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Michael Kramer discusses market divergences, interest rates and inflation (0:30). How many rate cuts will we see this year? (6:20) Bleak 2024 earnings picture (11:20). This is an abridged conversation from a recent Investing Experts podcast.
Transcript
Rena Sherbill: Michael Kramer, you write a lot of free stuff on Seeking Alpha under Mott Capital Management. You also have an investing group called Reading the Markets. How are you sharing for investors, how are you articulating for investors how you’re looking at the market and how we should be thinking about things coming down the pike these days?
Michael Kramer: So obviously, I’ve been following inflation very closely and the importance of it.
I haven’t been in agreement with consensus for a very long time on this topic, which has been sort of the – depending on how you’re investing, has either been great for you or not so great for you because while the views I’ve had on inflation being sticky and being more persistent and more problematic have certainly been correct and while my views on fewer Fed rate cuts have been correct and bond yields in the dollar have been correct, equity markets really haven’t been correct, right?
Equity markets have rallied despite inflation being sticky, in spite of interest rates moving higher, the dollar moving, strengthening, and things of that nature. So it’s been sort of like an up and down roller coaster ride.
But the things that I’m noticing when I look at the divergences between the things I’ve been looking for and predicting and the equity market, the things that I notice is generally that the bond market has a view that the Fed may only cut rates one time this year, possibly two.
While generally speaking, when you sort of go through sell-side analyst notes and economic data providers, you’re seeing that there are still expectations for rate cuts in July, or that you’re going to get more than two rate cuts this year.
And I think that’s generally helped to keep the equity markets sort of elevated and not really pull back. And so what I’m starting to notice more and more is these divergences between the amount of risk investors are willing to take versus what the bond market and the dollar seem to be telling us about the future of interest rates and where they’re going and inflation.
And so I’ve been trying very hard these days to really focus a lot on inflation being number one, what that means for where the Fed is likely to go, and then trying to set expectations around what that means for equities, but doing it in a way that also sort of gives people the sense that the market may not – the equity market may not respond in the manner in which you would like as quickly as you would like.
And that’s been sort of one of the key drivers, I think, of the way I’ve been sort of framing things more recently.
RS: In terms of being aware of it, I would imagine that’s the first steps, but how do retail investors navigate this kind of confusion and divergence?
MK: The easiest thing is to try not to think about things from a logical or illogical standpoint, but think about them from a hedging standpoint. And the truth is, from what I can tell, is that you can’t even use the VIX Index anymore.
Most people are accustomed to the VIX Index, right? Because that’s what they’re – that’s what they’ve been known. That’s what everyone’s been taught. You look at the VIX Index for fear. And that used to be the case. I mean, the VIX index still moves.
But because of, again, because of this precision hedging, I call it, where you can go out and get a specific option for a specific date, and you could do it literally the day before or the morning of because markets are so liquid that you’re not going to potentially see implied volatility rising in the VIX, right?
So you almost need to be looking at the VIX one day on a daily basis. Is it up? Is it down? You need to be looking at option pricing for one week out. For example, I follow something called the S&P 500 50 Delta one week option. And basically, all it’s looking at is the midpoint of the range and it’s looking at implied volatility one week from now.
And typically, before an event happens or if there’s like the – that volatility started going up last Wednesday for this Wednesday’s CPI report. And you can begin to see things, but you have to be looking at things in a much shorter timeframe than what you may have used to been able to do. And that sort of, again, creates this confusion about the market not caring around events because no matter what the Fed says at these press conferences, the market rallies, right?
If you notice almost every time Jay Powell opens his mouth, the market goes up and everyone takes it to mean that it’s because he’s saying something dovish. And so if you’re not watching in shorter dated implied volatility levels, you’re not really capturing what’s really driving trading.
And that, again, can create a lot of confusion about what’s really happening. Unfortunately, the media doesn’t really know either. And so things are reported that way. And that makes it a very challenging experience for people because right now we’ve been in an upward trend in the market and that’s largely around some of the things in hype you’re seeing in NVIDIA (NVDA) and the AI names and things of that nature, but even that’s been driven a lot by option trading.
So again, it sort of makes this a tricky market to navigate, even for me at times.
RS: In terms of what you are paying attention to, in terms of the Fed and what they’re saying, what’s your opinion in terms of how many rate cuts we’re going to see and what do you think that means broadly speaking?
MK: So I listen to almost every Fed speaker. I have services that I pay for that basically read me the news all day. And I listen and then, of course, through Bloomberg, I’m able to watch a lot of their meetings, interactions with when they do these conferences and stuff.
And if you listen to them, they all kind of tell you the same thing right now at this point in time, which is that they have less confidence today about the path of inflation that they’ve – than they’ve had. Many of them want to see a series or several data points showing them that inflation is on a 2% path.
And so if you think about what this means, right, and then what I do to think about what they’re saying and when they could potentially start seeing data points to suggest when they’re going to start getting their series of data points to suggest a 2% inflation rate, I look at the CPI swap market. And the CPI swap market tells us that inflation is going to be at around 3% year-over-year by December, right?
So that’s not going to get you those consistent 2% inflation readings in between, because I think the lowest print that I’m seeing right now comes somewhere in August or September, which is a base effect from last year’s higher prints that are around 2.8.
