Last week, catching up with an old friend over breakfast, the conversation drifted to business. As I outlined our company’s strategy and market approach, he paused, looked up, and quipped, “You know, scared money don’t make money.” My immediate thought went to a certain crypto commercial featuring Matt Damon, and I jokingly asked if that’s where he’d picked up the gem. He wasn’t sure, but the point, he said, was to challenge my perspective.
Driving back to the office, the phrase “scared money don’t make money” kept echoing in my mind, particularly in the context of today’s financial markets. After a bit of digging, I traced the saying back to the rap world, specifically Young Jeezy and Lil’ Wayne’s track “Scared Money.” The sentiment is similar to “fortune favors the brave,” urging boldness and risk-taking, not timidity, in the pursuit of financial gains. The implication is clear: to succeed, you need to overcome fear and embrace risk – ideally by investing in whatever is being touted!
However, in today’s financial landscape, the prevailing sentiment seems to be anything but scared. Instead, we observe a market characterized by fearlessness, even recklessness, a stark contrast to the caution one might expect given the economic backdrop. A recent Bloomberg report on fund manager sentiment highlighted this, noting that “Investors are the least pessimistic on stocks since February of last year,” a period preceding the Federal Reserve’s aggressive interest rate hikes. Further underlining this point, another Bloomberg article pointed to a surge in speculative trading, with a record 55% of the S&P 500’s total volume attributed to zero-day contracts.
In our assessment, this is precisely the time when a healthy dose of fear, or at least caution, would be prudent. Yet, the markets are behaving as if “scared money don’t make money” is the only mantra to follow, regardless of the circumstances. Equity valuations are stretched to near-breaking points, especially when considering metrics that smooth out short-term earnings fluctuations, such as price-to-sales ratios, market capitalization to GDP, and normalized earnings yields.
Underlying Economic Fatigue
While stock prices are reaching for the sky, the fundamental health of businesses is showing signs of strain. The tailwind of excessive fiscal and monetary stimulus is waning, and earnings growth is decelerating. Simultaneously, interest rates are on the rise as a substantial amount of corporate and commercial real estate debt is maturing. Increased borrowing costs are leading companies to prioritize debt reduction over share buybacks, a shift in capital allocation strategy.
The widely held belief that interest rates will ease in 2024 appears to disregard the persistent realities of trillion-dollar fiscal deficits, ballooning debt issuance, and structural changes in wages, productivity, and corporate pricing strategies. Despite these headwinds, unwavering faith in the Federal Reserve and the anticipated return of easy money is fueling investor confidence and encouraging the relentless pursuit of higher equity prices. Where is the “scared money” now? From our vantage point, it’s conspicuously absent.
Our recent quarterly review of a 300-company buy list reinforces our concern about an impending economic slowdown. While the rate of inflation is moderating, the cumulative effect of past inflation remains a significant burden, particularly for middle and lower-income households. Companies sensitive to economic cycles are still working through robust order backlogs accumulated during the stimulus years, but new orders are becoming less frequent. Inventory destocking has further dampened growth, impacting transportation and packaging sectors. Employment trends are also exhibiting increased uncertainty, with temporary staffing firms signaling recessionary conditions, even as many businesses hesitate to lay off permanent employees. The housing market has stabilized, but affordability continues to erode due to elevated interest rates and home prices. Finally, consumer-facing companies are reporting mixed to weak performance, with staples and luxury goods outperforming discretionary and value-oriented segments.
Two Diverging Economies
Our bottom-up analysis increasingly points to a tale of two distinct economies. Economy #1, buoyed by soaring asset prices, is thriving. Economy #2, grounded in employment and wages, is facing significant challenges. As economists and investors debate the nature of the economic landing – soft, hard, or nonexistent – we believe the dichotomy is already evident: Economy #1 is booming, while Economy #2 is experiencing a recession.
