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Q4 2024 Market Commentary



As we head into the fourth quarter of the year, most market watchers are upbeat. Corporate earnings have been solid, inflation continues to come down (although still above the Federal Reserve target rate), and the stock market has been strong for the second year in a row. Given the amount of fiscal stimulus in the pipeline, we expect both the economy and stock market to hold up well, at least for the rest of this year. Moreover, markets rarely have large sell-offs within 30 days of a Presidential election. The only meaningful exception in the last 30 years was in 2008 during the Financial Crisis. Where we differ from others is that we believe next year could be much more challenging, regardless of who wins the Presidential election in November. In this commentary, we will address the issues we see: geo-political conflict, rising equity valuations, rising fiscal debt loads, and a weakening consumer as reasons why we expect next year to be more difficult in financial markets.
During his recent visit to India, Jamie Dimon, CEO of J.P. Morgan, the largest bank in America, said in a CNBC interview, “My caution is all geopolitics, which may determine the state of the economy. Geopolitics are getting worse; they are not getting better.” We agree with this statement.
The most immediate concern for both the U.S. and global economy is if tensions in the Middle East escalate to a wider regional war, thus dragging in the United States and disrupting global energy supplies. A spike in energy prices would reignite inflation and stop the Federal Reserve from lowering interest rates. On Tuesday, 10-2-24, Israeli Prime Minister Benjamin Netanyahu pledged to respond with force to Iran’s second ballistic missile attack, insisting Tehran would “pay” for what he described as a “big mistake.” Iran has been the country financially and militarily sponsoring Hamas, Hezbollah, and the Houthis, all of whom are trying to attack and destroy Israel. Hamas attacks Israel’s Southwest, Hezbollah attacks Israel’s North, and the Houthis (on the tip of Yemen) attack any ship trying to go near Israel’s ports. These attacks have contributed to inflation by forcing ships to change their routes and driving up insurance rates on global shipping. According to Lloyds, because of Houthis attacks, shipping traffic through the Suez Canal has fallen from around 2000 transits per month before November 2023, to around 800 in August of this year.
Israel has the military capacity to wipe out Iran’s energy infrastructure and bring Iran economically to its knees. The United States has been trying to hold Israel back from such an attack because of the global economic consequences. Bjarne Schieldrop, chief commodities analyst at Swedish bank SEB, said that if Iran’s oil infrastructure is wiped out, prices could rise to $200-plus a barrel. Meanwhile, the war in Ukraine continues to be a drag on the global economy and appears to be at a stalemate with the West supplying more weapons, and Russia continuing to threaten to use nuclear weapons. So far, the West has crossed many Russian red lines without Russia turning to its vast (the largest in the world) nuclear stockpile. However, the West only needs to be wrong once for a major disaster. Already the war in Ukraine has been costly in terms of disrupted supply lines, increased inflation (Russia is a large producer of many key commodities), and rising defense budgets as a time when both the U.S. and Europe are running large deficits. Even if a solution can be reached, it will take Europe years to rebuild its weapons stockpiles leaving the world’s largest economic block, and major trade partner to the United States vulnerable to future crises. The Stockholm International Peace Research Institute, which tracks military global expenditure reports that the British military—the leading U.S. military ally and Europe’s biggest defense spender—has only around 150 deployable tanks and perhaps a dozen serviceable long-range artillery pieces. France, the next biggest spender, has fewer than 90 heavy artillery pieces, equivalent to what Russia loses roughly every month on the Ukraine battlefield. Denmark has no heavy artillery, submarines or air-defense systems. Germany’s army has enough ammunition for two days of battle. According to the Wall Street Journal, in the mid-1980s, West German military spending stood at around 3% of GDP and was over 5% in East Germany. In 2023, the now-unified country spent around 1.6%. Germany is the largest economy in Europe, yet the German defense budget that goes into procuring new weapons and ammunition has fallen from €10 billion in 2022 to €3 billion this year, according to Hans-Peter Bartels, president of the German Society for Security Policy, an armed forces lobby organization. The rest goes mainly to personnel, maintenance, training and building costs. At the current pace of rearmament, it would take Germany 100 years to return its artillery howitzer stockpiles to their 2004 levels, according to a report published this month (September 2024) by the Kiel Institute for the World Economy, an independent think tank.
As J.P. Morgan’s Jamie Dimon alluded to in his interview, the geopolitical problems can affect the economy in multiple ways. In Europe, the current state of depleted European militaries raises the risk that other problems brewing in the Eurozone such as in Moldavia and Kosovo seem more likely to flare into full fighting further disrupting trade in the region. In the Middle East, a war that causes energy prices to soar would quickly hit the U.S. (and global) economy.
The U.S. now has $35 trillion in debt and for the first time in our nation’s history, we now spend more on interest servicing that debt, more than $1 trillion on interest cost last year, than we do on defense spending. Last year, the Congressional Budget Office (CBO) reported $726 billion in defense spending, historically the country’s largest expenditure. Looking back at other great powers such as the British, French, Ottoman, and Spanish empires began to lose their great power status when they hit similar milestones. The Congressional Budget Office is forecasting large budget deficits until the year 2054 (2054 is the furthest the CBO projects out in time). To service this large and growing debt pile there is tremendous pressure on the Federal Reserve to lower interest rates. At the current rate, a one percent drop in interest rates will lower the U.S. debt service cost by $350 billion dollars annually. However, a spike in oil prices will cause inflation to come roaring back and in order to bring inflation under control, the Federal Reserve would have to raise interest rates, not lower them.

