Quarterly Investment Update: 2019 Quarter 4


The Fed Cannot Predict Recessions

The Fed has a hard job, they are tasked officially with keeping both inflation and unemployment low.  Balancing those two objectives is tricky even in good times.  When push comes to shove, the Fed’s main objective is to avoid recessions or at least minimize the damage.  With such a complex job, the Fed naturally draws lots of criticism.  In fact, critiquing The Fed has long been a favorite pastime of financial journalist, economists and market strategists.  We’ve done it ourselves.  One of the most common critiques is that despite all of the high-quality data and PhD staffers, the Fed cannot even predict recessions! 

While it is true that on the precipice of each of the recessions in the 2000s, the Fed was predicting further growth in the economy, these critiques miss the bigger issue.  The Fed knows that economics is a social science, not a hard science.  In hard sciences like physics, the participants’ state of mind is not a factor.  If you accidentally hit a baseball at a window, no matter what you think about it, it’s going through that window if it’s going fast enough.  But in a social science, the participants’ state of mind can have a profound impact on outcomes.  In other words, the Fed knows that they can impact expectations and behavior with their communication.  Therefore, the Fed CANNOT predict a recession for fear that they might actually cause the recession to happen! 

The Fed does have a tell though, when they cut rates multiple times, after a sustained period of raising rates, you can be sure that the Fed is worried about a recession.  In the chart above, we highlight each of the 14 times since the 1950s in which the Fed has cut rates multiple times after a sustained period of rising rates.  The grey shaded bars indicate recessions.  So, when the Fed cuts rates, are they predicting a recession by default?  If so, they have been correct 9 out of 14 times (64% accuracy with no false negatives), that’s better than most economists.  Will they be “right” on number 14?  The stock market is rejoicing over the recent and expected future Fed rate cuts, but we see more warning lights flashing.

Executive Summary

  • The Quarter in Review
  • Sentiment & Value Update
  • Expectations Matter
  • Unicorn Trouble
  • Energy

The Quarter in Review

US and international stock markets had an up and down quarter as markets recovered from a swoon in August triggered by trade war fears and the possibility that the Fed might not deliver on rate cut expectations.  A trade war truce in late August and a soothing message from the Fed salvaged what might otherwise have been an ugly quarter for stocks.  The bond market rallied powerfully with yields on 30-year treasury bonds hitting new all-time lows as investors bet that the Fed would need to cut interest rates further. 

Relevant Index Performance

Sentiment & Value

The chart above shows our opinion on where various markets are as of September 30th, 2019.  Many of the best purchase decisions are made when prices are cheap and sentiment is bearish or depressed (bottom left quadrant).  Conversely, many of the best sell decisions are made when prices are expensive and sentiment is bullish or euphoric (top right quadrant).  This chart and the comments below are intended as a behavioral guide, not as a timing tool.

Once again, despite all the fanfare, the S&P 500 price level closed the quarter only 1.57% higher than it was at its 2018 peak in September last year.  Over the last 12 months the prospects for US and global economic growth have slowed significantly and central bankers around the world have shifted their tone from raising interest rates in order to reign in inflation, to cutting rates in order to stave off a recession.  Rate cuts may help boost prices of both stocks and bonds in the short-term, but they are unlikely to resolve the underlying weakness in the global economy.  We continue to have a conservative stance.  All things being equal, if the S&P 500 were to trade below 2,600, we would be interested in increasing our exposure to US stocks and if the 10-year treasury yielded more than 2.50% we would be interested in adding to our long-term bond positions.

Source: Crescat Capital, Mauldin Economics

Expectations Matter

A common belief in markets is that it is hard to make money by following the crowd.  The reason for this is that expectations influence prices.  If everyone believes that the value of a stock is likely to rise in the future, then the price today begins to rise, thereby reducing the amount of future gains available.  Of course, investing is never quite that simple.  As the chart above highlights, in early 2008, the Google search popularity of “recession” peaked, only 11 months before one of the US’s worst recessions began.  So how can we try to distinguish between situations when the we should bet with the crowd vs situations when we should bet against the crowd?

