Daily Economic Update: January 14, 2025

Stocks eked out small gains yesterday. Yields rose slightly with the 2Y at 4.40% and 10Y 4.78%.  If you haven’t checked oil in a bit, it’s hit a 4-month high, some of the recent gains are attributable to further sanctions on Russian oil interest. Away from markets (for now), the impact of the ongoing tragedy that is that of the California wildfires is certainly something that will bear some continued watching.

In economic news, the NY Fed SCE showed: “Median inflation expectations were unchanged at 3.0 percent at the one-year-ahead horizon, increased to 3.0 percent from 2.6 percent at the three-year-ahead horizon, and declined to 2.7 percent from 2.9 percent at the five-year-ahead horizon.”  The survey also showed an increase in inflation uncertainty.  The rise of inflation expectations at the 3 year horizon doesn’t seem like something welcome by the Fed.  U.S. yields continued to climb and tech stocks got little reprieve from some of the recent selling.

While I move away from the discussion on valuations, in the first XTOD there is a link to an article titled 'Mega Cap World Domination' by Ben Carlson, that looks at some of what we’ve been discussing over the last week.  His answer to the current investment debate or what he calls, conundrum, is “I own index funds and I diversify.  Index funds will own the winners without having to pick them in advance. And diversification gives you the optionality to own the winners that often come from unexpected places.”

Today what we’ll touch on will combine two of the other major 2025 themes, one being fiscal policy and the other being “r-Star”.  So it’s fitting to discuss “Fiscal r-star”, an idea coined by Marijn Bolhuis, an economist at the IMF, recently discussed on David Beckworth’s podcast Macro Musings.  I mean who doesn’t need more largely unquantifiable “stars” to try to track?

So what is “fiscal r-star”?  It is the real interest rate that stabilizes a country's debt-to-GDP ratio when output is growing at potential and inflation is at target, given a path of primary deficits or surpluses set by the fiscal authority. This is distinct from the traditional concept of monetary r-star, which is the real interest rate that stabilizes inflation and maximizes sustainable employment.  Fiscal r-star can be thought of as the ceiling for real interest rates. If real interest rates rise above this ceiling, the debt-to-GDP ratio could increase rapidly (does this idea that higher interest rates can increase debt-to-GDP sound familiar to anyone??)

When you consider that the Fed’s liabilities are ultimately backed by the Federal Government and you look at things from a consolidated balance sheet perspective, Bohuis’ work highlights the tensions between fiscal and monetary policy.  If fiscal policy is passive (meaning that fiscal authorities adjust spending and taxes to stabilize debt levels), then fiscal and monetary r-star will be the same. However, if fiscal policy is active and not responding to debt levels, the two can diverge.  Under this framework a situation that could occur is that monetary r-star (the real rate needed to keep inflation in check) can exceed fiscal r-star (a lower rate needed to keep debt-to-gdp in check) which creates a tension that needs to be resolved.

So how might such a tense situation be resolved?  Well, a few ways pop out. One is that the fiscal house gets itself in order by reducing spending, creating growth or otherwise raising revenue.  Other resolutions could be steps taken by the Fed toward keeping rates lower at the expense of allowing higher inflation or other regimes of financial repression.  All said the possibility that the U.S. may currently find itself in a situation where this “tension” exists is potentially concerning.  Bolhuis also mentions that these larger fiscal-monetary gaps can increase the risks of an economic crisis.

Because of the risk that the Central Bank could keep rates low to accommodate fiscal authorities in times of tension, Bolhuis believes it is wise to maintain central bank independence. Perhaps subscribing to my favorite definition of central bank independence helps prevent a fiscal-monetary r-star gap.  That definition is by Peter Stella and reads: “I define central bank independence in one sentence, it's the ability to raise interest rates when the Treasury doesn't want you to. And the Treasury almost never wants you to, because of the cost of the debt.”

All of this still seems to leave open a core dilemma of sorts. The central bank is tasked with maintaining price stability, which typically involves raising interest rates to cool an overheating economy. However, if fiscal policy remains expansionary despite rising interest rates, it can create a vicious cycle. Higher rates increase the cost of government borrowing, leading to larger deficits and potentially even more borrowing, which could further fuel inflation.   This sounds very much like the Fiscal Theory of the Price Level to me.  During Carter’s funeral last week, I mentioned Volcker.  Stories from the Volcker era indicate that politicians took seriously the size and cost of financing budget deficits and clearly Volcker operated independently, essentially urging fiscal authorities to get their act together. 

If I had one takeaway from this work on “fiscal r-star” is that it highlights what appears to be somewhat of an inherent truth that to achieve the “best” macroeconomic outcomes there needs to be some level of coordination between the fiscal and monetary authority in working towards their objectives, or at least some explicit acknowledgment of the trade-offs.   Perhaps this paper highlights something John Cochrane often states (see this post from September) : “almost all current theories mix a fiscal tightening with a rise in interest rates. The rise in interest rates by itself has essentially no power to lower inflation.”  

