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All About the Fed

Written by Briton Ryle
Posted November 5, 2018 at 3:09PM

It's been said that the four most dangerous words for investors are “it's different this time.”

The simple fact is that while history may not repeat, it does rhyme. And so extrapolating a few unique data points into a sweeping conclusion that the rules of investment have changed is a recipe for disaster. 

Usually, investors start revising market history to justify buying stocks and pushing valuations higher. At the turn of the 20th century, the internet was changing everything. Six years later, it was housing prices that could never go down. Today it's the “cloud” that's changing everything. Even though “cloud” is just a different word for “internet”...

But I guess there you have it. Put a different word in there, and it really is different this time...

Now, don't get me wrong. As much as I've made fun of the whole concept of the cloud, it is a big deal. The anecdotal evidence is the ease with which we now stream movies and order food. But these services represent a massive investment in software, data centers, semiconductors, servers, etc.

It's what you call a bona fide investment trend. It's not just investors buying stock. It's big companies spending big money. Like all trends, it will end at some point. The pace of investment will slow, as will profit growth.

Sorry, I can't tell you exactly when that will be. I mean, it's not that I know and just won't tell you. Just last week, IBM spent a bunch of billions to buy Red Hat because that company is apparently critical to its cloud strategy.

Personally, I think buying Red Hat is critical to IBM's “please believe we are doing something and don't fire us” strategy. The jury's still out, obviously, but this is the first cloud buyout that really seems like a bad investment.

And that's one way you can start to gauge when a bona fide investment trend is getting long in the tooth: Companies start spending money that has no hope of generating ROI, just to placate investors.

Like, remember when that iced tea company changed its name and business model to "blockchain" when Bitcoin and the other cryptos were running? Yeah, that. It's that kind of behavior that should always have your B.S. detector pinging like a Geiger counter at Fukushima. 

Funny thing, though: I hadn't planned on writing about the cloud today. (Though by this point, we all know how willing I am to get carried away by a tangent.)

My goal today was to explore what I see as the four most dangerous words in investing: It's all about the Fed.

Dammit, That's Five Words

Ask a pundit, talking head, or guru why the market had its worst month in seven years, and they'll tell you it's the Fed's fault. In a nutshell, the Fed is doling out the double-whammy: raising rates and lowering its balance sheet at the same time. This is putting extreme pressure on bond yields, making debt more expensive.

Think of it this way: By the end of 2018, U.S. corporations will have bought back $1 trillion worth of their own stock. Same as last year. Same as the year before that. And the year before that...

And, of course, companies are borrowing money to fund these buybacks. Now, it's important to understand that Apple, for instance, has the cash to buy a whole lot of stock. Apple borrows because it makes sense to borrow at 3% (or whatever) and let the cash on your balance grow at a higher rate. 

Clearly, if borrowing costs rise, then this whole rosy buyback scenario changes. And I don't think stock prices will like losing a trillion in buying pressure. 

The bigger issue is the specific reason investors are clamoring for the Fed to stop hiking rates. (I mean, other than that they really like it when the market is all upside, no downside.)

Dear Goldilocks, Thanks! Sincerely, The Bears

Everybody's looking at the inflation/employment picture and thinking there just isn't a solid case for continuing rate hikes. Here we are with the unemployment rate darn near all-time lows at 4.1%... and inflation is barely over the Fed's 2% threshold. And so the logical pundit/talking head/guru asks, “Why hike rates when there's barely any inflation?”

It makes some sense — at least if you don't think about it.

Do you know how many times the U.S. economy has run with sub-4% unemployment and sub-2% inflation for more than a couple years? Exactly zero times.

Investors are telling the Fed that it's different this time. Oh boy. Isn't this article titled “All About the Fed”? 

Why yes, yes it is. And here's why...

The Fed's unemployment and inflation projections are calling for 4% and 2% — for the next three years (through 2021). And yet Fed Chair Jerome Powell says he will keep hiking rates. Ummmm...

Powell needs to make up his mind. Either inflation is ticking up and so rates have to rise, or there's no significant change in the inflation picture and rates can stay where they are. 

It's actually investors and the market that are right. Powell should stop hiking rates. And fortunately for everyone, I'm available for the next few minutes to explain why. 

We really shouldn't be talking about unemployment at 4%. Because 4% understates the number of people who aren't working. Let's go to a chart...

Click Image to Enlarge

The truth is, the U.S. economy is nowhere near full employment. To get there, the U.S. economy has to add, like, 10 million jobs. So while we wait around for HR departments to write up a bunch of new job descriptions, let's think about the possibility that the real unemployment rate is at least 10% higher than currently reported. And that it's very likely to keep a lid on inflation growth going forward. 

Fed Chair Powell should also take a look at slowing Asian industrial growth, and his own group's estimates for U.S. GDP growth. Seems to me we've seen the peak U.S. GDP in the second quarter at 4.2%. Q3 was 3.5% (and relied almost solely on increases in government spending, and CAPEX was only up 0.8% — thanks for the corporate tax cut!). 

The Fed says GDP will grow 2.5% next year and 2% the following year. And yet Powell wants to keep hiking rates. Sheesh. 

Now, here's the thing: I think Powell has probably gotten the message. I think the market signaled a shift in rate hike outlook last week. Select buying is the way to go for a solid year-end rally.

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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