The current valuation in financial markets also concern us. As of September 22, 2024, the forward earnings on the S&P 500 price-to-earnings (P/E) ratio was 27.45%, which was a 10.76% increase from the previous quarter and a 17.03% increase from the previous year. (P/E) ratios are how Wall Street measures the valuation of the stocks in the market. Historically, the forward (P/E) ratio on the S&P 500 has been 16. For (P/E) ratios to get back to historical levels earnings will have to rise, or prices will have to fall, or a combination of the two. Most analysts expect S&P 500 earnings to rise next year. We do not disagree that earnings will rise next year, and hopefully, if earnings rise faster than the market goes up, then valuations can come back to more historical levels without triggering a sell-off.

What we believe is not getting enough attention is the potential taxation on those corporate earnings. In 2018, the top tax rate on corporate profits was cut from 35% to 21%. This 21% tax rate is the lowest tax rate on corporate profits since the Great Depression. These lower tax rates have caused corporate earnings to increase. These increased profits are in part responsible for the increase in stock prices over the last six years as most stock analysts value companies on a multiple of corporate earnings. Thus, as corporate profits increase, stock prices usually go higher as well. Since corporate tax rates are at historic lows, and the national debt is now at a record high, it is not likely that this source of earnings growth can continue. We would note that the lower tax rates did produce increased and record tax revenue for the federal government, but government spending has increased even faster. A scenario we think that could happen, but which is not talked about enough, is that corporate earnings do increase next year, but so do corporate taxation rates which would make after tax earnings less, and equities even more expensive than they are now.
In addition to a higher than average (P/E) ratio and a potential change in taxation on corporate profits which could make (P/E) ratios rise further, the S&P 500 dividend yield (the amount investors receive for holding a security) is also well below its historical average. According to Yale Hirsh, publisher of the Stock Market Almanac, the dividend yield for the S&P 500 index from 1960- 2023 averaged 2.9%. At the end of the third quarter in 2024, the S&P 500 index yield was only 1.2%. When the stock market began its bull run at the end of the financial crisis, dividend yields alone were paying 2x-3x more than an investor could get holding a U.S. Treasury bill. Today, U.S. Treasuries are paying roughly more than 3.3 times the income than investors can get holding the S&P 500. So, you get paid more to be safe than to take risk.
Next, the state of the U.S. consumer, especially the bottom quartile of the U.S., is showing signs of stress. Consumer spending is important because it accounts for over 2/3 of the U.S. economy. Outside of mortgages, auto loans are the second largest category of consumer debt. At the end of the second quarter, 8% of all auto loans were 30 days or more past due, a 9.2% increase from the prior year and the highest delinquency rate since 1996 (Brankrate.com). Meanwhile, savings rates are hovering near their lows while consumer debt is near all-time highs. As you can see from the chart below, consumers have curtailed their savings and are maintaining their standard of living by increased borrowing.