You should obviously form your opinion on whether the concept of “fiscal r-star” and “fiscal-monetary gap” are valid and useful concepts and from there what implications there might be for investors if you reach an opinion that the U.S. is at risk due to such a fiscal-monetary gap.  Lastly, keep in mind this is different from “fiscal dominance” which is the idea that when government borrowings get so large the central bank is forced to keep rates low to accommodate those deficits and is something of the outcome after the fiscal-monetary gap crosses some tipping point.  

XTOD: What's the more likely scenario? 1. We have an AI bubble that turns into a bust (even if AI tech is huge in the long  run)  or  2. Mega cap world domination rolls on I have some thoughts:  https://awealthofcommonsense.com/2025/01/mega-cap-world-domination/

XTOD: Why it’s still early for crypto: We polled advisors across the country, and only 35% said they are able to buy crypto in client accounts today.  Worth noting: Advisors manage roughly half of all wealth in America.  There’s still a lot of room to run.

XTOD: As long as Marc Andreessen keeps promoting a16z's crypto vaporware, he doesn't belong anywhere near the levers of power. Ditto for crypto grifters like David Sacks and Howard Lutnick.  There's no excusing their behavior.

XTOD: Private equity is “leveraged micro-caps with lockups and high fees” and private credit is “high-interest-rate loans that banks wouldn’t touch.” [Rasmussen] warns advisors not to  let the “smoothed returns and laundered volatility trick you into thinking these aren't high-risk, high-fee assets with a lot of blow-up potential.” https://fa-mag.com/news/2025-may-be-a-whole-new-world-for-alternative-assets-80954.html

XTOD: Stan gave me this advice before my 1st born 15+ yrs ago.Best parenting advice I got.  TIME is all we have. Minimize regrets

XTOD: Habits that have a high rate of return in life:

- sleeping 8+ hours each day

- lifting weights 3x week

- going for a walk each day

- saving at least 10 percent of your income

- reading every day

- drinking more water and less of everything else

- leaving your phone in another room while you work

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https://x.com/BitwiseInvest/status/1878885763418652976

https://x.com/ParrotCapital/status/1878884743447756960

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https://x.com/JamesClear/status/1878890125306011971

Daily Economic Update: January 13, 2025

Friday’s payrolls report was a major beat on the headline (+256K v. 160K est) and showed a declining unemployment rate (from 4.2% to 4.1%).  You couple that with a UofM survey that showed consumers increasing their inflation expectations and you get a recipe for higher yields.  Yields moved the most in the belly of the curve, but were up across the board. Bank research desk seemingly rushed to change their rate cut forecast, with I believe BofA moving to zero cuts in 2025.  On the other side, some of the Goldman team is now in the camp that the market forward curve is probably too hawkish over the next couple of years: “We have more conviction that market pricing as a statement about the probability-weighted path of the funds rate over the next few years across many possible scenarios is too hawkish.”  

Rising yields weighed on equities as investors decided that higher yields do result in lower present values of future earnings.  Long duration equities were most impacted.   Major indexes declined over 1% on the day Friday and the S&P is at 5,827.

The 2Y starts the week at 4.38% and the 10Y at 4.76%.  On the week ahead bank earnings will be in focus along with inflation data:

Mon: NY Fed consumer inflation expectations

Tue: PPI, Fedspeak

Wed: CPI, Fed Beige Book, Fedspeak

Thur: Retail Sales, Jobless Claims

Fri: Building Permits, Housing Starts, Industrial Production

Moving away from the news of the moment, we’ll start this week with the best I can do to describe the counter to the “trees don’t grow to the sky” narrative, a narrative that in some ways says “this time is different”, arguing that long-term growth investing is a superior strategy in an age where some companies appear to have the potential for sustained, superlinear or exponential growth perspectives that don’t revert to a mean.  Perhaps one thing the meta-narratives have in common is the idea of disruption, but they come at it from different angles. The traditional approach is disruption leads to business cycles and as a result somewhat more of a mean reversion mindset, while the “this time is different” approach is essentially one of just finding those disruptive companies and if you do there is no necessary end to the high-growth trends.

At the heart of the argument seems to be an emphasis of increasing returns to scale, particularly in knowledge based industries with high levels of intangible assets, where success begets more success.  I write this not to imply that investors with this growth oriented mindset believe that trends last forever, rather that they believe there are plenty of opportunities to find companies with sustainable, competitive moats and leaders capable of continued innovation in the face of competition.  They don’t dismiss there are some ultimate limits to market growth and product or service saturation, but would rather likely espouse that the market as a whole has a hard time pricing in the type of exponential growth these types of companies are capable of achieving.  Along those lines, they would likely argue that traditional valuation metrics fail to capture the paradigm shift these companies operate in and their ability to scale often with limited physical assets, resulting in market inefficiencies.