This divergence is echoed in the commentary from numerous companies we track. Tempur Sealy (TPX), in their Q2 2023 earnings call, noted robust demand from high-end consumers, while the lower end of the market faced sales headwinds. Ralph Lauren (RL) shared similar observations, acknowledging “macro inflationary challenges facing our more value-oriented consumers” but offsetting this with “growth in our full price businesses.” Pool Corporation (POOL) confirmed this trend, highlighting strong demand for high-end pool construction, but weaker activity in the lower end due to “higher interest rates and uncertain macroeconomic conditions.” In essence, Economy #1 is enjoying luxury and leisure, while Economy #2 is struggling to keep pace.
The Forgotten Economy and Rising Labor Tensions
In this two-tiered economic system, a growing number of workers are realizing they are on the less favorable side of the divide. Wage growth has significantly lagged behind asset price appreciation and the escalating cost of living. It’s unsurprising that frustration is mounting among the working class, leading to increased disruptions related to wage disputes and shortages of skilled labor. As workers strive to regain lost purchasing power eroded over recent years, strikes and demands for wage concessions are becoming more frequent.
The escalating cost of housing has been particularly detrimental to workers living paycheck to paycheck. A Bloomberg report from August 17th highlighted that housing affordability has plummeted to its lowest level in nearly four decades. A Wall Street Journal article, “Striking L.A. Workers Want Hotels to Help Build Affordable Housing,” underscored the financial hardships faced by service employees, particularly concerning housing affordability. Unions are positioning themselves at the forefront of a movement to incorporate housing affordability into worker compensation negotiations, signaling that this is just the beginning of a broader trend.
Disinflation Narrative vs. Accumulated Inflation
Just as labor seeks to recoup lost purchasing power, the Federal Reserve and Wall Street are promoting yet another disinflation narrative. This narrative emphasizes the recent slowdown in the rate of inflation while conveniently overlooking the substantial inflation that has already accumulated. Of course, the very existence of the disinflation narrative is partly due to the high inflation rates a year ago, making current comparisons appear favorable. Economy #1 welcomes this narrative, while Economy #2 remains unconvinced, as disinflation, while a slowdown in price increases, does not alleviate the burden of already inflated prices for the working class.
While the Federal Reserve maintains its commitment to reducing inflation to 2%, Chairman Powell has recently suggested a willingness to cut rates before reaching this target. During his July 26, 2023, press conference, Powell stated, “you’d stop raising long before you got to 2% inflation, and you’d start cutting before you got to 2% inflation.” Again, Economy #1 applauds this stance, while Economy #2 sees little immediate relief. The bond market, seemingly, is also skeptical, with 10-year Treasury yields increasing 43 basis points since Powell’s press conference.
Reconsidering “Scared Money”
“Scared money don’t make money.” Perhaps, perhaps not. Our analysis suggests its relevance is highly dependent on the market cycle. Considering the unease in the bond market, we believe the greater risk is not that “scared money” will miss out, but that there is simply too much un-scared money sloshing around. This brings to mind another rap lyric, perhaps more fitting as the Federal Reserve’s theme song: “Mo Money Mo Problems” by The Notorious B.I.G. The Federal Reserve’s policies have repeatedly been employed to foster financial stability (read: asset inflation), bail out the overleveraged, and forgive investors who overpaid.
Whether it’s the bond market signaling caution or Economy #2 voicing its discontent, there are growing indications that more money is not the solution, but the problem. Should this realization gain further traction in the bond market, we anticipate and welcome a significant increase in “scared money,” which, in turn, will create genuine investment opportunities.
Eric Cinnamond
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Definitions:
Wilshire 5000: The Wilshire 5000 Total Market Index, or more simply the Wilshire 5000, is a market-capitalization-weighted index of the market value of all American stocks actively traded in the United States.
S&P 500: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
GDP: Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period.
Earnings Yield: Earnings for the most recent 12-month period divided by the current market price per share. The earnings yield can also be calculated by using the inverse of the P/E ratio.
Shiller P/E: A valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.
The ask: the price a seller is willing to accept for a security.
Basis points (bps): A basis point is a common unit of measure for interest rates and other percentages in finance. Basis points are typically expressed with the abbreviations bp, bps, or bips. One basis point is equal to 1/100th of 1%, or 0.01%.
Zero-day contracts: Zero days to expiration options, or 0DTE options for short, are options contracts that expire and become void the same day that they’re traded.
