The Market Is Telling the Fed What to Do

A rare one-day drop... An ever rarer one-day spike... Little has changed... 'Fear is back'... Sahm rule: Made to be broken... More T-bills than the Federal Reserve... Welcome to the party, Warren Buffett...

A dose of perspective seems like a good idea right now...

Digest editor Corey McLaughlin has already covered Monday's market panic... So I (Dan Ferris) will start by zooming out a little bit...

From its July 16 all-time-high close of 5,667.20 through Monday's close of 5,186.33, the S&P 500 Index's total decline is just shy of 8.5%.

That's a pretty large move for a three-week period, down or up. U.S. stocks have averaged about a 10% gain for the entire year for a few decades now.

But it's not uncommon. Since the 1980s, the S&P 500 has had a correction of more than 5% every year but two (1995 and 2017). So maybe the past few weeks' market action is nothing to get excited about.

If you're bullish on stocks and the current decline is over, history suggests it won't take long to put it behind us. On average, it takes about three months to recover from a correction of between 5% and 10%... and about eight months for one between 10% and 20%. In the grand scheme of things, for folks investing for the next 10, 20, or more years, that's nothing.

Also, as of this writing, the S&P 500 is less than 7% from a new all-time high. And the index is still well above its 200-day moving average, where it has been since last November.

If you thought the market was still in bull mode last week, this week's action shouldn't change that view.

The bottom line for investors is that the market's action since mid-July, including this week, doesn't mean you should change the long-term picture for your investments. Nor does it mean you should change any part of your savings plan. It's not fun to watch your 401(k) lose almost 9% in three weeks, but that's a purely emotional reaction to a relative nonevent.

On the flip side of all that...

My view of the overall stock market hasn't changed, either...

I've been telling you that stocks are egregiously expensive on a historical basis and still in mega-bubble territory. The cyclically adjusted price-to-earnings ("CAPE") ratio was 35.5 last time I mentioned it. Now it's 34.1.

So, while history tells you the decline since July was a nonevent... it also tells you that when stocks get as expensive as they are today, large, extended declines have always followed.

And in nearly every one of those instances, some large index like the S&P 500, Dow Jones Industrial Average, or Nasdaq Composite Index has gone into a decade-plus sideways market after that large decline.

Like all market nonevents, this one has been taken way too seriously by a bunch of folks trying to do that thing I'm always telling you it's so foolish to even attempt: make predictions.

After Monday's panic, the bond market is now pricing in a 50-basis-point rate cut in the short-term benchmark federal-funds rate at the next Federal Open Market Committee meeting on September 17 and 18.

So let me get this straight. A run-of-the-mill market correction, which has happened almost every year since the 1980s, somehow means the U.S. central bank will have to intervene in the short-term interest-rate market to... do what? Inquiring minds want to know.

The S&P 500 is allegedly a forward-looking data series, which gives us hints about future developments in the U.S. economy. So far this year (as of yesterday), the market is up about 10.9%. That's a little better than the average return of the last 30 years, at 9.9%.

Even after the recent decline, including the panicky day on Monday, the market is still signaling all-clear in the U.S. economy.

You may want to quibble with my suggestion that the market's recent action is totally normal...

Since the first of the year, the market's fear gauge – the CBOE Volatility Index ("VIX") – has spent most of its time between about 12 and 16, with a brief move up to 19 in April. It closed at 23 on Friday, August 2. Then the market had a panicky day on Monday, and it soared.

As Corey wrote in Monday's Digest, "Fear is back." The VIX spiked as high as 65.7 that day – its third-highest level ever (exceeded only by spikes in the fall of 2008 and March 2020).

The VIX is a 30-day average of near-the-money put and call option prices. It negatively correlates with the S&P 500 about 80% of the time. That means that when the S&P 500 declines, 80% of the time, the VIX rises.

When the market declines a lot, the VIX always rises as frightened investors purchase last-minute insurance policies on their stock portfolios in the form of put options.

Why were investors so scared on Monday...?

Well, the quibblers will say it's because a one-day decline of greater than 4% is rare (about 0.49% of market days since 1990), and the S&P 500 opened Monday down 4%.

The S&P 500 closed nearly 3% down for the day. That's still a relatively rare occurrence, at just 1.67% of market days since 1990. Even taking out the days when the market rose, it's still not common, coming to just 3.6% of all down days.

You still have to wonder why, with 146 greater-than-2.7% declines occurring in the past 34 years, only three of them generated these enormous VIX spikes...

