Any Reasons for Investor Optimism
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David Edwards:
Welcome, everybody. It's June 19th. We're going to do about 15 minutes of questions from Buff that were submitted previously. And then if a few more questions show up, we'll check in on those as well. Buff, why don't you jump right in with the questions came in so far?
Buff Parham:
Yeah. A little history, inflation in the 70s continued at a high rate for a long period of time and it resulted in stagflation. Eventually stagflation was only curved by Volcker taking the Fed interest rates really high, which causes severe recession. Coupled with Reagan's tax cuts, all of that eventually helped us jumpstart the economy and overcome the recession. That's the precedent we're working with. What do you see as the prospects for a similar period of extended stagflation, recession, and stock market declines adjusted for inflation?
David Edwards:
Yeah. What a great lead out question. A couple things about the 70s, for people that were in high school in the 70s, like me, the inflation kicked off when a series of OPEC oil shocks that took gas from about 50 cents a gallon to a dollar 50 in a very short timeframe. Oh, where have we seen that recently? Yes. When [inaudible 00:01:23] Ukraine... Gasoline which was $2 a gallon, may 2020 has recently been hitting $5 a gallon. I just pumped my first $100 tank of gas ever. That was certainly eyeopening, but the stagflation of the 70s is not the same as the stagflation of today.
David Edwards:
Today's inflation is what I call war inflation. We had the war on the pandemic. We had the war in Ukraine and disruption and supply constraints. Just everything is gummed up. People want stuff, but they can't get it. They're willing to bid it up. The inflation of the 1970s was triggered around a very important event. And that was the transition of the American economy from being primarily manufacturing, to being primarily services. There was a similar transition in the 1910s and 20s when the United States went from being primarily an agricultural economy to a manufacturing economy. And that was very disruptive to people. And The Grapes of Wrath was all about the Joad family, having to abandon their family farm and move West to California, hoping to find a better way.
David Edwards:
So in the 1970s, a lot of people were losing their jobs in the manufacturing economy and things were transmitting over to the service economy and that disruption created all kinds of problems. Unemployment was high, and yet, so was inflation, so stagflation. I don't really see that as being an issue right now, particularly with the unemployment rate at 3.6% and with two job openings available for every one person looking for a job. Yes, there's a disconnect between the skills that are needed and the skills that are on offer, but there's... We don't have stagnation just yet. The U.S. GDP was 0.0 in the most recent report, but it should rebound shortly. More importantly, as we get further into this year and into next year, those inflation numbers will start to moderate on energy and food. Why? Well, because it's self-correcting. When people are paying five bucks a gallon for gas, they get creative about how to use less gas, how they carpool, they switch to electric. There's a bunch of things that people can do.
David Edwards:
And maybe high energy prices are the gold to get us to think more about green energy, and climate change, and all the other things that will eventually wipe out our civilization if we don't take action now. So I'm not really worried about stagflation. I'm more worried about just how people are going to cope where your wages went up 5%, but your cost of living has gone up 10%. And I did an article in institutional... I'm sorry, international business times, a few weeks ago. The title of the article was, Should you clear inflation? The answer depends on your economic class. So for most people watching this webinar who are one-percenters and five-percenters, yeah, paying a $100 for a tank of gas is kind of painful, but you're driving a $60,000 car. So really a $100 gas is not a big deal for you. At the other end of the spectrum, 50% of average Americans are, what I would say be low income, making less than $60,000 per household, not per person, per household, $60,000 a year total.
David Edwards:
And for those families, $100 gasoline means the trace between gasoline or food. I happened to pull up to a gas pump the other day, and the person ahead of me had bought $10 worth of gasoline, which was one in three quarters of actual gallons. That's enough gasoline to get them to work today and tomorrow. And then they'll come back and get some more gas. So, inflation, in that regard, is different, but also the solution for inflation is different. I remember that Volcker recession very well because I was graduating from college in 1983, and I couldn't get a job doing anything in 1983. I couldn't get a job as a temp in 1983. I was able to get past that by 1984. So, the traditional approach to killing off inflation is to raise interest rates aggressively. And we saw that earlier this week, when the fed raise rates three quarter of the percent, and they pretty much have told us they're going to raise three quarters at the next meeting. And that takes interest rates to a level last seen in 2019.
David Edwards:
We're not really above the average yet of the last 10 years when the economy was doing just fine. But more to the point, rising interest rates won't affect the price of fuel, won't affect the price of food, won't really do much to solve labor shortages. It will cause the housing market to level off a little bit.