Another approach to investing that runs counter to the “trees don’t grow to the sky” narrative is one that was employed by Nick Sleep and Qais Zakaria when they ran their Nomad Investment Partnership and that tactic was to invest in business models that they describe as “scale economies shared”.  Nick and Zakaria were early and persistent investors in Amazon which they described as a potential “mouse that can turn into an elephant.”  The concept of Scale Economies Shared was central to their philosophy and born from an observation regarding one of Charlie Munger's favorite investments, Costco.  The idea is that there are companies that pass on the cost savings from scale and efficiency improvements to customers in the form of lower prices and as a result these companies continuously gain market share and retain large loyal customer base (a virtuous cycle) that over the long term leads to much larger amounts of free cash flow and much more valuable companies than most investors realize.  They called Amazon “Costco on speed.” Further these types of companies not only grow in good times, but they tend to also perform well in bad times due to their cost advantages.  Inherent in the investment philosophy of Nomad Investment Partners was that there is potential for sustained, long-term growth in exceptional businesses and certain businesses can defy mean-reversion. I should note that Nick and Zakaria were definitely long-term oriented, thinking in terms of decades, not quarters.  They also placed a lot of importance on finding exceptional businesses that were run by exceptional leaders (often founders) as these companies with strong leadership, innovative cultures, and customer centricity would likely be the ones to adapt, evolve, survive and ultimately defy growth expectations.  They have more in common with Buffett than say Cathie Wood in their approach to investing.

I probably didn’t do the discussion of this “meta-view” justice, but I’ll leave you with two ideas, both of which relate to investment time horizons.

“A lot of financial debates are just people with different time horizons talking over each other.” - Morgan Housel

“You can't make a baby in one month by getting nine woman pregnant” - Warren Buffett

No matter where you stand on the meta-investment narrative and your opinion on the application to markets today (including crypto 🙂), the wisdom that you want to leave yourself the room to survive short-term setbacks in order to stick around long-term growth is probably not too controversial.

XTOD: zuck says meta is putting in cubicles. it’s bringing back scotch at lunch and smoking in the office. zuck says the company amex cards work at the strip clubs again. he says it’s back to suit & tie dress code. zuck says they’re reinstalling the asbestos. zuck says no irish allowed

XTOD: "LinkedIn is OnlyFans for middle managers"

XTOD: A friend recently sent me a 2010 article of mine that shows that nearly everything we are discussing today was already an issue 15 years ago when, to most of the world, the Chinese economy seemed in excellent shape and its rapid rise unstoppable. What's interesting to me is that even back in 2010, some of us were saying that "low consumption in China is not a discrete problem that can be resolved with administrative measures". What was required was a transformation of the domestic distribution of income.

XTOD: "We may miss large profits from a major rebound in bond prices. However, our unwillingness to fix a price now for a pound of See's candy to be delivered in [30 years]  makes us equally unwilling to buy bonds which set a price on money now for use [then]." Warren Buffett

XTOD: I've always liked @nntaleb 's terms "extremistan" and "mediocristan" to describe the statistical setting you are looking at.  Natural catastrophes are part of extremistan, where a single loss can be larger than all prior large losses combined.

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https://x.com/BasedBeffJezos/status/1877855472054628362

https://x.com/michaelxpettis/status/1877943509803471266

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https://x.com/mikeandallie/status/1878053972558197238

Daily Economic Update: January 10, 2025

Jobs’ Day in ‘merica.  Consensus is for the headline to be ~160K (down from the 220K reading in the prior month) with the unemployment rate rising to 4.3%.  This one could be interesting, if readings are strong, the thinking is the relentless strength of the USD continues as will the “higher for longer” narrative. But what would a reaction to a bad miss look like?  We go into Jobs with a S&P around 5,900, a 2Y ~4.30% and a 10Y ~4.70%.

Whatever the outcome, pressure certainly seems to be building on foreign currencies and foreign yields, with the UK front and center with GBP at 1Y weakness and UK yields moving into Liz Truss and ‘head of lettuce’ territory with a 30bp move in 10Y yields in just 3 days.  It’s kind of crazy, but reflecting on Jimmy Carter and stories of the late 70s, it’s almost hard to believe how much political attitudes towards deficits have shifted towards a lack of real concern over debt and deficits.  When you think about the fiscal situation in many economies take a look at the commentary below from John Cochrane.   

