Inconsistent Economic Data, Bad Debt Deal, and Lack of Breadth Monthly Depth Report – June 2023

We just had the big outcome in the debt ceiling negotiations that everyone expected, and are also following the continuing trend in inconsistent economic data. We have a “bull” market created entirely by 7 stocks. On the positive side, there’s a new addition to the DKI Board of Advisors. Plus, we have a bonus story about my dad and learning to dismantle a snowblower. As always, it ties to investing. Let’s get started:

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Debt Ceiling Deal:

We had approximately 6 months of “emergency” debt ceiling negotiations which ended with an agreement just before the Treasury Department ran out of extraordinary measures to keep the charade going. From the Treasury to both political parties, the entire episode was a farce. Let’s go into detail, and for the partisans reading this, I promise to criticize everyone involved.

Treasury:?This department uses “extraordinary measures” to maintain the fiction that the US hasn’t exceeded the maximum amount of debt it’s authorized to issue. This maximum is called the debt ceiling. When employing “extraordinary measures”, the Treasury does things like not pay bills and not contribute to pension funds despite continuing to accrue those obligations. They also raid some government pension funds and use that cash to pretend we’re under the debt ceiling limit. Any business engaging in this kind of creative accounting would soon find itself facing an unpleasant investigation from the IRS, the SEC, or both.

The bills don’t stop. The spending doesn’t slow. The government just pretends that these obligations don’t count as debt. To give you a sense of the magnitude of the fiction here, government debt increased by over $300 billion in the first few days after the deal was done, and we’re facing at least $1 trillion of additional debt issuance in the coming weeks. This is a huge amount of money in a short amount of time both on an absolute basis and for a country on the brink of default.

Democrats:?The White House spent months talking about how a debt default or near default would be a disaster for the US and the world economy, AND also saying they wouldn’t negotiate. Which is it; a potential disaster, or something where there’s no need to negotiate?

They falsely characterized excessive spending as “investment” when it’s just pulling consumption forward and leaving the expense to the next generation. They’re still bragging about printing more dollars to increase spending while calling it “inflation reduction”. More spending, more debt, and more dollars create inflation, not reduce it. Sound money and staying on-budget would reduce inflation; a plan which isn’t even being considered. They falsely characterized the Republican plan as containing “draconian cuts”. The Republican plan involved continuing to grow insane spending levels, but at a slightly slower rate.

Republicans:?House Majority Leader, Kevin McCarthy pretended that Republicans were going to be the fiscal adults in the room and rein in excessive spending. This is completely untrue. McCarthy and Biden were “negotiating” over a small change in the rate of growth for discretionary spending which makes up a minority of government spending. The US has about $32 trillion of on-balance sheet debt and around $200 trillion of off-balance sheet liabilities making total obligations about a quarter of a quadrillion dollars.

Annual deficits are officially around $2 trillion, but once you include increases in obligations for things like social security, pensions, Medicare, and other mandatory future spending, the annual shortfall is closer to $6 to $8 trillion. Even if McCarthy had gotten everything he wanted, it wasn’t going to change the fact that the US continues to incur unpayable debt and obligations. His position was neither serious nor honest.

The Democratic position was the US will spend itself into insolvency quickly. The Republican position is to do the same thing only slightly more slowly. There is no functional difference between the two positions. Both lead to disaster. We had six months of theater pretending that the US was going to default when the only option either party considered was more printing, more spending, and more debasement of the dollar. If you want to know why we own oil, gold, and Bitcoin, this is the reason. As an American citizen, I think the government has charted an unwise direction. As the head of Deep Knowledge Investing, we will continue to find ways to help our subscribers make money even in a “bad” environment.

Inconsistent Economic Data:

DKI has been highlighting inconsistent economic data since last November. However, recent news has put that trend on steroids. The ISM Manufacturing Index and the Purchasing Managers’ Index are both showing contraction/recessionary indicators. Demand for goods is weak. Results from Walmart, Target, and Home Depot are all showing a shift from discretionary spending towards basic needs.

Lumber pricing is down, but housing prices haven’t crashed yet despite higher financing costs. However, services inflation and employment data are indicating huge demand. There are more than 10MM unfilled jobs in the US. The unemployment rate is still well below 4%. Wage growth continues although at a pace that falls short of inflation. These are all issues we’ve been exploring most weeks in our 5 Things to Know in Investing piece and add additional detail in posts for paid subscribers. While the investing environment is complicated, there are some stocks that we think will benefit from existing conditions.

