Stocks (^DJI, ^IXIC, ^GSPC) ended Wednesday in the green, recovering from Tuesday’s sell-off fueled by January’s CPI inflation print. Smead Capital Management CEO Cole Smead joins Yahoo Finance’s Alexandra Canal to talk about equity and bond markets’ trajectories in relation to the Fed’s interest rate forecasts.
“The market’s been wrong-footed for quite a long time on this idea that the Fed is going to lower rates in a hastened fashion and have to do that because of the economy,” Smead explains. “I think the real shocker to people is, one, the economy is incredibly strong and continues to chug along. You can see that in the job numbers…”
For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.
Editor’s note: This article was written by Luke Carberry Mogan.
Video Transcript
– You’re speaking of higher stocks. We’re joined now by Cole Smead, Smead Capital Management CEO and portfolio manager. Thank you so much for joining us.
So great news. We finally closed in the Green after that major sell off yesterday. Given that, do you think the market reaction to those hotter than expected CPI numbers was a bit overblown? And could it possibly be a good thing that now it seems like the Fed and markets are at least on the same page when it comes to those potential rate cuts down the line?
COLE SMEAD: Yeah. Thanks for having me. To your point, the market’s been wrong footed for quite a long time on this idea that the Fed is going to lower rates in a hastened fashion and have to do that because the economy. I think the root chakra to people is one, the economy is incredibly strong and continues to chug along. You can see that in the job numbers.
The second thing is the CPI is staying stickier than people would have expected. And we started this year with people coming into the year saying, great, we’re going to be lowering rates in March.
Now the Fed futures are in July. If they don’t end up moving till October, I think there’s a lot of people that are going to be sitting there thinking, why was I taking so much risk when I could have collected over 5% in short-term rates?
And I think that’s really the picture to cast here is do stocks make sense based on how much you can get paid short-term in the fixed income money markets. And in many respects, the answer is no.
– And Cole, so I’m interested to get your take. You know, when do you think the Fed does start cutting by how much? And how does that kind of impact and influence your investment strategy, Cole?
COLE SMEAD: Well, it’s a good question to ask, Josh. So let me– so think about it like this.
If we’re going to end up at the end of the day at 3%, then all the equity people should be feeling really good about stocks. Because ultimately, we’re going to go to a lower level of the short-term cost of capital. OK.
If we’re ending up somewhere north of 400 basis points, that’s still very tight monetary policy compared to what most people invested over the last 15 years. And I think that’s really the way to think about it. We always talk about recency bias.
We always talk about anchoring bias, kind of like the things that Daniel Kahneman wrote about. And yet here we sit where people want to go back to what they’re used to, where they have muscle memory. And the reality of the situation looks to be that the Fed will be tight for a much longer and higher levels than people would have anticipated.
That does not bode well for most assets. Now, you’re the bond market, you’ve already dealt with that to a certain respect. If you’re real estate, you’re dealing with that. Stocks are really the last person to find Jesus.
– So, Cole, given that, do you think that we could potentially see a no landing scenario where we don’t reach that 2% inflation rate?
COLE SMEAD: Well, I don’t think about it, the nominal level of inflation. Because, again, inflation can be a pretty tricky argument. If you go back and look at the 1970s, we had a pick up of inflation into the late 1960s.
And then it came off its high. And the roller coaster took it back higher from 72 to 74. So the idea that just because inflation came to a lower level that it’s bagged, that’s where the market’s really false.
That’s where a lot of people betting on the Fed futures are really wrong in our opinion. Is that, oh, it’s lower. Therefore, it’s gone. No.
Let me just point out a couple of examples. Baby boomers left the workforce after the pandemic. They’re gone. They’ll never come back. That’s a structural problem.
Secondly, government largesse. It’s still present. We’re going to add 1% to GDP just in Medicare and Medicaid and Social Security next year. That is a structural problem.
Lastly, the problems we see outside the United States are structural problems. We’re going to deal with higher costs because of wars. Unlike my childhood might I add.
So that has not changed. That will not change. So the idea that inflation is bagged off of effectively policy tools, the problem with that is the Fed said the same thing in 04 reality was their best chance was good luck back then.
We had an economic calamity four years later, even though they said our policy tools are so much better. My point is that just because the Fed feels good about their policy tools, it doesn’t mean inflation is bad. It might have just been good luck. That’s it in the interim.
– So let me ask you this. Because you say it’s time to quote by the dogs, oil, and banks. Those are two interest rate sensitive areas of the market. Why do you think now, in particular, is a good time to get into those sectors?
COLE SMEAD: Yeah, you’re just paying far less multiples to get the returns on capital that you’d get otherwise. So, for example, someone might say, but, Cole, there’s asset light businesses out there that produce higher returns on capital those businesses.
Yeah, but you have to pay far higher book multiples. For example, going out and paying 40 times revenues to use Scott McNealy’s quote from 02. That’s like assuming over the next 40 years. I don’t have to pay any expenses.
And I don’t have to pay the government at all, which is illegal by the way. The problem with that is it just doesn’t work historically speaking. Versus I can go out and find a bank today that produces higher than a 10% return on equity and pay below book for that.
That’s a pretty good way to make money in historical stock returns. In banking and oil, the same thing. You can get better returns than many other businesses. And you don’t pay the same multiples.
Are they liked or loved industries? No, banking just had a big problem last year. People ran away.
Oil stocks didn’t have such a good ’23. The disappointment is really, in my opinion, not only what protects you, but was what it’s likely to make you a lot more money looking forward.
– What about small caps, Cole? The Russell 2000 had its worst day since June 2022 yesterday. But a lot of strategists are bullish on small caps in the long run. What’s your take?
COLE SMEAD: Yeah, I don’t think there’s really like a small cap. If someone says they put a gun to my head and say Russell 2 versus the S&P, I think the Russell 2 will do better. It’s not because small caps look so incredible, it’s because big cap tech looks so stupid. And Russell 2 owns none of that.
– Cole, thank you, as always, for joining us today. Really appreciate it.
COLE SMEAD: Thank you, guys. Appreciate it.