Optimism? Really? Yes. Widespread media omens always occur just as the bad stuff ends. Why? Because the problems and the results are at their most obvious. In the stock market, when things are known, they are already priced in. It’s what comes next that is key. This time, a turnabout is in the works because those negatives carry important positives. So, get ready for optimism.
The three big negatives that are actually positives
Three negatives have been the root of widespread stock market omens. The stock market’s choppy foundation-building is the sign that positive reality is making headway.
- The Federal Reserve is not tightening – it is lessening its easy money policies
- Inflation is not uncontrollable and extreme – it is manageable and moderate
- The U.S. economy is not entering a recession – positive GDP growth continues
The Federal Reserve’s tough inflation talk is stronger than its actions. Interest rates, while no longer zero, are still below the inflation rate – the point at which “tightening” could begin. Until then, the Fed’s easy money machine continues to produce, albeit at a lower rate. Then there are those multiple $trillions the Federal Reserve “printed” by buying bonds with created demand deposits. The Fed has yet to start reducing that surplus money supply that still circulates.
As to inflation, the CPI headline 9.1% is inaccurate. In my last two articles, “Inflation: Scare Tactics With No Understanding” and “Inflation Dynamics Point To A Slowdown,” I explain how real inflation is much lower. The serious concern is the “fiat money” inflation rate – that is, the loss of purchasing power caused by excess currency. That rate currently is hidden by other rising prices coming from abnormal events and actions (Covid 19 repercussions, supply shortages and geopolitical disruptions). The rate is likely about 5% – the point above which the 3-month Treasury Bill “real” (inflation-adjusted) yield finally becomes positive again (it’s only 2.4% now).
That 5% level is also the point at which the Federal Reserve can actually begin to tighten – if it still wants to. Chances are, though, the abnormal price actions will have corrected, thereby driving down the reported inflation rate. If so, the Federal Reserve can claim success, and – more importantly – the capital markets will be back to setting interest rates without Fed interference.
Note: The Federal Reserve’s control of interest rates since 2008 should be viewed as an experiment. Not allowing the capital markets to do their job of setting prices (interest rates) for 13+ years has meant that this U.S. government agency has singlehandedly overridden capitalism’s key resource allocation process.
Now, about that recession talk
A popular major concern is that Fed tightening has preceded most recessions (albeit with differing time lags). However, as explained above, making money less easy is not tightening. Instead, it is a healthy slowing-down action for tempering speculative growth.
Cited now as proof a recession is in the works is that “real” GDP growth was negative in the first quarter and could be in the second quarter also. The popular view is that the dual quarter negatives define a recession.
Let’s deal with that popular view first. It is incorrect. The NBER (National Bureau of Economic Research) determines whether and when a recession happens after examining and evaluating all relevant conditions. Because no two recessions are alike, this evaluation necessarily takes time (many months) and uses both objective and subjective analysis. The time delay is why that shortcut, dual-drop “rule” was created.
Now to the calculation problem: Overstated inflation. This is a 3-step process:
- First comes the nominal calculation of GDP: $6.0 T (a 13% increase over the $5.3 T in the 1st quarter of 2021, and a -2.3% drop from 4th quarter 2021)
- Second comes the seasonal adjustment (SA) to smooth out the quarterly GDP growth rates that follow a regular, seasonal pattern: down in the 1st, sizably up in 2nd, moderately up in 3rd and sizably up in 4th. So, 1st quarter SA adjusted up to $6.1 T and 4th quarter SA adjusted down to $6.0 T. Those amounts changed the quarterly growth from the -2.3% nominal drop to a 1.6% SA rise
- Third comes the inflation adjustment to determine the “real” growth rate. This is where the problem lies. It was calculated by adjusting for the GDP “implicit price deflator” of 2% (over 8% annualized). That dropped the seasonally-adjusted growth rate of 1.6% to a “real” (0.4)%. However, that inflation adjustment has abnormal components comparable to the CPI. An accurate inflation rate of 6.6% or less would erase that negative result.
Note: The Federal Reserve’s preferred inflation measure is the PCE (Personal Consumption Expenditures) excluding food and energy. For the first quarter 2022, that rate was 1.27% (5.2% annualized). For comparison, the rate for the CPI excluding food and energy was 1.58% (6.5% annualized).
The bottom line: Optimism is coming, so own stocks
This slowdown is getting rid of excesses and the rising interest rates are bringing moribund growth drivers back to life – the many areas that were harmed by near 0% interest rates. As interest expense rises, borrowers will become more sensible. And as interest income rises, the economy will get a good boost from the holders of all those $trillions in short-term assets. Moreover, investors will once again have options that all produce returns equal to or greater than the “fiat money” inflation rate.
All the above means optimism is just around the corner, so it’s a great time to own stocks.