PART ONE:
Optimism:
The reasons for the Federal Reserve's aggressive rate hikes, which began in 2022, have paused:
The growth rate of Inflation has slowed to a reasonable level.
Short-term treasury rates have probably peaked.
The Fed Chair Powel said, "We have seen real progress on inflation."
The removal of a major unknown of aggressive rate hikes is great news for the stock market.
Therefore, the S&P 500 rallied.
For additional reading on our view of the Fed pause: Why the Fed Pivot is Metaphorically Immediate and Not a Process (fulcrumwa.com)
Our forecast for the S&P for 2024
Our forecast for the S&P for 2024 is a positive double-digit number, and we expect the S&P to be about 5353 by the end of 2024. We are assuming no Fed rate cuts and no resumption of Quantitative Easing. If either occurred, our assumed return might be too modest. Likewise, if the reasons for the Fed to raise rates aggressively resume (Inflation heating up too much), then we would be too bullish.
Aristotle defined virtue as the mean between two extremes: some call this the golden mean. Here, we assume virtue for the 2-3 percent economic inflation. Disinflation would be negative inflation growth and too weak; likewise, inflation, measured by the Consumer Price Index of 9.1%, is too hot. We assume inflation will be in the virtuous sweet spot for a while. So, do we throw caution to the wind? Of course not. While inflation growth has slowed, the growth rate of inflation could increase in the blink of an eye should there be rate cuts and a resumption of Quantitative Easing. Remember, not long ago, inflation was around 9.1%, and several banks had liquidity issues in the past year and are no longer in business. In the following pages, we will try to explain the action of our modern economic cycle and relate it to the speed and havoc of a cyclone.
Volatility Delta
In the last several years, we have seen the P/E ratio of the S&P go above 20, which is well above its long-term average. Facilitating this expensive valuation was the Fed having an extremely accommodating economic policy or very loose economic policy with the Fed fund rate near zero and Quantitative Easing (Q.E.). Q.E. is an increase in the Fed's balance sheet to accommodate liquidity at low rates. Now, the zero-rate policy is over, and the Fed rate is near 5%, and it is reducing its balance sheet called Quantitative Tightening. We believe inflation will remain a concern, even though the Fed is less hawkish. Therefore, we argue that there is a new ceiling on the S&P Price to Earnings ratio (P.E.), which will be about 20. However, we are not suggesting it is smooth sailing from here. Should inflation resume because of the wealth effect of a more profitable stock market and consumer optimism, the Fed may not cut rates as some expect and continue hawkish language. Should this occur, we could see the S&P sell off to a P/E of 17, implying a correction of about 18%. Nonetheless, our outlook for 2024 is a 12-plus percent growth rate of earnings for the S&P 500 and an ending price of around 5353.p
Slowing Inflation:
During the pandemic of 2020, the Fed infused a tsunami of economic stimulus. In turn, the stimulus brought high inflation, which caused the Fed to pivot from being extremely accommodating to being restrictive. The Fed set the brakes on the economy, and it brought a lot of volatility to the stock market.
The Fed in 2021 was facing inflation at historically high levels. Inflation measured by the CPI was 9.1 percent in June 2022. Today, the CPI is 3.2%. The PCE deflator reached 5.57% in February of 2022-unacceptable level as well.
Please see chart:
Data by Bloomberg; Chart created by Jonathan V. Bever
Gap Inflation:
How does the world's largest economy with a 20 trillion-dollar economy reach inflation of 9.1% and a real GDP about twice its average? Print a lot of money, lower interest rates to near zero, give the consumer confidence that there is no end to the stimulus, and let GDP soar to 5.92%.
See chart below:
Data by Bloomberg; chart created by Jonathan V. Bever
5.92% is about two times its trend of about 3.28, the blue line on the chart above. In summary, this GDP and inflation are too high, and to avoid a train wreck, they should be slowed to a sustainable level. We address this overstimulation in a prior blog:
The Fed Dot Plot
Why all the chatter and conviction regarding the Fed cutting rates in 2024? In 2022, the Fed began a rate hike policy, moving rates from almost zero to 5.25 percent in a matter of months. The speed of rate hikes shows just how concerned it was with inflation. Fast forward to 2023, and the Fed is considering cutting rates next year, which you can see in the Fed Dot Plot: Implied Fed Funds Target Rate. You can see why there is much anticipation of a series of rate cuts in 2024.
Data by Bloomberg; Chart created by Jonathan V. Bever
Avoiding Economic Recession
Further, if we look at the Fed target rate for the 5-year treasury yield, we can see a correlation- an indication of recession. Historically, when the Fed rate gets above the 5-year treasury yield, it is a harbinger of a recession in about a year. So, either the 5-year Treasury yield goes higher, or the Fed rate goes down, or we enter a recession; then the Fed lowers rates. As Inflation slows, we don't see the 5-year treasury yield going higher. We argue that avoiding a recession makes more sense; therefore, the Fed will likely cut rates.