David Edwards:
Mortgage rates were 3% in January. Now their 6%. So the housing market, which was going like this for much of the last couple years, is going to kind of go sideways for a while. They got to go down because there's still way more demand for housing than it's availability, but it is going to level off. So I don't think the fed raising rates aggressively is going to do much for inflation. I think the war ending in Ukraine would help, that's several years in the future.
Buff Parham:
But to your point, I did notice that the cost of building materials is plummeting given the lack of housing starts. So, for all the fixer uppers, there are some good news there.
David Edwards:
Yes. And I had a chance to counsel some clients earlier this year who wanted to get out of one house and build another house. And I said, "Sell your house now!" And they did and now they've engaged in architect. And by the time they get around to putting a shovel in the ground, two years from now, I think they'll be able to get a good house at a reasonable price.
Buff Parham:
Well, let's talk about equities for a second. I think it's safe to say we're now in a bear market, but in your view, what's the difference between the bear market mentality, as opposed to a bull market mentality for investors? And is buy and hold the right strategy until further notice?
David Edwards:
Yeah. So the stock market and the real economy don't always move together the way they should.
David Edwards:
We used to joke that the stock market has forecast nine of the last five recessions. Well, that was a comment from the 70s. Now it's more like the stock market has forecast 13 of the last seven recessions.
David Edwards:
If you only go by the stock market, we are totally heading for recession because look at the valuations: the stock market has fallen, the S&P 500 has fallen 23% so far this year, and that NASDAQ has fallen 35%. Doesn't it totally mean heading toward the recession? No, it doesn't.
David Edwards:
The stock market over swings to the upside, over swings to the downside. So by the end of last year, it had definitely swung to the upside too far. It's about 10% overvalued. Well, now it's kind of 15, 20% undervalued. Why does it swing so wildly? Well, let me explain. There is friction in the real economy that does not exist in the stock market.
David Edwards:
You can't buy a car in the morning and sell it in the afternoon. You can't buy a house in the morning and sell it in the afternoon. You can't get married in the morning and get divorced in the afternoon. There's friction in all of that. But you can buy a stock in the morning and sell it in the afternoon and buy and sell, and buy and sell, and buy and sell, and buy and sell. And in the last two years, particularly last 18 months, a lot of new investors entered the stock market. They had a thousand mark check from U.S. Treasury, and they had a free Robinhood account. And they went in and bought the FAANG stocks, Facebook, apple, Amazon, Netflix, Google. They bought the meme stocks, game stock, and American movie theaters. And they bought the NASDAQ 100, the 3500, and they bought Bitcoin. And for the first 15 months of their investing experience, all they knew was up, and they were a genius, look at that, my stocks are going up, I must be a smart person, I can very soon retire at age 35.
David Edwards:
Well, then we got to January and the markets began to falter a little bit. And particularly in the crypto markets, which are a market I would never have allowed my clients to enter, the smart money that bought Bitcoin at a 1,000 and 5,000 started to unload. And I wrote an article for National Business Times in January talking about how Bitcoin was currently at... It was about 40,000 then. And I said, "Yeah, there's a floor at 30,000. If it breaks to that floor, I think that the next rally point is 10,000." Well, Bitcoin, this morning hit 18,000. So yeah, it actually got down into the 17,000. That was back up [inaudible 00:10:38] into twenties, but I think it's heading lower. And Bitcoin down 70% from the record high is the best performing Bitcoin. The theory on the second, most popular Bitcoin, is down about 80%.
David Edwards:
And between January of this year, and right now... In January, the crypto markets were worth about three trillion dollars. That's a lot of money. U.S. Star market is worth $48 trillion. Well, now the crypto markets are worth $900 billion, $800 billion, it's hard to keep track because it's moving so fast. And so $2.2 trillion of investors capital has been vaporized in the last six months, and that spills over to other financial assets. I like to say that when you can't sell what you want, you have to sell what you can. And in the last two weeks, in particular, a lot of the crypto exchanges have stopped distributing funds, have seized up, have gone out of business entirely. And a lot of people are desperate for money. They can't sell crypto anymore so they sell the S&P 500, and the bank stocks, and the meme stocks. And I think that has a lot more to do with the current bear market situation than anything going on in the economy.
Buff Parham:
I was going to ask you about the contagion and you think it's real? In terms of-
David Edwards:
So, if the stock market was truly connected to the economy...
Buff Parham:
Right.