The consumers plight is reflected in the Consumer Confidence Index. The index which reflects the optimism or lack thereof consumers, has been declining since 2021. The consumer Confidence Index has been used by economists because it has a high correlation to the directional trends of future consumer spending. Most economists cite the rise of inflation as the primary culprit of consumers sour economic outlook, and the reason for the decline. Indeed, Redfin, the large housing website company, reports that the monthly mortgage payment needed to buy the median priced home in the United States increased from $1,480 in 2021 to a record 8 high of $2,840 in April of this year. As prices have risen, consumers have cut back on the number of items they buy. This in turn has caused companies to lay off workers as the number of units produced and consumed has decreased, even though revenue is up because of higher prices. This weakness has in turn triggered a warning level for the economy as the Sahm Rule has been activated.

   The Sahm Rule, which was developed by Federal Reserve Economist Claudia Sahm, states that if the 3 month moving average of unemployment rates rises by .50 percentage points from its low in the last 12 months, then the economy is in a recession or will be shortly. This rule usually triggers 2-8 months prior to a recession and predicted the recessions in 1953, 1957, 1959, 1970, 1974, 1980, 1981, 1990, the Tech Bubble of 2000, and the Financial Crisis. As you can see from the Federal Reserve Economic Data chart below, the rule is now being triggered. The grey bars on the chart below represent recessions, and the blue line represents the change in unemployment levels.

   While we do think stocks are trading at elevated valuation levels and are susceptible to a market sell off, and possibly a short recession, we do not think the market is going to fall apart, but just have a normal pull back which would be healthy. There are two main reasons for this belief. First, as we mentioned in our commentary earlier this year, there is a tremendous amount of cash sitting in banks and in money market funds. Over the last 4 years, 6 trillion dollars have accumulated in money market funds looking to take advantage of the high yielding money market funds caused by high interest rates. As interest rates come down when inflation slowly subsides, the rates that these money market funds payout will also come down. As the earnings on these money market funds decrease, the dollars in these money market funds will begin to look for higher paying investments like dividend paying stocks.
  Second, and just as importantly, because of the massive amount of inflation and money printing that has happened worldwide, investors still need to have stock exposure just to keep up with inflation. As the chart below shows, global central banks have printed almost 70 trillion dollars of new money since 2005, which is about 70% of the global economic activity (world gross domestic product equaled 101 trillion in the year 2023 according to the World Bank). This means that the buying power of every dollar has been devalued by almost 70% over 19 years, which means investors have to have growth in their portfolios if they want to keep their buying power. For these reasons, we think that the stock market will find support when the sell-off does come.

   In conclusion, we believe that next year could be a tougher year for the financial markets. Although at the current time corporate profits are solid, we believe that geopolitical problems in the Middle East and Europe as well as potential changes in corporate taxation could expose the above average valuations in equities, high government debt loads, and a weakening U.S. consumer. As a result, we continue to like large capitalization, brand name companies who provide goods and services that consumers and businesses use on a daily basis and are returning cash back to investors from either dividends or stock buybacks as the best way to deliver positive risk adjusted returns. Thank you for your continued support.

Sincerely,



This newsletter is distributed for general informational purposes and does not constitute investment advice nor is it intended to constitute legal, tax, or accounting advice. No part of this newsletter nor any links contained therein is a solicitation or offer to sell investment advisory services except where applicable in states where we are registered, or where an exemption or exclusion from such registration exists. Information throughout this newsletter is obtained from sources which we believe reliable, but we do not warrant or guarantee the timeliness, accuracy or completeness of this information and the information presented should not be relied upon as such. All investments involve risk of loss, including the possible loss of all amounts invested, and nothing within this newsletter should be construed as a guarantee of any specific outcome or profit. This newsletter is confidential and is intended solely for the information of the person to whom it was delivered and may not be reproduced or redistributed in whole or in part nor may its contents be disclosed to any other person under any circumstances. The information contained in this document is believed to be accurate as of the date hereof and is subject to change without notice. Schnieders Capital Management is not affiliated with any of the companies or indexes mentioned in this newsletter.

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