Please see the chart below:
Data by Bloomberg; Chart created by Jonathan V. Bever
Cyclone of Inflation/Deflation
A massive force is causing the natural economic cycle of expansion and contraction to offer a bigger punch than ever before in history. As a result of the Great Financial Crisis of 2008/2009, the Fed added a tool called Quantitative Easing (Q.E.). It can now increase its balance sheet to accommodate the economy at a low-interest rate, which it can set by policy, thereby aiding an economic boom. On the other hand, its ability to slam the brakes on and slow down the economy to bust Inflation can be done swiftly. This is an incredible economic tool. However, the unfortunate result of the Fed putting the brakes on the economy was the stock market volatility of 2022 as stocks had an earnings recession. Value investors were likely rewarded by having less volatility than growth investors.
The Fed's shift from being extremely stimulative to being extremely restrictive in a relatively short period is like going through an economic cyclone. Financial damage can ensue, and weak financial structures can crumble. Will the speed of rate hikes, rate cuts, increases, and decreases in the Fed balance sheet be a new normal? As we do not know, we suggest you do not get too comfortable in your Fed outlook.
Crude Oil
Crude oil prices spiked in 2022 when Russia went into Ukraine. Nonetheless, we argued in 2022, when the Fed is about to pivot, that we would not advise being overweight oil. The Fed pivots when the economy has slowed and inflation moderates. A slowing economy implies less consumption of oil. Further, high oil prices can be seen as a tax on the economy. High gasoline prices take billions out of the consumers' pockets, thereby removing the discretionary spending power of the consumer and slowing the economy.
Crack Spread
"A crack spread refers to the overall pricing difference between a barrel of crude oil and the petroleum products refined from it. It is an industry-specific type of gross processing margin. The "crack" being referred to is an industry term for breaking apart crude oil into the component products, including gases like propane, heating fuel, and gasoline; light distillates, like jet fuel, intermediate distillates, like diesel fuel; and heavy distillates like grease." Investopedia.
In 2022, with the global events, crude oil prices, the crack spread, and gasoline prices spiked. There is a levered effect and correlation to the consumer regarding the gasoline price. Higher gasoline prices take billions out of consumers' discretionary spending.
Please see chart: top line-Crack Spread; second line-Average Gasoline Price; third line- West Texas Crude:
Data by Bloomberg; Chart created by Jonathan V. Bever
Blog Part II
We will transition from the factual economic data environment that some may find tedious to wade through to a different part of the imagination, the world of fairy tales. Some fairy tales capture metaphors of the economic environment we are in. The Wizard of Oz by L. Frank Baum arguably is an allegory to the evils of Inflation and the necessity of an economic policy that can accommodate people living in the North, South, East, and West in the U.S. This policy would have to include a silver standard or, as we interpret this as a loose monetary policy as well as a tight monetary policy which we interpret as a gold standard. One standard without the other can lead to an economic imbalance.
The Wonderful Wizard of Oz by Lyman Frank Baum
The Wizard of Oz is an American classic work of literature published in 1900. In 1939, a movie based on the book came out with the same title. The main character, Dorothy, grew up in the Kansas prairies and lived in a house made of wood. Winds from the north and south blew, and a cyclone developed, lifting Dorothy's home and her dog Toto. They ended up landing in a magical land called Oz. Her house landed on the Wicked Witch of the East, and Dorothy acquired her silver shoes (not ruby slippers as in the movie). The Munchkins who lived there were very grateful to Dorothy. "We are so grateful to you for having killed the Wicked Witch of the East and for setting our people free from bondage." We are going to make the argument that "bondage" is a reference to financial bondage.
Most of us know this story from the movie; however, there are differences between the book and the film; we recommend reading the book as there are nuances that are not in the film. These nuances can be interpreted as the author Frank Baum making a statement about U.S. monetary policy while telling a wonderful fairy tale.
Dangers of a Gold Standard
"The Wizard of Oz is a story about the dangers of a gold standard."
"The Wizard of Oz film was based on an L. Frank Baum's novel, was published in 1900 amid political tension in the U.S. Previously, the Coinage Act of 1873 had effectively stomped out the policy of bimetallism in the U.S. As a result, if you held silver bullion, you could no longer use it to make U.S. coins. This was followed by an economic depression and a rallying cry from many Americans to bring back bimetallism." Big Think
The Gold Standard Act
"The Gold Standard Act was an Act of the United States Congress, signed by President William McKinley and effective on March 14, 1900, defining the United States dollar by gold weight and requiring the United States Treasury to redeem, on-demand and in gold coin only, paper currency the Act specified.[1]
The Act formalized the American gold standard that the Coinage Act of 1873, which demonetized Silver, had established by default. Before and after the Act, silver currency, including silver certificates and the silver dollar, circulated at face value as fiat currency and was not redeemable for gold.[2]” "Wikipedia
The Wizard of Oz was published in 1900, about the same time the U.S. switched from a silver currency standard to a gold standard. You might be surprised to hear it is an attack on the Gold Standard while telling a wonderful fairytale. Dorothy acquires the silver shoes from the Wicked Witch of the East and defends and defeats the Wicked Witch of the West. These silver slippers finally took her home to Kansas. Silver can be taken as an antidote to Inflation and the evil witches. The bad witches represent being under the spell of economic slavery because of inflation.