And so what this implies to me is that there’s a good chance you may not actually see a rate cut not until May of 2025, because if the CPI market is, and again, I’m basing my decision based off of what the CPI swaps market is saying and what the Fed speakers are saying, if the swaps market is correct and, in my experience, they generally tend to price inflation too low. And then as time goes by and we get closer to the dates, those numbers tend to come up.
So if the CPI swaps market is right, and we’re going to be in a 3% to 3.5% range by the end of this year and we start seeing inflation tailing off, again, maybe in December, January of next year. By the time you get enough data points that’s going to give the Fed the confidence we’re on a 2% path again, it’s probably going to be in May of 2025. And that is obviously not priced in anywhere, right? Even the bond – even Fed fund swaps right now are pricing in two to three rate cuts by January of 2025.
So there’s a little bit – I’m being a little bit more aggressive on that. But again, I’m just taking off of what I’m seeing in the swap pricing and I’m taking it from what I’m hearing them say.
RS: And what do you think that means for the bond market?
MK: Higher interest rates on the front of the curve. The two-year is probably a little bit too low right now. It probably should be closer to 5% to 5.1%. And it would seem to me that the bond market is also mispricing the long end of the curve.
So I’ve been thinking the 10-year should be around 5%. And so what I’m generally thinking about is that rates need to go higher and they need to be there. They’re going to be there for a much longer period of time. The other issue is obviously, I’m a big believer in the velocity of money supply and that’s a basic ratio of money growth over nominal growth.
Money supply has basically not been growing since 2021. And nominal growth has been growing in the 5% to 7% range on GDP now for some time, which means that you have rising velocity.
And rising velocity, I’m going to be actually presenting this at the Seeking Alpha Conference, this is what my topic is going to be, is – has been rising and velocity of money supply or MZM or M2 now is really more than sufficient, basically correlates very highly with interest rates, 10-year rate over a – going back into the 1960s.
And essentially, as velocity rises, you see bond yields rise with it. And so as long as in my view, you continue to see rising velocity, which is a component of money – of nominal GDP growing faster than money supply, you’re going to continue to see bond yields move higher because inflation is going to be higher. And so that’s another reason why I’m sort of in this very higher for longer camp.
RS: What’s your take on what you’re seeing from the earnings picture?
MK: Earnings for 2024, give or take a couple of dollars, have been at $240 per share since December of 2022. They have not changed. Those earnings estimates have been the same since nearly – since December of 2022.
Earnings estimates came in – earnings have beaten estimates this quarter only because they plunged between January and April for the first quarter. Earnings estimates are now back to where they were in the first quarter in January.
So what you’re seeing is earnings estimates came down and then they went back up as results came out. So if you’re at the same point you were in, in January today and you beat, I mean, is that really better? I don’t really know that it’s better. I think it’s pretty much as expected, right? I think you only beat because expectations dropped.
Then when you look at the second quarter, those estimates are coming down. Third quarter estimates are coming down. Fourth quarter estimates are coming down. The only reason why they’re holding up at this point, because basically, if you look at sales growth, it’s non-existent.
In fact, sales growth, I believe, if my memory serves me correctly, is actually expected to – is only expected to be around 3% or 4% this year, which is your inflation rate. So where there is no real sales growth, it’s just inflation.
And the only reason why you’re going to get right now around 10% earnings growth in 2024 is because analysts still think you’re going to get 12% net margins, which is just historically a ridiculous number.
Normally, you’re somewhere around 10% in margins. And normally, net margins start higher and then they come down over the period of time. And the same thing we saw, the same thing happened in the fourth quarter. First, fourth quarter net margins were around 11%. They finished somewhere around the low 10s or upper 9s. First quarter numbers started around 11%. They came all the way down into the low 10s.
Now you still have second, third, and fourth quarter numbers, which haven’t come down yet for net margin. So I just don’t see how you’re going to get the $240 or so earnings estimates that have been priced in since December of 2022. I think those numbers are probably going to start coming down as we continue to go through the quarters, because we don’t really have real growth.
We have inflation. And the assumption is that you’re going to continue to have margin expansion. But the problem becomes is if the consumer becomes more pinched, that could mean that margins aren’t going to be quite as strong as what analysts are projecting at this point.
I mean, does it mean that you’re going to have negative earnings this year? No, I don’t know that you’re going to have negative earnings. I just don’t think you’re going to have $240. You could have $230, right, or $235, which would still be better than last year. But I don’t know that it deserves a 21 multiple on the S&P when you have a 4.5% interest rate.
I mean, when you adjust the interest rate, when you adjust the growth rate for the interest rate, you’re paying about 6% –you’re getting about a 6% premium on earnings growth, but you have a 4.5% – but you’re paying 21x earnings. In the 2015-2016 period in time, even 2018, you were getting basically higher risk – risk-free adjusted growth rates, but you’re only paying 17x or 18x earnings.
So I’m not – I don’t know how this all sort of holds together from a fundamental standpoint. It makes it really challenging. And so, all of a sudden, if you do $235 a share in earnings and equity investors finally wake up to the idea that you have $235 in earnings and they don’t want to pay a 21 multiple anymore, they decide they only want to pay 17, well, guess what? The S&P 500 is only worth 39.95. So you’re taking on a lot of risk right now.
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