A Nightmare on Wall Street

Good Afternoon,

Fintwit and market news had a week about as contradictory as unemployment and inflation this year. Markets are slumping so much that they gifted you Credit Suisse/Lehman comparisons and Elon Musk entering his merger arbitrage era. Unemployment is a leading indicator of a recession, so tomorrow's unemployment report is leading the debate. Let's dive in. 

Bottom Line Up Front

Contribute something new to the news you’ll coffee chat over 

• Elon's buying Twitter...still. For the same initial price two quarters ago. His legal team's billable hours were reported to run over $1 billion.

• Peloton plans to cut 500+ jobs in attempts to "save" the company, announcing the news the same week as its partnership with Hilton. It's true Paris Hilton energy, who took Kim K to her first spin class when Kris Humphries' ex was just Hilton's closet organizer.

• US mortgage rates slipped to 6.66%. This joke wrote itself.

But first, a quick note from The BAD Investment Company.

Tired of ESG Bullsh*t? Fortunately, there's a money manager that decided that B-A-D might be the better acronym for investors.The BAD ETF (NYSE: BAD) launched last December and is taking a different stance in this green washed world focusing on 3 industries for which the ticker represents – B-A-D. 

• Betting – Casinos, gaming, and online gaming operations – 33%

• Alcohol – Alcoholic beverage manufacturing and distribution – 23%

• Drugs – Pharmaceutical and biotechnology product development and manufacturing – 33%Cannabis cultivators & distributors - 10% 

The case for these BAD industries remains strong for a simple yet important reason – they have historically offered attractive risk-adjusted returns. In addition to these industries overcoming government scrutiny, these industries have shown resilience during economic downturns because people tend to indulge in their vices, or what some call hobbies.  

As a result, we believe these asset classes are typically underappreciated and therefore under-valued but the reality is that people will continue to consume alcohol, gamble, and need medicine in good times, and in BAD.  

In regards to the betting and cannabis aspects, as these industries become more widely accepted socially and legally, they may offer investors additional growth as more states look to legalize those industries for additional tax revenues.

Learn more about the BAD ETF fund details and sign up for our mailing list to get the latest fund insights and information.

Deep Dive: The Fed's Recessionary Sneaker Drop 

Inflation readings have yet to show slowing in previous month’s data. That is about to change. 

On Wednesday, ADP’s monthly employment report disclosed the U.S. private sector added 208,000 jobs in September. This release was notably above forecasts. Markets raced up surrounding the report, but by Wednesday, the S&P 500 pulled back 0.5%. Prediction markets have priced in the outcome of Friday’s jobs report. Let’s examine the broad-sweeping effects. 

Bottom Line Up Front

• Once inflation spikes above 5%, on average, it takes at least 10 years to bring inflation down to the Fed's target of around 2%. Examples in recent history include Greece, where it took 28+ years. In the 1980s, it took Italy, Portugal, and Spain approximately 16 to 18 years. 

• There is a direct, significant correlation between inflation rising above 5% and the time horizon it takes to decrease thereafter. Thus, it may take substantial time to get back to the 2% level that the Fed wants inflation to be.

• Jerome Powell continues to signal the Fed is going to act aggressively. Correspondingly, investors were treated favorably in a long, bull market. 

Therein lies the divergence that is playing out in the capital markets at present. Although the Fed continues to emphasize they will be and remain aggressive in tightening, capital markets are not fully listening. 

Pay Attention to This

Powell’s aim to have real rates positive across the “entire” yield curve” is a warning sign to investors. Prediction markets approximate the U.S. will be running around six and a half percent inflation. Should this play out, returns across portfolios will scarcen. 

Let’s take a back-of-the-envelope analysis on 6.5% inflation, with the 10-year treasury yield needing to be at minimum 6.5%. What type of equity premium would you put on that for equities – close to a couple hundred basis points? Then, what would that make the multiple of the S&P 500? Thus, you end up with approximately an 12.5x earnings multiple as opposed to a 19x multiple. That's a big gap. 

Yet equity markets have not come close to pricing in long-term inflation. This poses a scary situation for capital markets. 

Heading into Q4, one would expect capital markets to, if they reflect the sentiments of the Fed, go down from where they are currently. Thus, they could be headed for another slump in terms of performance moving forward. Yet another notable occurrence last week was big banks’ CEOs coming in front of the Congress. As expected, they were grilled on the economic growth rate slowing down this month. In various pockets, and specifically the housing market, they are now seeing a significant slowdown. 

Forecasting the Full Force of a Recession

Much of the current generation of investors has yet to experience the full force of a recession, notably the Great Recession of 2008. It comes at no surprise that the Fed is trying to engineer an economic slowdown. This would allow the Fed to, correspondingly, slow down inflation. What they are ready to accept, and what investors should prepare for, is as follows: 

• A slowing economy

• A higher unemployment rate

• Maintaining tighter monetary policy

• Restrictive monetary policy

Each of which should be expected to remain for a prolonged period of time. 

Although we have yet to officially enter a recession, most asset classes have been hit relatively hard. The Federal Reserve is executing on its most aggressive rate hike sequence since the 1970s. And it is doing so from an extremely accommodative starting point, applying it to an economy addicted to debt.

Naturally, this hike will sting and assets are reacting to it accordingly. Year-to-date, asset classes have been on the move: 

• Risk assets have been hit by quantitative tightening. 

• Bonds have been hit by the Fed hiking rates. 

• Currencies have suffered from a strong dollar and random local monetary policies. 

• With the one exception being gold.

All that in the name of dealing with the highest level of inflation since the 1970s.

Investors know this will end poorly. The Federal Reserve will stop when the main concern shifts from inflation to unemployment. This year has seen a robust job market, which means the Fed will continue to tighten. 

What Next 

Stocks can rally as unemployment climbs: Around the last nine recessions, the S&P 500 (green line) and the unemployment rate (purple line) moved. As the U.S. labor market cools, there are many instances in recent history when stocks rallied as the unemployment rate climbed for months. It further serves as a reminder that stocks are a discounting mechanism, pricing in what’s expected to happen and not what’s currently happening.

We could be at the bottom. Or we could go much lower.

For long-term investors, time in the market matters more than timing the market. It will pay to remain invested and balanced precisely when it is most difficult to do so. 

Lit's Pick

Bearish on 100 year-old West Village apartments with no heating going into this winter. That's why we're taking the odds that the mortgage rate will be >7.0% by the end of the year for $0.65. That's all for today, have a great weekend!

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