CWS Market Review – March 7, 2023

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There’s a classic bit from the original Saturday Night Live cast where they parody the Carter-Ford presidential debates from 1976.

During the skit, Jane Curtin, as one of the panelists, asks a very wonkish question alluding to several facts and figures. Chevy Chase, as President Ford (who doesn’t bother trying to look like the president), appears completely bewildered and famously responds, “it was my understanding that there would be no math.”

I mention this because the question Jane Curtin asks has to do with the Humphrey-Hawkins Act, which at the time was only a bill.

Today, it’s a law and its official name is the Full Employment and Balanced Growth Act of 1978. The act is more informally known for its two major sponsors, Congressman Augustus Hawkins and Senator Hubert Humphrey. The act was signed into law a few months after Humphrey died.

The act has an interesting history because it started out as a classic Keynesian bill that aimed for full employment. Instead, the final bill was stripped of those provisions, and it was given a Friedmanite flair. For example, the act requires the Fed to outline its targets for monetary aggregates.

Another mandate of Humphrey-Hawkins is that the Chairman of the Federal Reserve must testify before Congress twice a year on monetary policy. Each testimony lasts two days, one day each before the House Financial Services Committee and the Senate Banking Committee.

Several years ago, I went to the Senate hearing to see the festivities live. I was surprised to find that except for the senators and a few cameramen, the room was nearly empty. I even got the seat directly behind Chairman Bernanke.

Today, Jerome Powell gave his Humphrey-Hawkins testimony before the Senate Banking Committee. In his remarks, Powell said that interest rates will likely go higher than the central bank had expected. The big change is that inflation appears to have reversed its direction and it may be accelerating again.

“The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated,” Powell said in remarks prepared for two appearances this week on Capitol Hill. “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”

Home prices appear to be one of the few areas where prices are going down. This news is especially difficult for the Fed because it had recently downshifted to 0.25% rate hikes. That was seen as a sign that the Fed was winning the battle against inflation. Now that’s in doubt.

In December, the Fed updated its economic projections. At the time, the Fed saw interest rates peaking at 5.1%. In fact, Wall Street thought the Fed was being unduly alarmist. Not anymore. Now traders think the Fed was too optimistic.

Interestingly, Powell didn’t specify how high he thinks rates could go but his remarks had an immediate impact on the market. The two-year Treasury yield broke above 5% for the first time since 2007. Yesterday’s traders thought the odds of a 0.5% hike at the Fed’s next meeting (in two weeks) was 31%. Now it’s up to 70%.

After that, traders expect two more 0.25% increases, one in May and another in June. Traders then expect the Fed to hold tight through the end of the year. There are even some bets that the Fed will start cutting early next year.

I should caution that the futures market is merely a mass of traders placing bets on the future. There are no guarantees, but it’s interesting to note that the perceived ceiling for interest rates keeps rising.

I often talk about the 2/10 Spread because it has a good historical track record in predicting recessions. Today, the 2/10 Spread dropped below -100 basis points. The two-year Treasury now yields more than 1% over the 10-year Treasury. This hasn’t happened in 42 years.

The stock market did not take the Powell news well. At its low, the Dow lost 593 points. The S&P 500 lost over 1.5% today and the index closed below 4,000. The banks got hit especially hard today. The S&P 500 Financial Index lost 2.54% today.

I need to stress how dangerous inflation is for investors. The recrudescence of inflation is the most important obstacle Wall Street currently faces. A depreciating currency may appear beneficial in the short-term, as anyone who remembers the 1970s can attest, but it’s eventually very destructive. In 1977, Warren Buffett wrote an essay on this subject called, “How Inflation Swindles the Equity Investor.”

For businesses, inflation has an unusual impact on the bottom line. Bear in mind that not all earnings are the same. Inflation exacts a heavy toll on asset-heavy businesses. Inflation has an impact similar to putting a magnet near a compass. Everything gets a little screwy. For example, companies with high assets relative to their profits tend to report ersatz earnings.

At first, inflation gives the illusion of prosperity. Businesses create their products in fewer and more expensive dollars and then sell them for cheaper dollars and more numerous dollars. As an accounting item, the business may appear more profitable, but no wealth has been created.

Inflation also favors the debtor in favor of the creditor. Again, any benefit is short-lived. In fact, once lenders see the impact of inflation, the ultimate outcome is to price the marginal borrower out of the credit markets.

Stocks have historically not performed well during periods of high inflation. Inflation is, at root, a tax on capital. In the late 1970s, the stock market’s P/E Ratio dropped well below 10. I don’t even want to think we could return to those kinds of valuations. It’s no accident that Walmart was such a big winner during the 70s since it was so focused on giving shoppers lower prices.

Professor Robert Shiller, a Nobel prize winner, maintains an online database of historical market data. It goes back 150 years. A few years ago, I went through the numbers to see how the stock market has responded to differing levels of inflation.

The stock market has performed well up until inflation gets to about 7%. Anything above that, and the stock market gets ugly. The math isn’t hard. Equity prices are squeezed on two ends. Inflation causes interest rates to rise and that makes for higher borrowing costs. Also, equity valuations are discounted at a higher rate, which translates to lower earnings multiples.

Things may get more dramatic soon. The February jobs report is due out this Friday. Wall Street’s consensus is that the U.S. economy added 250,000 net new jobs last month. After that, the February CPI report comes out next Tuesday.

Stock Focus: Donaldson

This week, I want to feature Donaldson (DCI). This was a former Buy List stock that I stupidly let get away. Since 1990, shares of DCI are up more than 10,800%.

Donaldson is in the filtration biz which is one of those areas that few people ever think about, but it’s a lot bigger than you might imagine. The company was founded by Frank Donaldson in 1915 and it’s based in Minneapolis, MN.

Donaldson currently has a market value of about $8 billion. It’s a member of the S&P 400 Mid-Cap Index. A few Wall Street analysts follow it, but not many. In the last 35 years, Donaldson has split its stock 2-for-1 five times and once 3-for-2. That works out to 48-for-1.

Last week, Donaldson reported fiscal Q2 earnings of 75 cents per share. That was two cents more than estimates. Donaldson also narrowed its full-year guidance to a range of $2.99 to $3.07 per share. That’s an increase of eight cents to its low end. The company has already made $1.50 per share for its first two quarters. Donaldson expects sales to rise by 2% to 6% this year.

Donaldson currently pays out a dividend of 23 cents per share. The company has increased its dividend for 27 consecutive years. In 1987, DCI paid out a dividend of about one-third of a penny per share.

Wall Street expects DCI to earn $3.17 per share next year. That means the stock is going for just under 21 times next year’s earnings. That’s not bad.

Donaldson reminds me of Peter Lynch’s advice to find companies that are boring. They sound boring. The product is boring and industry is boring. I’d rather not have to wince each time the CEO decides to tweet something.

That’s all for now. I’ll have more for you in the next issue of CWS Market Review.

– Eddy

Posted by on March 7th, 2023 at 6:51 pm


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.