Let's close out the week with some odds and ends you might find interesting.  Next week we’ll attempt to tackle the other side of the meta-narrative, that being that not everything is cyclical and mean reverting.  Be on the lookout for that post Monday morning.  If you missed the previous posts from this week on business cycles, credit cycles and CAPE, you should read them before Monday.

Before we get to Monday, here’s Buffett and Munger weighing in on the “trees don’t grow to the sky” narrative, with this excerpt from their 1999 shareholder meeting:

 

WB: "If U.S. GDP grows 4% - 5% a year, with 1% - 2% inflation, which would be a very good result, I think it’s very unlikely that corporate profits will grow at a greater rate than that... You can’t constantly have corporate profits growing at a faster rate than GDP. Obviously, in the end, they’d be greater than GDP. It’s like somebody who said New York has more lawyers than people... So, if you have a situation where the best you can hope for in corporate profit growth over the years is 4% - 5%, how can it be reasonable to think that equities, which are a capitalization of corporate profits, can grow at 15% a year? It is nonsense, frankly. People are not going to average 15% a year or anything like it in equities. I would almost defy them to show me, mathematically, how it can be done in aggregate... The only money investors are going to make, in the long run, are what the businesses make. Nobody’s adding to the pot. People are taking out from the pot, in terms of frictional cost: investment management fees, brokerage commissions, all of that... [Corporate profits] can’t double in five years with GDP growing 4% a year or some number like that. It would produce things so out of whack, in terms of experience in the American economy, that it won’t happen... If you trace out the mathematics of something and bump into absurdities, you better change your expectations."  

CM: "There are two great sayings. One is, 'If a thing can’t go on forever, it will eventually stop.' And the other I borrowed from my friend, Fred Stanback: 'People who expect perpetual growth in real wealth in a finite earth are either mad men or economists.'"

Away from the meta-narrative topic, here’s a couple of economic related posts you might have missed.

From Allison Schrager: Risk Management 2025 Style.

• I don’t know what will happen, and no one else does either.

• I am of the mind that the term premium is the most important of all macro/financial indicators.

• Higher rates are back—up and down the curve—and the term premium tells us nearly everything we need to know. If it continues to increase, it suggests a higher growth and risk environment. Which, frankly, is how it should be.

• In a higher rate environment, institutional investors will crave less yield, making expensive fees and liquidity lock-ups less appealing. This shift will expose underperforming private investments.

• Moving into a high-rate for longer environment will reveal where all the bodies are buried in financial markets. And no place is more opaque and full of skeletons than private markets. Maybe this is the year we find out what’s in there.

• As long as uncertainty exists, there’s no such thing as good or bad debt—only good or bad risk management. This means selecting prudent investments, managing their costs, carefully structuring financing (such as loan types and interest rate risk), hedging and insurance. It sounds obvious, but these considerations are often overlooked, particularly in public finance.

From John Cochrane: Inflation and the Macroeconomy

• A one-time fiscal shock gives rise to a one-time rise in the price level. (I owe a lot to George Hall and Tom Sargent, and to Jim Bullard for this analogy.) There is nothing specially fiscal theory in this story. Fiscal theory emphasizes an aspect that is true in all models, however: debt and deficits only cause inflation when people do not expect the new debt to be repaid by higher future surpluses. Debt that will be repaid doesn’t cause inflation.

• A one-time unfunded fiscal shock produces a one-time rise in the price level, an inflation surge that can go away on its own. That otherwise puzzling easing is even clearer evidence for this story. Raising interest rates helps bring down inflation more quickly, but at the cost of somewhat more persistent inflation, just as we are seeing.

• surely our policy maker’s realization that they did overdo it, and consequence reluctance to take responsibility. They should say “Yes. We faced the pandemic and its aftermath with $9 trillion of vital extra spending. We took most of that out of the pockets of government bond holders with a 20% haircut via inflation rather than raise taxes for a generation. We faced supply and relative demand shocks, and chose to make all prices rise rather than some, and especially wages, decline, which we thought would cause a recession. You’re welcome.”  Instead, a dog-ate-my-homework attitude pervades

• If we are not proud of this inflation, being honest about what happened is the necessary first step to not repeating it in the next shock..

• If businesses could forecast that prices would go up next year, they would raise prices now. Hence inflation will always be somewhat unpredictable.

• Tariffs are a corporate tax on imports, partially passed on to consumers. Corporate income taxes are also partially passed on to consumers. You can’t bemoan the inflationary effect of tariffs and deny the same effect of corporate taxes.

• Fundamentally, inflation comes from debt we won’t or can’t repay. Long run tax revenue is good for inflation, but that mostly comes from more growth not higher tax rates.

• The biggest question for inflation, in my view, is how we will react to the next shock. Bird flu could break out and be much worse than Covid. China could blockade Taiwan, provoking a catastrophic global trade, supply, and financial meltdown. A severe global recession could break out. What happens then? Uncle Sam will come knocking for $10 trillion.

