Confusion and the Need for Second-Level Thinking

Note: I was so absorbed in writing this blog while waiting for my connecting flight home at the Phoenix airport that I only realized after it was too late that I was at the wrong gate and that my flight was changed to a different gate in another terminal. In my defense I never received a text notifying me of the change, and even after running as fast as I could to get to the other terminal only to find my gate closed, the attendant at the desk said she was surprised at how late they were notified of the change. I missed the flight but fortunately was able to get on the last one of the evening three hours later.

A quote attributed to Mark Twain, but probably inaccurately, says “If I had more time I would have written a shorter letter.” I took the opposite approach. The extra three hours has led to a much longer blog. Apologies in advance.

This is going to be a very frustrating blog because I’m going to point out cross currents that make it very difficult to have a strong conviction about interest rates, jobs, inflation, and stock prices. I’m glad I’m not the only one feeling a bit disoriented, or even confused, as I took comfort in reading this tweet from Dan Loeb, a very successful and highly regarded investor.

Second-level thinking is not easy and it can make your head spin. And if Dan Loeb is now saying that third-level thinking is needed then I hope you’re not prone to migraines because this requires A.I. type mental computations to gain clarity.?

Here is how I see the world, and have been seeing it for awhile, and yet, while what follows may sound coherent, at least at first, I still have some underlying dis-ease such that I don’t feel highly convicted.

I believe that we’re out of the Long Emergency (2009-2022) of too little demand, not enough fiscal support, and the belief that interest rates could not exceed a certain level because the amount of debt in the economy would lead to potential deflationary effects as loans defaulted and collateral values declined. This led us to emphasize variable rate loans for well over 10 years as we believed, correctly for a while, that the yield curve would remain steep and that we were in an environment of lower lows and lower highs in terms of rates.?

Everything changed with the bazooka of federal spending to counteract the economic collapse brought on by the Covid shutdown. And rather than pull back from the emergency spending, it has stayed in place and even grown. This has completely changed the Fed’s reaction function as this fiscal support has reversed the conditions of the Long Emergency and now the clear and present danger is inflation. This has led to real rates being quite high after being negative during the Long Emergency. The economy has held up in spite of higher interest rates because the one million construction jobs that normally would have been lost have actually grown due to immense spending on infrastructure and the green economy as well as a booming apartment construction market. In addition, labor hoarding is probably happening to some degree. Throw in much tougher immigration enforcement and we may be facing a very deep labor shortage in the construction industry.

This chart shows construction employment as a percentage of total nonfarm employment. One can see that it drops fairly materially during recessions (with the exception of 2000-1) but so far no downturn yet.

The money chart for me, which shifted my bias from floating rate debt to now being much more focused on fixed, is this one.

I went back to see what the historical relationship has been between the unemployment rate and the federal deficit as a percentage of GDP. Between 1948 and 2019 (pre-Covid) the deficit as a percentage of GDP has averaged approximately 3.5% less than the unemployment rate. To use an example, today the unemployment rate is 4.0%, this would imply an equilibrium deficit of approximately 0.50% of GDP. So what is the current deficit? 6.3%! This is far too high given how low the unemployment rate is and gets to the heart of my angst. And this chart shows that federal spending is still quite strong, although the deficit is not as high as it was during Covid as a percentage of GDP.?

And, according to Deutsche Bank, the deficit is going to remain quite high through 2027, and probably beyond as well.

Will DOGE make a dent?

There has obviously been a lot of coverage of Elon Musk’s DOGE and the work his team has been doing to uncover fraud, waste, and employment inefficiencies. I have been curious as to where the bulk of federal employees work and now I have the answer from this chart. One can see that it is overwhelmingly military and security related. Thus, the only way to move the needle from an employment standpoint is to make cuts in these areas.

I will now digress into a contrarian investment idea for those who think DOGE will be more sound than fury. Easterly is a REIT that focuses on buying properties leased to government entities. One can see that it has performed very poorly over the last five years. Its downtrend started years before DOGE so it was already being negatively impacted by having a lot of office exposure, even though most of its leases are government guaranteed. This chart does mask that the downturn continues as the stock is down nearly 16% over the last six months.?

One can see how the dividend yield has continually increased as the stock price has dropped and the dividends paid has remained the same. It was yielding close to 4% in 2020 and is now 9.46%.

Now let’s turn to interest rates as 10-year Treasury yields have dropped by over 0.5% (based on its recent low) from its January high. I found this chart and narrative particularly interesting showing how sensitive the 2 and 10-year Treasuries have been to surprises in core CPI. From The Daily Shot:

Since 2023, Treasury yields have become significantly more sensitive to core CPI surprises, with both 2-year and 10-year yields reacting sharply to inflation data. This suggests that markets now expect a more forceful Fed response to inflation fluctuations than in previous years, reinforcing the importance of upcoming CPI releases for rate expectations.

Since all eyes should be on inflation to help figure out the Fed’s policy stance, it’s helpful to look at derivative inflation indices like this ETF, which owns a basket of stocks that should benefit from inflation. One can see that, while it has come down from its peak that was reached after the Fed started cutting rates, it is still holding its uptrend. Thus, from the market’s perspective, one can surmise that inflation is still a risk and may keep the Fed on hold. As an aside, after Friday’s well-received inflation report from the perspective of the bond market, this ETF was up 0.43% as of this writing, another example of a confounding crosscurrent that probably requires second-level thinking to make sense of.