There are four witches in the land of Oz. The witches of the North and the South are good, and the witches of the East and West are evil. The Good Witch of the North kisses Dorothy's forehead to give her a mark of protection and sends Dorothy and her dog down the yellow brick road toward the Emerald City. Along the way, she meets three companions who travel with her: the Tin Woodman (who wants a heart), the Scare Crow (who wants a brain), and The Cowardly Lion (who wants bravery). Their goal was to return Dorothy home to Kansas.
Some assume the yellow brick road is a metaphor for gold or the path of a gold economic standard.
Interestingly, before being allowed entry to Emerald City, one must wear green glasses, which is why everything is green. This could be an analogy of the money printed by the U.S. treasury or even forecasting the Federal Reserve printing fiat money.
The Fed Reserve was created in 1913. The Great Depression would arrive in 1929. The gold standard was abandoned in 1933.
The Tin Woodman
The Tin Woodman is a sad figure in The Wizard of Oz. "There was one of the Munchkin girls who was so beautiful that I soon grew to love her with all my heart. She, on her part, promised to marry me as soon as I could earn enough money to build a better house for her, so I set to work harder than ever." However, the Wicked Witch of the East put a spell on him, and he ended up cutting off his arms, legs, and heart. Ultimately, he lost his love for the Munchkin girl, so sad.
He was a woodsman by trade. Houses are made of wood, so why was it so difficult for a woodsman in the Land of Oz to chop down trees and make a home like the one Dorothy was living in Kansas? A simple answer: the Inflation under a gold standard- is very high. He gave an "arm and a leg" to buy a home. Let's compare the Tin Woods man's pursuit to the pursuit of the good life; you can put in whatever that means to you. We call it the American Dream.
Gold Standard Advantage
"According to historian Alan Gevinson, these folks felt that the gold standard was the best way to keep the dollar stable, maintain a competitive marketplace, and promote economic liberty. On the other hand, Silverites felt that currency should be redeemable in gold and Silver. Since Silver was more easily accessible, the idea was that "free silver" could create a more flexible money supply. They hoped this would lead to a fairer economy and much-needed social reforms. Big Think
The gold standard came with certain benefits. For one, it helped curb Inflation because banks and governments had little influence, if any, over a nation's money supply. That runs counter to the way things are done today. However, the gold standard also had its drawbacks. Gold proved less flexible in the face of challenging economic conditions — a reality that took center stage during World War I. The Great War sent European financial systems into a tailspin. As a result, the U.S. dollar became a more prominent global currency as many nations abandoned the gold standard to navigate massive military expenditures. Big Think
As Silver is more common and almost everywhere, it was like having a loose monetary policy. Gold is scarcer and mirrors a tight monetary policy.
If there is only one policy, then it would be at the expense of one party in perpetuity and to the benefit of another for perpetuity. This would not be fair. Again, it is better to have tension between two extremes for balance and fairness. As we mentioned, virtue is a balance between two extremes.
The Fed can act Metaphorically like a Silver Standard and Metaphorically like a Gold Standard.
We argue the money printed by the Fed is magic money. This magic money works. In effect, the Fed can move its economic needle in the direction of the "old Siver Spanish model" or toward the Gold Standard. Spanish Silver: easing of monetary conditions. Gold Standard: tightening of monetary conditions. Easing of money supply (Spanish Siver) is stimulative. Tighten economic policy (gold standard) tightening economic policy. This analogy shows the ongoing tension the Fed must balance between economic boom and bust, recession and prosperity, high inflation, and deflation, and between two extremes, which is a virtue. (For more reading on the Gold Standard Act, please go to the end of the blog.)
Is there one economic policy that is the cure for all? If there is, then it is probably one that has tension between two extremes. Baum seems to be pointing out that tension between a silver standard (easy monetary supply and a gold standard a more restrictive monetary policy) is a good thing—one without the other leads to extremes and economic bondage. Today, we have neither a gold nor silver standard in the old sense. However, maybe we do it in a more abstract and practical sense.
We believe Baum is making a monetary statement about the harm of only having a gold standard. So, before turning your gold into a golden calf, we recommend reading the Wizard of Oz.