• The Fed will be pressured to buy all the new debt again, and hold down rates so the government can borrow cheaply. And Inflation could be the least of our problems. What happens when the US and other governments are unable to raise what they need?

• You should read the concluding couple of paragraphs.

Marcus Nunes with a response to Cochrane

• I think there is a much simpler and consistent answer.  My “guiding light” is the equation of exchange in growth form: m+v=p+y, where m is the growth in money supply, v is velocity growth, p the inflation rate and y the growth of real output. Then, p+y is the growth of nominal aggregate spending or NGDP.

• Market Monetarists, on the other hand, assume velocity can change. Therefore, monetary policy should be conducted so as to keep NGDP growth stable. For that to happen, the Fed should strive to vary money supply growth to adequately offset changes in velocity growth.

• At the start of the C-19 pandemic, velocity growth tanks, so NGDP falls way below trend, bringin inflation far below target. The Fed, however, reacts quickly, increasing money supply growth to try to offset the fall in velocity growth.

• One effect of the big microeconomic shocks was to significantly disrupt relative prices. By February 2021, NGDP had reached the trend path it was on following the Great Recession. Should the Fed have acted to constrain NGDP to remains on that path?

• relative price disruptions can be so large that trying to keep NGDP at the stable path that prevailed before the shock can have significant long term negative consequences. Therefore, there may be situations, hopefully rare, when a higher stable path is desirable

• “why is inflation stuck at 2.5%”, I feel comfortable to argue that results from putting a large weight on Owners Equivalent Rent (OER), which is an imputed prie, a price that no one pays, and suffers from lagged calculations.

XTOD: Below we see the share of the top 10 and top 50 stocks in the US. A popular narrative making the rounds on Wall Street in recent weeks is that this concentration will lead to a long winter of below-average returns.  Much like the CAPE model (which states that high P/E’s lead to lower 10-year returns), a high concentration can diminish future returns.  At first glance, that seems plausible, per the chart below.  It shows the concentration of the top 50 lagged by 10 years (and fitted to show the suggested return), with the suggestion that the next 10 years will produce below-average returns.  If true, a new secular winter is coming fairly soon. However, both the CAPE model and concentration thesis count on mean reversion: that the pendulum will swing the other way.  But as the first chart shows, the pendulum doesn’t always swing the other way, at least not right away.  Periods of top-heavy concentration can last for decades, as was the case during the 1950’s and 1960’s.  The chart above is compelling because it captures the .com bubble, which did indeed mean-revert, but if we take that math back to the 1920’s (below), we see that it’s far from consistent.

XTOD: There is something that I find very perplexing. There was no mention of talking about ending QT in the minutes.   Anyone involved in markets is fully aware that QT combined with a heavy issuance calendar is straining GC and causing SOFR spread to FFR to gap.  This is now penalising USTs levered longs and feeding into TP.  If these liquidity strains are visible to everyone, surely they are visible to the Fed. With the cost of financing for secured longs HIGHER than lending unsecured intrabank held at the Fed, looks like the FOMC is actually looking for a liquidity driven tantrum.  Yes reserves are still high but balance sheets are strained.

XTOD: Perhaps one of the GREATEST five-day stretches of football this world has EVER known begins today.   Enjoy.

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https://x.com/BenScottStevens/status/1877355165545578764

Daily Economic Update: January 9, 2025

The stock market will be closed today in honor of the National Day of Mourning for former President Carter.  The bond market will observe a 2pm early close.

Yesterday shares of quantum computer related companies took it on the chin (down 40%+...don’t feel too bad though some names are still up 700%+ in the last couple of months) after Jensen Huang had remarked that quantum is at least 15 years away from being anything. Of course the broader market is also focused on what policies Trump might roll out, including talk of a national economic emergency that could be used to manage imports. Overall stocks were mostly flat.

In data, jobless claims at 11-month lows show you still can’t get fired.  While ADP showed that maybe you won’t get fired, but the pace of hiring isn’t so brisk either, though yesterday’s JOLTS might show that turning towards more hiring.  The term I find most endearing to the current job market is one I heard called “the great stay”. We’ll see what Job’s day brings on Friday.

In Fedspeak we had Waller expressing some optimism that inflation will resume its descent to 2% and that additional rate cuts will prove appropriate.  The 30Y Auction was pretty good in my estimation.  The FOMC minutes indicated the Fed is likely to slow the pace of rate cuts as they estimate they are closer to neutral.  While the risks to the committee's employment and inflation goals were assessed as mostly balanced, there was sentiment that progress on inflation had stalled and could be more persistent.

The 2Y remains ~4.30% and the 10Y at ~4.69%.