The other two were obvious: the 2008 crisis and COVID-19 panics were crazy times. I get it. But there's nothing like that going on right now. It just seemed like there ought to be some obvious reason why this particular spike was so large. And there was... but it's nothing like I'd imagined...

As it turns out, it was mostly a technical glitch...

In an analysis posted on the social platform X, Andy Constan of macro research firm 2 Graybeards concluded that the VIX didn't hit 65 on Monday... at least, not in a way that's meaningful to overall market volatility.  

The apparent spike to that level was due entirely to the mispricing of a single option, which threw the VIX calculation wildly out of whack. Constan recommends looking at the VIX futures, not the VIX, as a clearer fear gauge. The August 2024 VIX futures contract peaked at about 32 on Monday, according to data compiled by Bloomberg.

That's still a serious spike, but not one of the three highest on record.

I would point out that the VIX has dropped quickly since Monday... to 20.4 at today's market close. That's barely above its long-term average closing value since 1990 of 19.49, according to data compiled by Bloomberg.

So the VIX went absolutely nuts for a few hours, then got back to slightly above normal over the next couple of days...

I'd love to say Monday's VIX spike means more folks are coming around to my way of thinking about stock market valuations, but that's probably not true...

If the market fails to recover to the July 16 high in the next three months, then maybe I'll start believing that. Even then, recent history suggests stocks will still be historically expensive at the next market bottom.

In fact, a good student of stock market action and human behavior shouldn't be surprised at all if Monday turned out to be the bottom of this correction. It's typical for investors to capitulate like that. They all throw in the towel at the bottom... which is how corrections tend to end.

If that's true and the market heads higher, I'll probably just get more bearish with each uptick.

Monday's market action may have refuted one of my recent ideas...

Here's something I suggested in my June 28 Digest:

The market is overwhelmingly focused on rate cuts, ready for money to get cheaper and boost stocks. And today's stock prices already reflect the expectation that this will happen.

So if the Fed cuts rates by less than the market expects, everyone will feel that effect. It would suggest that the Fed sees greater inflation pressures than the market currently believes.

This shift could also drive up long-term yields like the 10-year Treasury note, creating a yield-curve reversion. Stocks priced near record valuations are wholly unprepared for higher long-term interest rates, which would drive up companies' borrowing costs.

In other words, the Fed could cut rates... only to see other rates rise. And that would be bad news for stocks.

The 10-year Treasury yield was 4.3% that day. It has since fallen and plunged to a near-term low just below 3.8% on Monday as panicked investors bought bonds – yes, even 10-year bonds.

The 10-year is yielding 4.1% now, but what will happen if investors continue to sell stocks? Will its yield fall as investors buy longer-term bonds along with T-bills and other safer short-term instruments? Or will investors fear that Fed cuts will rekindle inflation, making longer-term bonds unattractive?

I don't know, but I doubt the question will really be answered before the Fed's September meeting.

I still think there's a chance that the Fed will either not cut rates or cut less than the market expects... either of which would be considered a hawkish move that doesn't support equity prices. And honestly, if the central bank does cut rates as much as the market expects, history suggests it could be signaling trouble for the economy or stocks.

Not that we need to wait for worrying signals...

The 'Sahm rule' recession indicator was triggered on Monday...

Corey mentioned it in his Monday Digest. Here's how I described it a couple weeks ago for subscribers of The Ferris Report:

Named for its creator, former Fed economist Claudia Sahm, the indicator helps pinpoint the start of a recession. It compares the three-month moving average of unemployment with its low over the previous 12 months. If the moving average has risen at least 0.5 percentage points above its 12-month low, that means a recession has begun.

This indicator has a perfect track record of signaling recessions over the past 50 years.

At the end of June, the indicator stood at 0.43. At the end of July, weak jobs-report data pushed it above the 0.50 threshold, and it now stands at 0.53. The indicator with the perfect track record says we're in a recession.

Its creator disagrees. When a recent jobs report triggered the indicator, Sahm herself wrote a Bloomberg opinion piece titled, "My Recession Rule Was Meant to Be Broken," which begins:

The US is not in a recession, despite the indicator bearing my name saying that it is. The Sahm Rule, which was triggered with Friday's weaker-than-expected jobs report, joins a long list of economic tools skewed by the unusual disruptions of the past four and a half years.

In the same article, Sahm admits that she created it to "act as an automatic trigger for fiscal policy, such as stimulus checks, in a downturn." Automatic means the rule indicates economic weakness is already happening and, if you're a politician, you're supposed to say something should be done about it sooner rather than later.

