The Practical Economist

EDITOR'S LETTER - August 7, 2017


We left the most recent Letter up for six weeks.  You can chalk that up to being a laconic summer, but that's too easy.  We think the most recent Letter had plenty to make you think.   

Too many people confuse certainty with elegance.  The business press is littered with drama and pronouncements, but how is its scorecard on describing the entirety of the picture?

We do not claim to always know the full picture.  Elegance is knowing what you don't know--to the extent possible--and disposing of it all properly.

We think we made you a good case for how to think about the more likely economic scenarios over the medium-term.

Now, we're going to talk about...the equity market.

If you're hearing anyone talk at all, you're probably hearing it become increasingly chic to state that the equity market is overvalued and is preparing for a major pull-back.

Now, before you scream at us we may need to remind you to look back at the archives.  You will find that the directionality of some major indicators had us on edge. 

But we never predicted a major market correction.

When we started out to write this new Letter we contemplated 'forcing' you, Gentle Reader, into answering for us the question that, for you, should be of paramount importance.  It's too easy to for you to read a pronouncement that we have put a ton of thought into and...then simply dismissing, because you are presently invested in a particular paradigm.

We decided not to go this route,'re on your honor to (1) give very serious and long thought to what we're about to say before you say "but", and (2) to ask us for clarification, before you move past it.

When you think about the stock market, it's true that you should be thinking about earnings--especially how they're coming in against forecasts.  But missing forecasts doesn't result in major market corrections.  It doesn't drive a bullish movement, doesn't drive a correction, either.  That's part of the truth that "they" don't tell you.

There are two major indicators that should be informing your understanding of major market direction.  The first deals with earnings. 

Smarter people will tell you that the market is about earnings.  The smartest people will tell you that it's about earnings against...borrowing.

It is true that leverage had been flirting with rising to troubling levels, but the fact is that leverage levels have been moderating.  In other words, you may continue to spout about market valuation at your peril.

Now let's chat about that second major indicator that should on your equity scorecard.

And that is...the level of short-term interest rates.  Part of the exercise is being able to determine when short-term rates are too high (or too low!) for the economic engine. 

You will remember that e have been telling you for some months that the economy is on course to slow down.  That slowing is happening. 

It's true that, if you go back 18 months, interest rates were actually too high...meaning that they were stoking economic growth that a rate that could have proven problematic, and that made the pact of positive change in the equity market almost alarming...alarming in the sense that it was bounding ahead too fast for what investors' brains thought was possible.

But that's the point of what happens when interest rates are, in a sense too low, i.e. that rates are stoking fast growth.

And where are we now?  After waiting to raise interest rates very long into the expansion that really took off in 2015, the Fed raised rates half a percentage that now, we're facing a situation, not of just a moderating influence on growth, or of slowing growt in the faces of unchanged rates, the Fed is facing a situation of higher rates going into an economic slowing..

Smart, huh? 

Is it plain talk you want?  We're okay at the moment, but...the margin for error is narrowing.

Just pay attention.