Outside of markets, wildfires in Cali and a potential ice and snow storm in the southwest. Remember the 2021 Texas ice storm that triggered a power crisis due to freezing causing mechanical failures in the generation of electricity?  Hopefully none of those issues for any impacted locations with this storm.

This blog is about economics and markets, so it’s of note that it was Jimmy Carter who appointed Paul Volcker as Fed Chair.  Volcker recounts the time in his memoir chapter titled Attacking Inflation.  In 1978 inflation was running at 13%, in early 1979 the Iranian Revolution led to gas shortages and the ability for the Carter administration to pass new policies was seemingly impossible. It was around this time Carter gave what would be referred to as his ‘malaise” speech, referring to the poor, divisive mood of the country. Not long after that speech Carter reshuffled his cabinet, removing Miller from Fed chair to Treasury secretary and ultimately setting the stage for Volcker.  It’s not lost to history that this was not a politically popular appointment back in 1979, Volcker was a staunch advocate of a politically independent Fed. After Vocker’s appointment it wasn’t too long until Volcker resorted to an unscheduled FOMC meeting on October 6, 1979 (the Saturday before Columbus Day and during a Papal visit that had distracted news agencies) to raise rates and focus squarely on the supply of bank reserves via reserve requirements, allowing the Fed funds rate to be set by the market. This “Saturday Night Special” and subsequent interest rate hikes probably did little to help Carter’s re-election prospects.

In an effort to wrap up the discussion of “cycles”, today I wanted to focus on CAPE, or the cyclically adjusted price-to-earnings ratio. CAPE is a valuation metric designed to assess whether a stock market is overvalued or undervalued. It was popularized by economist Robert Shiller and is sometimes referred to as the Shiller CAPE ratio.  CAPE is typically calculated for an index like the S&P 500.  The calculation is often performed by calculating the real (inflation-adjusted) price of the index as well as the average of the last 10 years of real earnings per share and dividing this price measure by this earnings measure to derive the CAPE ratio.  The purpose of using the last 10 years of earnings is to smooth out the fluctuations in earnings caused by the business cycle.

Those who adhere to the idea of cycles believe that CAPE can be a strong predictor of future stock market returns, a higher CAPE suggests lower returns, a belief predicated on mean reversion.  Current measures of CAPE are in the high 30’s (38 according to YCharts) while some measures suggest the long term average CAPE is in the mid to high teens and measures in the 20s are more typical.  The suggestion associated with the current level of CAPE is that markets might be in a stage of euphoria that has inflated asset prices and investors should proceed with caution.

However, CAPE is not without its share of critics, an oft cited criticism being that changes in accounting standards such as the adoption of mark-to-market accounting  have increasingly distorted the earnings measures. Other concerns relate to a level of insensitivity to changes in business mix and capital structure over time as well as a concern that the measure inadequately accounts for the relative attractiveness of stocks vs. bonds.

As it relates to this latter criticism, there is a 19th century saying “John Bull can stand many things but he cannot stand 2 percent.”  The meaning of which is that the average investor is easily dissatisfied earning low rates of return and the consequence of which is he has a propensity to speculate in an effort to earn more, often without thinking of the consequences.  The relevance to today is directly tied to the level of interest rates in the economy and whether or not they are “restrictive” or remain “loose” encouraging speculation. And whether or not investor experience with years of low rates have permanently shifted risk premiums.

Will something like a large reconciliation package based by Trump potentially be a catalyst that moves yields even higher, propelling us to a new phase in a credit cycle or offering “John Bull” a rate of return on “risk-free” investments that he can sufficient stand?  Which leads to the question of whether the stock market can stand a 10Y Treasury over 5%, or will 2025 risk a repeat of 2022?

As Cliff Asness wrote in his recent letter written from the perspective of the year 2035 looking back on the decade beginning 2025: “First, it turns out that investing in U.S. equities at a CAPE in the high 30s yet again turned out to be a disappointing exercise.  Today the CAPE is down to around 20 (still above long-term average). The valuation adjustment from the high 30s to 20 means that despite continued strong earnings growth, U.S. equities only beat cash by a couple of percent per annum over the whole decade, well less than we expected.”

Will this be our fate?  I don’t know.

XTOD: Would Greenland State University play in the SEC or Big10?

XTOD: Waller on the same page as Powell - noting that most of prices in core PCE are increasing at less than 2%. The segments that are not are imputed prices, which are perceived to be less indicative. The inflation problem is mostly over.

XTOD: I'll tell you a secret. It's the bond-equity correlation that drives term premia, not issuance (or QE). Trump's policies threaten new supply shocks, which would keep the correlation positive. Term premia should widen further if the worst of his policy ideas are realised.