David Edwards:
... Then the stock market would consider, wow, over the last year, company revenues have gone up 20% to a record level. They're at a record level right now. And over the last year, company earnings have doubled to a record level. And over the last year... Oh, there was a third point. I can't remember now. Offset by interest rates. Yeah, the interest rates were zero. Now they're one and three quarters, okay? So, that's not the description of an economy that's heading into a brick wall. That's an economy that's getting by with some issues. But, like I said, the stock market can overshoot to the upside and overshoot to the downside. And right now we think it's pretty undervalued and we're taking advantage.
Buff Parham:
Yeah. The wildest thing I heard was people saying, "Well, we think crypto was a great hedge. You get some inflation. Oh, well." How much of a safe haven do you think the bond markets are right now?
David Edwards:
This has been a brutal year from the bond market. And the reason why is because the fed was very clear at the end of last year, beginning of this year, that they were going to raise rates sharply over the next two years. The bond market said, "Oh, wow, we're going to take all of that projection for the next two years and just slam it into the first quarter." So every bond investment that we have right now, if it's government bonds, agency bonds, corporate bonds, high yield bonds, preferred stock, even floating rate bonds have all been slammed hard. And that's the bad news. The good news is we were getting only a yield of two and a half, maybe 3% on our bond investments, and now they're up to four, four and a half percent. And they'll continue to rise as time goes by. And sometimes that's the reality. You've got a safe haven asset class bonds, but even they can have an off year.
Buff Parham:
Unfortunately, media attention to the war in Ukraine has begun to wane.
Buff Parham:
Russian forces are taking control of probably 20% of the country, the Eastern section in particular. What happens next in this struggle, you think?
David Edwards:
Yeah. So way back in the end of February, when the war first broke out and we hosted the webinar, we said there were four scenarios that we are focused on. One, the scenario, Russia takes the whole country in a couple days, right? That's off the table. That did not happen. The second scenario is that we get into a horrible, long slog that could go on for years. That's where we are right now, right? This war will not end this year. It won't end next year. It could end... It could be going on in five years. The third scenario was that the Ukrainians will be able to push the Russians out of Ukraine. And that is possible, but it won't happen right away because the Ukrainian people, they're very eager to fight, but they need Western weapons, NATO weapons, U.S. weapons. And then, when those weapons are shipped over, which takes time, they have to be trained on how to use them.
David Edwards:
The initial conflict, the Ukrainians were using Russian tanks and Russian ammunition that they left over from the Cold War. Well, now they're having to use American tanks, NATO tanks, NATO drones, and all of that takes time. The problem that the Russians have is that they've got a very thin sliver of Ukraine across the top of the Black Sea, the bottom part of Ukraine. And they can hold onto that for a while. They can just keep leveling every building that they see, killing every creator that they see... Why? Other than that's what the Russians know best. They did that in Syria. They did that in Chechnya. They did that in Georgia, right? But now that little sliver could be cut off. Already the Russians have pulled their Navy 65 miles offshore because of the fear of another cruise missile strike, which took out their big cruiser, the Moskva.
David Edwards:
So they can't support their ground forces from the sea, they don't have an air force in place, and the Ukrainians have these clever little drones that could just fly in over a tank, unnoticed, drop a grenade from 200 feet, up 300 feet up, and blow the top of the tank off. And so, there's this asymmetric guerrilla war that the Russians should have known about from their experience in Afghanistan. And they should have seen what the North Vietnam ministry [inaudible 00:16:37] Americans. Way superior firepower during the Vietnam War and yet the Vietnamese still won. So the fourth scenario that I feared the most was that Putin would get so frustrated with how the war was going that he would lob a tactical nuke at Kyiv, try and kill Zelenskyy. And I feel like everyone's backed away from that outcome, but it is still a risk. And if it happens, well then everything we're talking about doesn't matter.
Buff Parham:
Well, on that pleasant note, I think you answered all our questions. Anything come in?
David Edwards:
No, it's a super quiet night. Everybody is appreciating the beautiful weather. They're trying to spend some time with their kids for father's day. There's even a three day weekend. Everyone has tomorrow off. So I would wrap up. Let's get back to the beautiful outdoors.
Buff Parham:
Sounds like a plan!
David Edwards is president and wealth advisor with Heron Wealth, a $500 million registered investment advisor based in New York City working with 225 client families across the U.S. and around the world.
At time of publication, Edwards and/or his clients held positions Amazon, Apple and Google.