In other words, if the Sahm rule works, it's not predicting a recession... It's saying we're already in one...

That's a view shared by a Stansberry Investor Hour podcast guest and macro analyst, Simplify Asset Management's Mike Green, who says we're "almost certainly in recession that probably started in the fourth quarter of 2023."

And I think I know why Sahm won't abide by her indicator's output... Sahm left the Fed and now works for the asset-management firm New Century Advisors. She won't be the first to declare a recession because she knows clients and her bosses will crucify her for it.

Everybody in that industry knows that you make money by getting and keeping clients' assets. And you keep clients by losing money when everybody else is losing it and making it when everybody else seems to be making it.

It makes no sense to chase client assets out the door by predicting a recession. She'll call it a recession only when the whole world already knows it... when it's the safe thing to do.

Having worked at the Fed – a typical D.C.-area hive of pedigreed bureaucrats – Sahm is certainly familiar with the concept of plausible deniability... making folks believe you didn't know some unpleasant fact any sooner than anybody else did.

So when her indicator with the perfect track record says we're in recession, she has to tap dance in a Bloomberg editorial and say something like, "Sahm Rules are made to be broken, and if only the Fed would cut rates, there'd be no recessions ever. It's not a recession, I swear! Don't fire me, please!"

So investors might not love the results of that rate cut they're counting on...

We all seem to have swallowed hook, line, and sinker the idea that the Fed controls the stock market.

But maybe, just maybe the Sahm Rule works the way it always did before, and the Fed doesn't control the market, but only reacts to it.

And maybe cutting rates in September will just be its final acknowledgement that yes, we've been in a recession since at least July (by the Sahm Rule) if not since last fall (as Mike Green said).

And if all that plays out, then maybe a 50-basis-point cut will scare the crap out of everyone and the stock market will hate it even more than Monday's disappointing unemployment report.

Maybe the market already knows things aren't great, and the 10-year yield below 4% is the market cutting rates before the Fed can do it.

I hope not... but hope is not a strategy.

Finally, the world's favorite investor seems just as concerned as me...

Last quarter, Warren Buffett sold more than half of Berkshire Hathaway's biggest equity position, Apple. It owned more than 900 million shares of Apple last December, 789 million at the end of March... and just 395 million shares as of the end of June.

Where's he putting the cash? In the safest place he can find. Berkshire now owns more T-bills than the Federal Reserve: $235 billion compared with the Fed's $195 billion worth of the shortest-term Treasury obligations.

Bloomberg estimates Berkshire paid an average of $37.51 per share for its Apple stake. With the stock above $200, Buffett made more than 460% in capital gains on the position.

So Buffett – who says his favorite holding period for stocks is forever – is selling massive amounts of his largest position and buying massive amounts of T-bills.

If he's really a long-term investor who loves to hold forever, buying T-bills instead of stocks suggests he doesn't see anything priced for a good long-term return.

In other words, while I was telling you future returns on Magnificent Seven stocks were unattractive and T-bills were a great buy, Buffett was selling Apple and buying T-bills.

Welcome to the party, Warren.

New 52-week highs (as of 8/8/24): AbbVie (ABBV), Alpha Architect 1-3 Month Box Fund (BOXX), CBOE Global Markets (CBOE), Equity Commonwealth (EQC), Fair Isaac (FICO), Intercontinental Exchange (ICE), Intuitive Surgical (ISRG), Kellanova (K), Lockheed Martin (LMT), Motorola Solutions (MSI), Procter & Gamble (PG), Planet Fitness (PLNT), Regeneron Pharmaceuticals (REGN), Veralto (VLTO), Viper Energy (VNOM), and the short position in SolarEdge Technologies (SEDG).

In today's mailbag, feedback on a take in yesterday's edition from Stansberry Research senior analyst Brett Eversole... and compliments on our "emergency briefing" from Stansberry Research founder Porter Stansberry, senior partner Dr. David "Doc" Eifrig, and Stansberry's Investment Advisory lead editor Whitney Tilson... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"I find Brett Eversole's analyses always interesting. May I suggest a debate between Brett and Dan Ferris at Stansberry's October conference? I would love to see that." – Subscriber Sherwin R.

"Thank you so much for putting together the above-mentioned video [on Wednesday]. Included was a host of worthwhile information... I also liked that I could control playback speed (which I did) and/or skip parts (which I did not) if I so desired.

"Hands down the best, most useful video presentation I have seen from Stansberry Research." – Stansberry Alliance member Dale W.

Good investing,

Dan Ferris
Eagle Point, Oregon
August 9, 2024