XTOD: Don't know about you but I feel pretty badly about this stat: "The share of U.S. adults having dinner or drinks with friends on any given night has declined by more than 30 percent in the past 20 years." Here's the @TheAtlantic  article on an awful trend in American life: https://theatlantic.com/magazine/archive/2025/02/american-loneliness-personality-politics/681091/?utm_source=newsletter&utm_medium=email&utm_campaign=the-atlantic-am&utm_term=The%20Atlantic%20AM

XTOD: Enough courage to get started + enough sense to focus on something you’re naturally suited for + enough persistence to stay in the game long enough to catch a few lucky breaks + a lot of hard work.   There’s your recipe.

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https://x.com/FedGuy12/status/1877001286387654805

https://x.com/darioperkins/status/1876990044935786970

https://x.com/KenBurns/status/1876984398467264660

https://x.com/JamesClear/status/1877041330095874486

Daily Economic Update: January 8, 2025

Gulf of America, Greenland, the Panama Canal…No more fact checking on Facebook (I don’t have the app, but seems to be another example of the shifting "culture") but stocks slide? Nevertheless yields rising was the major takeaway for yesterday.  Over in data, JOLTS showed job openings at a much higher level than expected with most of the openings showing up in professional and business services and financial areas. ISM services remained in expansion increasing to 54.1, with decent component readings.  The data did nothing to dissuade investors from betting on higher yields and led to an ugly 10Y auction that cleared at 4.68% with weak bid-to-cover and other demand metrics.  Concerns over the overall quantum of treasury supply certainly don’t seem to be helping.  The 10Y rose 7bps and is yielding ~4.68% while the 2Y remains around 4.30%.

On the day ahead we get ADP, and the moved up Jobless Claims data, the 30Y auction, FOMC Minutes and some fedspeak.  It’s bound to be a busy one as investors position for Friday’s job’s report.

Continuing the start of 2025 exploring one of what I describe as the competing “meta-narratives”, the idea of cycles, that there are limits to growth, “trees don’t grow to the sky”.  Yesterday we talked about the business cycle in general, today we’ll dig into the “Credit Cycle” and the work of Hyman Minsky in his Financial Instability Hypothesis, something we touched on back in October when famed investor Paul Tudor Jones raised the idea of another “Minsky Moment”.

When I started this theme this week it was unbeknownst to me that the great Howard Marks was going to play right into my hands (or steal my thunder) with his first memo of 2025 “On Bubble Watch” in which he reflects on the 25th anniversary of the dot-com bubble.  Marks is an ardent believer in impermanence, disruption, the inevitability of cycles, psychology and that overpaying is the greatest investment risk.  He’s in the camp “trees don’t grow to the sky”.  His memo feeds nicely into today’s topic on Minsky and tees up tomorrow’s discussion on CAPE., we both actually referenced Kindleberger (someone’s whose quotes I shared over the holiday)....great minds think alike I suppose.

While I discussed the basics of Minsky’s framework in that previous post, one of the striking features of his hypothesis is that a capitalist economy does not depend on an external shock (war, pandemic, etc.) to generate a business cycle (though it may help to start the process), we are more than capable of generating a business cycle all on our own and often amplified by interventions from policymakers.

Minsky has a specific description of credit cycles in his hypothesis, but more generically, a Credit or Debt Cycle is a way to describe the changing availability and pricing of credit in an economy.  Credit takes on increased importance in the real economy as it’s generally a necessary ingredient for business and household investment, particularly big ticket items like real estate.  In general when the economy is growing, credit increases and when the economy is contracting it decreases.

That all sounds pretty benign on its face, but these credit cycles have tended to produce long and deep business cycles both on the way up (expansion, mania) and the way down (recession, panic, crash).  I state this somewhat definitively because there is empirical, historical evidence as well documented by the likes of Charles Kindleberger in his 1978 book, Manias, Panics, and Crashes. But why are credit cycles so important?

In building his financial instability hypothesis, Hyman Minsky, was influenced by earlier work of Keyne’s and Irving Fisher.  From Keynes, Minsky took to ideas related to the role of capital development, how financing and creation of capital assets can drive fluctuations in economic growth and also Keyne’s “veil of money” which connects money to financing through the element of time, essentially that money flows to firms in expectation of future profits, while firms can only pay back that financing through realized profits.  From Fisher, Minsky was influenced by Fisher’s classic “debt deflation” theory, whereby excessive debt can lead to falling asset prices, which leads to defaults, which leads to declining economic activity, which leads to further defaults and a self-reinforcing downward spiral (interest Nine Inch Nails album too).  Inherent in the earlier work of Keynes and Fisher and other classical economists such as Adam Smith, Knut Wicksell and John Stuart Mill is a view that markets aren’t always self-correcting and can experience periods of disequilibrium and that expectations can change financial structures and contribute to instability.  Minsky takes things a step further and emphasizes the fragility of the system and its propensity to have a disaster.

