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The rollercoaster for stocks continues. After a monster 2024 run, the S&P 500 (SPY) fell slightly over 2% yesterday after the Labor Day holiday, led by Nvidia's (NVDA) 9.5% fall. Markets are jittery going into Friday's jobs report. Last month's jobs report was quite bad and followed months of reports showing unemployment steadily rising. Another significant rise in unemployment in Friday's jobs report would signal that a recession has already begun. This is while large-cap US stocks are still trading near their 1999 bubble peak valuation, though volatility has risen sharply. And Berkshire Hathaway (BRK.A) (BRK.B) continues to steadily unload billions in stock, leading to speculation as to why.
Nothing Has Changed – Yet
My take on what Berkshire is doing – after the 35% rally in large caps since last October's lows, it's hard to see much value. If you think of investing as buying shares in businesses, then many of the valuations being thrown around make zero sense. Would you pay 50x earnings for a business that's growing at 10% annually? You invest $1,000,000, and this year you'll make $20,000. But wait, there's more. Next year, you get a whopping $22,000! Or you could stick your money in a money market for zero risk and earn $55,000 in interest. If you're wondering who would buy this business, it's Costco (COST), and you can currently buy the stock for 50x earnings and less than 10% growth. Are they going to sell some AI chips with their hotdogs? Berkshire used to own Costco stock but sold it when the valuation got crazy. But every "growth" mutual fund manager can't get enough of it.
I can give dozens of examples of super-overvalued blue chips. Even stocks like General Electric (GE) are suddenly trading for 40x earnings. Late last year it was around 20x, which isn't all that crazy. But 40x certainly is! I've had conversations with acquaintances where I ask them about valuations on popular stocks, and they freely admit that they don't look at or care about valuations at all. When people are blind to valuations and will pay any price for an asset as long as it's going up, it's a classic characteristic of a bubble. And these forward earnings estimates all assume the softest of soft landings – they're pricing the type of post-recession earnings recovery you tend to see – but from peak-cycle earnings instead.
Recession Evidence Is Mounting
July's jobs report rocked the markets when it showed that unemployment rose from 4.1% in the previous month to 4.3%. This came after the rate of unemployment had risen steadily by 0.1% per month since March. This is what the start of a recession looks like. Once unemployment starts going up, it tends to increase at an accelerating rate until imbalances in the economy are cleared. These same imbalances being cleared tend to send the stock market down 35-50% in a recession.
Of course, Wall Street analysts think this is a fluke, and they're expecting unemployment to go down to 4.2% this month. The main reason that they think unemployment is about to go down is Hurricane Beryl, which makes me think no one read last month's jobs report.
NOT BERYL (BLS)
The BLS made a special box on the front page of last month's jobs report saying that the rise in the unemployment rate wasn't from Hurricane Beryl, and yet here we are with Wall Street economists saying that it was a fluke and don't worry about the jobs numbers because there was a hurricane in Texas. I would know if they were right – I got hit by the eye of Hurricane Beryl and am still searching for anyone who lost their job because of it! Texas lost jobs in June as well, and there wasn't a hurricane then.
Then you have the issue of jobs revisions. There's something called the birth-death model that the government uses to guess the amount of jobs being created by new businesses. Because more businesses open than close on average in a growing economy, this is usually a fair adjustment to make. The problem with this is that it causes the official data to see huge revisions when the economy goes into recession. If part of Friday's non-farm payroll report is a statistical model that simply assumes a net 80,000 jobs are created each month by new businesses and the real number is -20,000, then that's a huge problem. This same concept caused the Fed to be late in raising interest rates in 2021 because they thought the jobs market was weaker than it was, but the economy had turned.
The fact that the surveyed unemployment rate went from 4.1% in June to 4.3% in July is powerful evidence that the non-farm payroll reports for this month and last will be revised down again, probably to a negative number. My best guess for unemployment this month is 4.4%, not a total disaster number but another sequential weakening of the labor market.
To these points, this is the current pace of hiring. As hiring has slowed, it's not a coincidence that unemployment has risen. And hiring will continue to slow as the economy stalls.