Cyclone Index
Created by Jonathan V. Bever
Bringing Kansas and the Land of O.Z. together
It's not until Dorothy frees "Silver" by beating the two evil witches that she is able to return home to Kansas.
We may idealize living in a country like Kansas or a big city like the Emerald City, but each has pros and cons. Living on a farm is a lot of hard work, and living in the city has a lot of Inflation. We have a complex fiat currency system, a Fed Bank to help with the money supply, and an economy much more significant than probably imagined in 1900. The Fed can replicate a restrictive economic system like a gold standard and offer a less restrictive economy, increasing liquidity like a silver standard. While we are "not in Kansas anymore, Toto," perhaps we finally have the right mix of economic magic to last a long time.
We want to help you pursue your version of the American Dream without giving an arm and a leg to Inflation or losing your home in an economic cyclone.
We don't want you to become the Tin Woodsman, giving an arm and a leg to pursue the good life, the American Dream, and end up losing your heart. Likewise, we don't want you to be a Munchkin held in bondage by the wicked witch of Inflation.
People do learn to live with cyclones and other adverse weather. Nature is not evil, but it is something we must adapt. You may not like the weather, but you must dress appropriately.
Additional reading:
The Gold Standard Act
The Gold Standard Act was an Act of the United States Congress, signed by President William McKinley and effective on March 14, 1900, defining the United States dollar by gold weight and requiring the United States Treasury to redeem, on-demand and in gold coin only, paper currency the Act specified.[1]
The Act formalized the American gold standard that the Coinage Act of 1873, which demonetized Silver, had established by default. Before and after the Act, silver currency including silver certificates and the silver dollar circulated at face value as fiat currency not redeemable for gold.[2]
The Act fixed the value of one dollar at 25.8 grains of 90% pure gold, equivalent to about $20.67 per troy ounce, very near its historic value. American circulating gold coins of the period comprised an alloy of 90% gold and 10% copper for durability.
After the realigning election of 1932 following the onset of the Great Depression, from March 1933 the gold standard was abandoned, and the Act abrogated, by a coordinated series of policy changes, including executive orders by President Franklin D. Roosevelt,[3] new laws,[4] and controversial Supreme Court rulings.
The history of the United States dollar began with moves by the Founding Fathers of the United States of America to establish a national currency based on the Spanish silver dollar, which had been in use in the North American colonies of the Kingdom of Great Britain for over 100 years prior to the United States Declaration of Independence. The new Congress's Coinage Act of 1792 established the United States dollar as the country's standard unit of money, creating the United States Mint tasked with producing and circulating coinage. Initially defined under a bimetallic standard in terms of a fixed quantity of Silver or gold, it formally adopted the gold standard in 1900. Finally, it eliminated all links to gold in 1971.
Since the founding of the Federal Reserve System in 1913 as the central bank of the United States, the dollar has been primarily issued in the form of Federal Reserve Notes. The United States dollar is now the world's primary reserve currency held by governments worldwide for use in international trade. Wikipedia
The Wonderful Wizard of Oz. By Lyman Frank Baum.
Definitions
S&P 500, or simply the S&P, is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices, and many consider it to be one of the best representations of the U.S. stock market. Wikipedia
Consumer prices (CPI) measure prices consumers pay for a market basket of consumer goods and services. The yearly (or monthly) growth rates represent the inflation rate. Bloomberg
PCE deflators (or personal consumption expenditure deflators) track overall price changes for consumer goods and services. Deflators are calculated by dividing the appropriate nominal series by the corresponding real series and multiplying by 100.
The preferred measure of core inflation in the United States by the Federal Reserve is the change in the core personal consumption expenditures price index (PCE). This index is based on a dynamic consumption basket. Before that, the inflation outlook was presented in terms of the CPI. Wikipedia
Central bank balance sheet
The central bank balance sheet is one of the forms of reporting by the country's central bank, which reflects the state of its allocated, borrowed, and owned funds as of a specific date.
The central banks of most countries in the world calculate and publish balance sheet data monthly (for example, in Austria, Japan, Poland, Russia, Luxembourg, the Netherlands, and Mongolia). In a number of countries, the central bank balance sheet is published quarterly (for example, in Estonia) and weekly (in Australia, the Eurozone, the U.K., and the USA).
Today, the balance sheet is actively used by central banks in their monetary policy, in particular, in the formation of its transmission mechanism.
The central bank's balance sheet consists of assets and liabilities. The table below shows the classic structure of a country's central bank balance sheet. Cbonds Glossary.
The Fed Balance Sheet
4.1 report provides a consolidated statement of the condition of all the Federal Reserve banks in terms of their assets and liabilities. It lists all assets and liabilities, providing a consolidated statement of the condition of all 12 regional Federal Reserve Banks. May 11, 2020 Investopedia