The basics of Minky’s model (as discussed by Kindleberger) are as follows:

• “Displacement” - some shock comes along that alters the economic and profit outlook for at least one important sector of the economy and this attracts investment while pulling it away from other sectors. If this new opportunity dominates the old opportunities a boom is underway. This gets further fed by the expansion of bank credit and the formation of new credit instruments and even personal credit outside of banks.

• “Euphoria” - the desire to speculate fueled by credit stimulus feeds into demand, prices increase, new profit opportunities emerge and a positive feedback loop ensues.  

• “Overtrading” - which could mean pure speculation that prices will increase further and the use of leverage, both of which can be accompanied by an overestimation of profits.  When this speculation is taken on by a large number of firms and households we potentially lose rationality and it is termed a “mania”.  All the while the credit system stretches further.

• “Revulsion” - eventually something spurs the realization that the market can’t go higher forever, it might be a bank failure, an uncovered fraud, but people and firms begin to liquidate and there is a “revulsion” against lending against the collateral that were being speculated on.

• “Panic” - which is really just the revulsion stage going to a point where people want to get through the door before it shuts and that last until…that’s for another time.

Or to summarize, as Morgan Housel describes Minsky, “calm plants the seeds of crazy”.  Stability breeds instability by encouraging excessive risk taking which leads to booms and eventual busts. 

To map this model to today we can look at AI as a possible example (to be clear I’m not saying AI is a “bubble” or anything of the sort).  A new technology, AI, comes along creating new opportunities, it attracts a lot of capital (see AI chip spend and data center spend), encourages risk-taking, and generates a wave of optimism.  As AI proves profitable, widespread optimism takes hold, credit is available for businesses associated with this trend and perhaps exuberance pushes asset prices higher, even exceeding their intrinsic value.  At some stage a belief that the good times will keep rolling sets in and businesses and investors try to leverage their bets further, which further inflates asset prices, often moving to the “ponzi” stage of financing where rising asset prices are required to refinance assets as cash flows can’t even cover the interest.  In the model this would sow the seeds of revulsion, where some event eventually causes investors and lenders to re-evaluate the landscape. In the AI example, this could be some revelation that obstacles to further scaling the models cannot be overcome.  A sudden shift in sentiment could lead to selling and as a result the contraction of credit.  Ultimately a panic could set in as liquidation of investment holdings creates a self-reinforcing cycle.

All of this is a story of a movement through the credit cycle from “Hedge Units” where there is sufficient cash flow generated to meet contractual liability obligations, to “Speculative Units” where cash flow is sufficient to cover interest but not repay the principal - meaning assets ultimately need to be sold or refinanced to meet the commitment, to “Ponzi Units” where the repayment of the debt is based solely on the ability to sell or refinance based on an asset that has increased in value.

That seems like enough foundational cycle related stuff, tomorrow we’ll get into a valuation metric based on the idea of cycles, specifically CAPE, the cyclically adjusted price-to-earnings ratio.

XTOD: One day MS dreams of taking Bitcoin private so that they can mark it to whatever they wish each day and further outperform the public coin markets

XTOD: Barry Naughton: "Japan spent almost a decade trying to painlessly restructure a financial system that had suffered a huge reduction in the value of its assets. And now China seems to be repeating some parts of that." In itself, debt is simply a set of transfers – an explicit transfer today followed by an explicit or implicit transfer tomorrow. Secondly, as John Kenneth Galbraith explained, the creation of fictitious wealth at first boosts economic activity through a wealth effect, but as it is written down, it dampens economic activity even more vigorously through a negative wealth effect.  In China's case, most of the accumulated debt has been used to fund investment, but if this investment had been productive, then by..

XTOD: 4. If you don’t define your own version of success someone else will for you; take time every year to reflect on your values; do everything you can to live in accordance with them.  

5. There is no bigger trap than thinking the accomplishment of some goal will change your life. But what will change your life is the person you become in the process of going for it.  6. The people with whom you surround yourself shape you. We are all mirrors reflecting onto each other. Choose wisely. This is everything.

XTOD: U.S. President-Elect Donald J. Trump has stated that he won’t commit to not using Military Force to capture the Panama Canal and/or Greenland, and that he wants to change the “Gulf of Mexico” to the Gulf of America.

https://x.com/ohcapideas/status/1871406046943891567?s=46&t=D2AESCsaw42dAEzgmjXHQA

https://x.com/michaelxpettis/status/1876172997410861133?s=46&t=D2AESCsaw42dAEzgmjXHQA

https://x.com/bstulberg/status/1870930223711277309?s=46&t=D2AESCsaw42dAEzgmjXHQA

https://x.com/sentdefender/status/1876676322086302175