I’m not sure I recall seeing so many different takes on the Street in the last few years as investors try to assess what is likely to happen in markets and the economy over the next 12-24 months.
On one hand, you have the camp of the bulls. This camp believes that the economy is/will undergo a mild recession. They think that this ‘mild’ recession will do enough to slow consumer demand to allow for inflation to stop accelerating. They also believe that once inflation cools down from this mild recession, it will start to go away in its entirety, almost completely on its own. They also think the recession will be quick and painless as well. That is why they are bullish on the US stock market. They think that inflation will go away on its own, and thus the Federal Reserve will not have to go crazy with interest rate hikes and Quantitative Tightening. That will give room for the stock market to make new all-time record highs, especially the growth stocks that have been beaten down over the past year.
Then on the other hand, you have the camp of the bears. This camp believes that the economy is relatively strong, and thus think inflation will not slow down without serious Federal Reserve intervention. They believe that since the economy is strong, inflation is only going to moderate if the Fed continues raising interest rates at a sharp pace to combat inflation. This would be bearish for US stocks, most predominately growth stocks as a lot of growth businesses have models that rely on low interest rates to continue to grow their revenues. Also, growth stocks are worth the present value of all future earnings, discounted to the current interest rate in the economy. Thus, interest rates going up means that growth stock valuations must come down, all else being equal. Those in the bear camp believe the best move is to sell most of your holdings, and go to cash. After all, if the Fed is going to raise interest rates, and that is going to get inflation to slow, cash becomes more valuable. Cash especially becomes more valuable if it generates a higher yield while stock prices are falling.
Then there is a third camp - this is the island you will find me on with a few other lonely investors. This is the stagflation camp.
What if everyone has it all wrong here? Is that even possible? Well its happened before. Everyone had it wrong going into the 2008 Financial Crisis. Everyone had it wrong in the dotcoms. Remember Enron? Lehman Brothers? Those were two of the most highly touted blue chip companies on the planet at one time. Never underestimate the power of crowds, and just how wrong crowds can be.
When it comes to stagflation, the term describing an economy in a severe recession with rising inflation, it has only happened once in the history of the United States, the decade of the 1970s. Prior to the 1970s, mainstream economists did not believe ‘stagflation’ was even possible. In hearing most investors, both from the bull and bear camps speak today, it is extremely evident that everyone has accepted the 1970s as a one-time fluke.
For those of us in the stagflation camp, we believe one part of each narrative from the bull and bear camps. My view on one hand is that the bears are correct to believe inflation is going to continue to worsen if the Federal Reserve does not intervene and start hiking interest rates dramatically. What they have wrong, and where I agree with the bulls, is that the Federal Reserve will not continue its inflation fight much longer. The Fed pivot the bulls are anticipating is in fact coming.
But the bulls are right for the wrong reason. They think a Fed pivot is coming because inflation will go away by the end of the year. A Fed pivot is not coming because of an end with inflation, but because the economy will continue to weaken moving into the fall months. Now here is where the bears are wrong - the economy is not strong. In contrast, it is incredibly weak. We have gotten numerous economic data points which suggest so in the beginning of the third quarter. That is why the Fed does not have the tools necessary to fight inflation, because the economy cannot handle interest rates much higher than the levels we are at now. In fact, it is reasonable to believe the economy can’t even handle the 2.5% increase in rates we’ve has since last year. That is why stocks are in a bear market and the economy contracted for two straight quarters. Most middle and lower class Americans have only been making ends meet by using lifelines like credit cards, personal and auto loans along with many Americans using equity lines of credit on their homes. If it becomes much more expensive to service those debts, the consumer will get even weaker from here as their income is not enough for them to be able to afford the much higher cost of living we are experiencing now.
So if I see a Fed pivot coming, why would I not be bullish on US stocks? Well, I am in one way. I am bullish on value stocks. Growth stocks, which comprise most of the US stock market as a whole, will get crushed under the upcoming Fed pivot. Again, growth stocks are worth the present value of all future earnings discounted to the current real interest rate, accounting for inflation. Thus, if the Fed chooses to stimulate the economy at the expense of allowing inflation to continue to accelerate, as I believe they will, growth stocks will get crushed. We also have to account for a loss in earnings for a lot of businesses as we head deeper into recession. Now I think overall earnings may hold up for a majority of corporations somewhat, because businesses have shown a great ability to execute by passing higher costs onto their customers. Higher inflation will mean in general terms that revenues for businesses will be higher, especially if the Fed doesn’t work to create the demand destruction necessary to fight inflation.
That is why I want to own value stocks. If inflation will continue, and real interest rates will keep falling even as nominal interest rates keep rising (very bullish for gold), you can’t hold cash like the bears are suggesting. You certainly can’t own the highly speculative growth part of the market, and bonds are return-free risk. Value stocks however are likely to do fairly well in the next 12-24 months as most of the value-stocks sell products and services people need, and thus have the pricing power to raise prices, and provide their shareholders with more future profits. Even if the stocks themselves do not perform well, the businesses are likely to perform well, which means higher dividends and more share buybacks in the future. Besides, wen you own value stocks, you get paid income from your dividends in the good times and the bad, and you’re essentially getting paid to wait for the market to turn in your favor. It is easy to see in the action from yesterday and this morning that investors are starting to show a preference for value stocks. This screenshot below was taken at 11:00 AM EST.
Let’s take a quick look at Target earnings from yesterday. Here are the major bullet-points from CNBC’s website:
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