Our favorite lens to use comes from legendary investor George Soros.  Mr. Soros developed a theory about financial markets called “reflexivity.”  In very basic terms, reflexivity distinguishes between beliefs that are self-reinforcing and beliefs that are not.  When an expectation is wide-spread and it drives self-reinforcing behavior, reflexivity suggests that investors should focus less on the fundamentals and ride the wave with the crowd. 

Worrying about a recession is a classic reflexive belief.  When people worry about a recession they generally reduce or eliminate spending on discretionary expenses.  This reduction in spending directly reduces the revenue & income for all sorts of cyclical businesses.  A slowdown in business can cause even more people & businesses to worry about a recession, causing yet more reductions in spending.  These simultaneous reductions in spending are the very definition of a recession.

At the moment prices of most stocks do not reflect concerns about a recession, but as the chart above shows, concern about a recession is clearly rising.  Moreover, Duke University’s recent survey of Chief Financial Officers (CFOs) revealed that 67% of US CFOs expect the US economy to be in recession by the end of 2020.  The combination of high prices and the early stages of spreading recession fears reinforce our belief that now is a time to be more conservative than usual.

Source: “You Don’t Want a Unicorn” written by Ame Dyckman, illustrated by Liz Climo

Unicorn Trouble

Sometimes it is hard to appreciate just how massive the change in a speculative investment’s value can be when expectations change.  But when expectations suddenly flip from wildly optimistic to skeptical, the results can be sobering to say the least.  The recent mania surrounding the “Unicorns” (privately held startups with valuations above $1B) is a great example.  WeWork, a prominent Unicorn, has just experienced one of the most dramatic collapses in recent memory.  Nine months ago, investors were giddy about the possibility of a valuation of $65B at IPO.  Now, investors are licking their wounds after failing to IPO at only $11B.  To add insult to injury, WeWork is contemplating massive layoffs and there are rumors of bankruptcy.

Here’s how it went down.  Markets work best when businesses are competing to win investments.  In bubbles, this relationship often flips upside down and investors end up competing to win allocations in businesses.  When this happens, outrageous lapses in investor judgement eventually follow because management gravitates toward the investors who will give them the most leeway.  Below is a very short list of some of the indulgences that investors in WeWork tolerated along the way:

  • CEO used company $$ to invest in his friend’s health food start-up
  • CEO borrowed hundreds of millions from the company to buy real estate that he eventually leased back to WeWork
  • CEO shares have 20x voting rights compared to other shares
  • Company allowed to take on over $34B of non-cancellable leases (read: debt) despite losing over $2B per year

When the fresh eyes finally got a look inside the WeWork business, they saw massive losses and no clear path to profitability.  Suddenly, the “party of the year” turned into the party nobody wanted to attend.  With public markets on high alert for similar signs of excess, Unicorn valuations will be under pressure for the foreseeable future.  While there may be more cleanup to do, a return to sound investment principles is great for investors going forward.

Source: Bespoke Investment Group


Issue: Despite a rally in the price of oil, energy stocks have performed terribly relative to the S&P 500.  The Energy sector of the S&P500 is now at its lowest weighting since at least 1990.

Impact: Occasionally, long periods of underperformance can be so pronounced that they distort the weighting of a sector within the S&P 500.  Previous instances have created excellent long-term buying opportunities.

FC Advisors’ Take: The energy sector has had a very rough time since the oil price crash in 2014.  In addition to the collapse in the price of oil, energy stocks have suffered from the rising popularity of “green” investment strategies and the growing expectation that the future of automobiles is in electric vehicles.

Despite these headwinds, even the most aggressively green projections for the next 20 years show a small increase in global natural gas consumption and a modest decrease in global oil consumption.  With no expected increase in the price of oil, many oil producers now offer extremely high returns on capital, attractive dividends (4%+) in addition to some insulation in the event that inflation ever picks up.  Moreover, oil companies have drastically reduced spending on future oil production, potentially causing a supply shortage that could boost oil prices in the future.  It appears that expectations have gotten ahead of reality in the energy world.  We’ve added some exposure to oil producers and may add more.

If you have questions about these topics or any other financial needs, please contact

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