Based on the deficit charts shown earlier, one can see that it’s logical for investors to still be concerned about inflation re-emerging, although the probabilities are not nearly as high as they were in the more immediate aftermath of Covid.

And, yet, I have also been a believer that once the yield curve de-inverts (long rates return to being higher than short rates), that is the time to be on recession watch. What’s interesting about the chart below is that recessions tend to ensue after the 10 minus 3-month T-Bill deinverts and temporarily re-inverts only to de-invert again. I know that’s confusing but generally what happens is the Fed starts cutting faster than the 10-year drops and this leads to a de-inversion. Currently we have reinverted with the 10-year at 4.25% and the 3-month T-Bill at 4.31%. If the 10-year stays at 4.25% and the Fed cuts by 0.25% then we will de-invert once again, reinforcing the recession signal.

Another recession watch indicator is the Sahm rule, which I won’t explain here but you can read about at the bottom of the following chart. It is definitely telling us that we should be on recession watch.

And while higher 10-year yields would push the yield curve back into de-inversion mode, from a technical standpoint, now that yields have dropped below 4.31%, there may be some more downside in yields. It’s interesting the following chart shows the key rate level being 4.31%, which is the rate that keeps the yield curve essentially flat (one basis point negative).?

Perhaps investors were too euphoric about stocks and too pessimistic about bonds such that any downside surprises in economic reports would lead to a selloff in stocks and purchases of Treasuries. This has been the case recently with the ratio of the S&P 500 to long-term Treasuries having dropped 8% from its peak. During the much bigger July to September drawdown 10-year Treasury yields dropped by approximately 0.8%. This suggests we might test the 4.00% level over the next month which would put us further into inversion territory from a yield curve perspective unless the market is firmly convinced the Fed will be cutting rates and short-term rates will follow lower. Right now the next rate cut is projected to take place at the June 25 Fed meeting so we have close to four months before the market thinks this starts to play out.

Retail investors have become incredibly bearish on stocks which suggests that a rally is in the cards. I don’t think we’re at that point where economic weakness leading to lower interest rates is good news for stocks because I think there is still strong earnings growth baked into estimates. We are at a very interesting juncture where bonds are somewhat favorable from a technical standpoint and the ratio of stocks to bonds is still quite high. And, yet, there has been a big correction in that ratio and retail investors are very bearish which would suggest that ratio could turn back in favor of stocks. The question is whether both will rise but with stocks rising more.

But maybe the retail investors are right, at least in the short term, as this concern from www.sentimentrader.com highlights.

Now let’s turn to housing as I haven’t covered that for awhile. After a nice run up between July and December, the homebuilder ETF has given up almost all of its gains. And this is in spite of the recent drop in interest rates. Over the past six months the ETF is down 12.8%.

Home purchase activity remains quite weak.

New home prices remain at record high levels.

How long can this last given the elevated inventory levels?

And with a nine month supply of new homes, I would expect builders will have to offer some compelling incentives to move their inventory. This is probably weighing on their stock prices.

And while I would normally sign off hoping that readers will have gained more clarity after reading my blog, in this case I am sort of hoping you find yourself more confused because misery loves company.

Clearly there are more headwinds in the economy with the prospect of significant federal government layoffs, tariffs, and the potential for U.S. defense firms to lose significant European orders. Housing is not providing much support and there is a glut of apartments and now new single-family homes. This doesn’t bode well for future construction spending. On the other hand, there are still inflationary pressures from continued deficit spending that is too large relative to the unemployment rate, onshoring, tariffs, and mass deportation risks, and a sharp crackdown on illegal immigration. The stock market has been showing weakness, particularly high flying tech firms, and bonds are finally getting a bid as rates have come back down such that the yield curve is inverted again, which suggests that a recession may be a bit further off in spite of more states on recession watch.?

I will sign off with some very interesting second-level thinking which speaks to my angst regarding far too much federal spending relative to the health of the economy and what this person believes are the true intentions behind Trump’s policies. I will then close it with an excerpt from a poem.

Not only do I feel the need to make a more concerted effort to engage in second-level thinking in an attempt to gain more clarity, I also felt the need to turn to poetry to help tap into my subconscious to get a better handle on my confusion. I did a search on poems focused on confusion and found one that really spoke to me. I will sign off with an excerpt from the poem Infinity Loop by San.

With a compass of sheer curiosity, I roam,??

An oxymoron guiding me to unknown realms,??

Chasing the edge of a world that’s never shown,??

Looking for paradise at every place,

Only to find in the void, a blank space.

Each question a spark, a thread to unwind,??

But this thread, it tangles, no answers to find,??

In the labyrinth of thought, I’m lost, confined,??

Curiosity’s compass, leading a confused mind.

?I feel like Scorpio, the psychopathic serial killer who is Sergeant Harry Callahan’s nemesis in Dirty Harry when he is on the receiving end of Harry’s final soliloquy.

“I know what you’re thinking. Did he fire six shots or only five? Well, to tell you the truth, in all this excitement, I’ve kinda lost track myself. But being as this is a .44 magnum, the most powerful handgun in the world, and would blow your head clean off, you’ve got to ask yourself one question: “Do I feel lucky?” Well, do ya, punk?”