More recession evidence–
- Mortgage applications continue to stall. There's some argument that the boom in the housing market pulled forward years of demand – a large cohort of buyers feared that if they didn't buy immediately, they'd be forever priced out. Another argument is that pretty much everybody who could qualify for a mortgage at current rates and home prices has bought. Either way, interest rates have eased a bit and buyer demand is not recovering. We get new data on active listings for homes this week, and I'll be very curious to see how much inventory is starting to pile up. And if existing homes are starting to pile up, that's evidence that we don't need the 1.54 million homes under construction either.
- Personal income was revised down, while spending was revised up for Q2. Not exactly what you want to see. The U.S. savings rate is now 2.9%, near the all-time low set right before the 2008 recession.
- The recent PMI reports had some interesting commentary from businesses. Companies cite downsizing through attrition and not hiring backfill. We're not seeing a ton of layoffs this cycle (yet), but historically, unemployment is created by a slow pace of hiring rather than mass layoffs. As the regulatory costs of layoffs have risen over time and the workforce has aged, it makes more and more sense to slow hiring rather than lay off employees like companies may have done 20-30 years ago. Reducing hours and shifts is also a common strategy for companies dealing with a drop in demand.
- Credit card and auto loan delinquencies are high and rising. Credit cards in particular are headed to levels unseen since the 2008 recession.
- Funny money purchases are way off the business cycle peak. Rolexes, boats, sports cars – the demand for all of these has been falling sharply over the past 18 months.
- Hiring in Canada and the UK is falling off of a cliff. The UK had a strong tourism season this summer, but British job postings are tanking now that summer is over. Canada, in particular, looks to be headed for a deep recession. We expect Canada and the UK to lead the US because households there have more variable-rate debt that resets, while US consumers have been able to hold on to 3% fixed-rate mortgages. US job openings are slightly above pre-pandemic levels, while hiring is well below pre-pandemic levels.
Economists were almost unanimous at the start of 2023 calling for a US recession. Now they're almost unanimous calling for a soft landing. What gives? My take – a recession didn't happen right away because so many consumers had 3% fixed-rate mortgages and large-cap stocks had issued long-term bonds. Both groups started earning more interest on their cash, while their debt was fixed rate. Like most of the econosphere, I missed this and didn't anticipate that the economy would hold up for so long. But the leading areas of the economy have been pummeled since the Fed started hiking, and now we're seeing the full effect of the tightening kick in on the rest.
Now an interesting question – if the Fed hiking rates helped big companies and affluent households by giving them extra interest income, what happens when you take it away by cutting rates? Cutting rates actually might weaken the economy. It certainly would make corporate profits go down – if you look at Big Tech income statements, they're making a ton of money from interest in the past 2 years.
How Will The Fed Respond?
Market expectations are currently split between a 50 bps Fed cut and a 25 bps cut. Right now, there's roughly a 60% chance that the Fed goes ahead with a 25 bps cut, and a 40% chance of a 50 bps cut. I don't think the Fed will go 50 bps here, for two reasons.
- The Fed will want to save face. They could have cut 25 bps in July but opted not to. If they go 50 bps now, it makes them look incompetent. A better approach would be to cut 25 bps and state that they're willing to cut more aggressively going forward into any substantial labor market weakness. Of course, to my earlier point, cutting interest rates too much might actually weaken the economy.
- Politics. If the Fed cuts 50 bps right before the election without signaling it beforehand, Republicans can easily argue that the Fed is trying to save the race for Democrats. Taking the politics into account as well, I think the Fed will go 25 bps, even if unemployment rises.
Bottom Line
It's not my goal to crank out endless bearish proclamations from the South of France or to be the next "Dr. Doom". Some of my readers are likely to be more bullish than me, and that's okay. But if you're reading this, I want you to have the facts about the extremely high valuations investors are currently paying, and about what's going on with the economy at a turning point. With stocks near bubble highs, I've largely focused my energy elsewhere. In July, I published a free guide that's helped people I know to search for and recover tens of thousands of dollars worth of unclaimed property this year. And last month, I published a free guide on how to use quant strategies to win betting on NFL and college football. The common theme between all of these is to use little-known information to find value, often paired with a healthy dose of patience.