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Lack of Market Breadth:

As I write this piece, we’re seeing reports of a new bull market. Market indexes are not at all-time highs, but have bounced about 20% off the lows. As of the beginning of the month, all gains in the S&P 500 had come from 7 mega-cap tech stocks. These are the FAANG (Facebook, Amazon, Apple, Netflix, Google) stocks plus Nvidia and Microsoft. Some of these companies have produced excellent results and Nvidia’s updated guidance was almost double that of analyst expectations. Because the S&P 500 is market cap weighted, these 7 stocks have an outsized impact on the index. As of just a week or two ago, the other 493 stocks in the index had contributed nothing to the “bull” market.

I tend not to place a lot of importance on old market rules of thumb, but I don’t ever recall seeing a market this tilted before. To have a bull market driven by 7 stocks is a new level of performance concentration. At least in the 1970s, we had the “nifty fifty”. What should we call this; the stellar seven? With Nvidia trading at over 20 times revenue and 50 times earnings, it wouldn’t take much to see some of these gains stall or reverse. Either way, 7 gainers vs 493 others isn’t a sign of a healthy market.

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A New Addition to the DKI Board of Advisors:

I’m excited to announce that acclaimed and award-winning economist, Mish Shedlock has joined the DKI Board of Advisors. I’ve been reading his work for over a decade and have always been impressed with his detailed research, thoughtful conclusions, and clear writing. He’s smart, interesting, and has the kind of passion for discussion and debate that is consistent with DKI firm philosophy. We’re in the process of adding his bio page to the website, but in the meantime, please check out the rest of the Board here. They’re a remarkable group and provide incredible expertise to the firm and expert counsel to me. Mish has already submitted his first guest post for DKI readers. It’s on consumer credit and is available here. That piece isn’t paywalled so if you’re one of our free subscribers, please check it out.

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Home for the Summer and Lessons from My Dad:

I spent most of the winter in Thailand, Argentina, and Nicaragua. They were amazing experiences, but I like to spend summers at home in my idyllic beach town of Westport, CT. It’s also an opportunity to catch up on some deferred maintenance. Many people in finance hire others to do the “dirty work”. But, when I’m home, I try to do as much of the work as possible.

My dad also has a career in finance and is a pretty handy guy. As a kid, he showed me how to use tools and how to approach repair projects. When I graduated from the University of Michigan and was packing to move to NYC to work in the Mergers & Acquisitions Department of Morgan Stanley & Co., he gave me a red toolbox and a starter set of tools.

My mom kept clucking that I wouldn’t know what to do with the tools because I hadn’t watched my dad fix enough things. Yet, in the last few weeks, I’ve changed the oil and spark plugs in my lawnmower, dismantled and fully serviced my snowblower, cleaned out the barn and greenhouse, did some light plumbing work in three bathrooms, and regrouted much of my pool deck. There was also some electrical work, and I’m pleased to report no injuries or electrocutions.

So, what did my mom get wrong about me and my dad get right in teaching me? My dad never taught me how to do a specific thing. He taught me how to approach a project. It’s a process and a methodology. I learned how to diagnose a problem, how to test different solutions, and how to put it all back together carefully. That approach plus YouTube instructional videos goes a long way.

As always, we’ll bring it back to finance. Someone I used to work with once told me he was a good stock analyst because he was a curious person. He liked to figure out how things work. I think he was right. Most people who are good stockpickers are endlessly curious and like to learn. There are some who think that any time spent doing manual labor instead of stock research is a wase of their time. I think having knowledge of how the real physical world works instead of viewing everything as an abstraction is effective. Plus, it’s a better workout and more interesting than going to the gym.

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Time to Wrap it up for This Month:

We’d like to thank you for reading this letter and to welcome our new subscribers. We’re now seeing the highest renewal rates in DKI history. I’m grateful for your time and attention and that we’ve gained the trust of long-term subscribers. For those of you who see the value in our deep-dive analysis, we invite you to support us here.

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If any of you have questions, concerns, or thoughts regarding issues we should address in a future depth report, please feel free to reach out to me at [email protected]. If you think a friend, RIA, family office, or portfolio manager would be interested in this monthly commentary, please feel free to pass it on to them. Also, if you send this letter to more than 5 people, please get in touch and let me know.

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Thanks for being part of Deep Knowledge Investing,

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Gary Brode

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