
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I was recently lucky enough to compose a birthday card for one of my children that I have included below. As you all know I am extremely lucky as a husband and father, and I wanted to share the card with all of you. Feel free to use it as a template to give to someone that you love.
Each year we delineate the incredible path, talent and beauty of our dear (family member). This year we award a Certificate of Awesometicity.
It is awarded to a select few who grace us with Amazing Actions, Work Ethic, and Outstanding Presence in our lives.
This award is based on a very demanding set of qualifications based on traits and character dynamics:
Tremendous Lovability and Likeability
Work ethic, fitness and persistent efforts in self improvement
Personal qualities that deserve admiration and imitation
This certificate brings numerous benefits to (family member)
A future filled with achievement, positive developments and general awesomeness.
A lifetime of professional accomplishment, financial success and sophistication
Additionally, there are certain benefits that should be emphasized
Unlimited staycations at all Family real estate holdings, including airfare, ground transportation and all meals
Lifetime emotional support, recognition and unconditional parental / sibling love and support.
Perpetual bonds of this family of which you are a crucial component.
It brings us great joy to bestow the award upon you. Please always carry it with you as a reminder of just how incredible and precious you are, our incredible (family member)