Jim Stack has been a renowned market contrarian since predicting the 1987 stock market disaster as a young analyst. In his Investech Research weekly and his money-management firm, Stack Financial Management, which manages $1.5 billion in assets and is based in Whitefish, Montana, he takes a “safety-first” strategy. In addition, Stack was named to Barron’s list of top investment advisers.
When I spoke with him late last week, he expressed concern that Wall Street wasn’t paying enough attention to the market’s many speculative excesses, and that the Federal Reserve was too relaxed on inflation. Howard Gold: You claimed in your most recent edition of Investech Research that the Federal Reserve abandoned its hawkish approach and began undoing interest rate hikes in December 2018 due to fear. Could you explain how that may have paved the way for some of the subsequent events? Stack, Jim: As we enter 2019, the economic recovery in the United States has already been one of the longest in the country’s history. However, the Federal Reserve had begun to raise interest rates, and the stock market had taken note, resulting in the worst December since the Great Depression. So the Fed quickly reversed course and said, “Oh, well, we didn’t mean it,” and it wasn’t long before they began lowering interest rates again. So they brought the punchbowl back to the party, and especially when the pandemic hit, they decided to add more and more alcohol to it, to the point where I believe a lot of Wall Street participants are investing as if they’re a little tipsy, even as the PCE (Personal Consumption Expenditures price index), the Fed’s favorite inflation tool, is way above their 2% target. Gold: What do you think the current state of inflation is, and how has the Fed’s policy affected it? Stack: We’re recovering from a pandemic in which everything was shut down, and now there’s a huge demand and a shaky supply chain. And, as the Fed has argued, such pressures are just temporary. The difficulty is that many of the current inflationary pressures are not temporary. [The Fed] couldn’t get the PCE above 2% save for a few months from 2009 to this year, but it’s now gone straight through the 2 percent barrier, up to 3.1 percent. It’s only lately hit 3.5 percent, and it’s also a lot stickier, in my opinion. The Atlanta Fed has released a Sticky Price Consumer Price Index, which comprises items and services that don’t move in price much that often. When they do shift, though, they continue to rise. Medical treatment, car insurance, and alcoholic beverages are examples of these. And the CPI for Sticky Prices has risen to its highest level in 30 years. Inflation will rise, according to the Fed. And I believe that prices will continue to rise in the next months. And this could spell disaster for a stock market that has become one of the most interest-rate sensitive in history. Gold: The bond market does not appear to be concerned about inflation. For the past few weeks, the 10-year Treasury note has yielded between 1.45 percent and a little over 1.5 percent, peaking at roughly 1.76 percent. (On Thursday, it yielded 1.30 percent.) So, do bond investors have it wrong? Is it wishful thinking to believe that they can’t see inflation approaching? Stack: I wouldn’t call it wishful thinking; I’d call it foolish faith in the Fed, which has been attempting to talk down inflation and persuade everyone that this is a passing fad. And it was widely assumed that in the Fed meeting a few weeks ago, they would concede that we are seeing some upside inflation shocks, and that they would start putting a cap on the punchbowl and possibly end asset purchases. Instead, the Fed stated, “We’re going to keep adding to that punchbowl because we believe this inflation is transitory.” And, based on our experience in the 1970s, I believe you have to go through those major inflationary cycles to understand how far off the Fed can be. That is my main fear today: the Fed is being very convincing, and I believe that is what has caused bond yields to fall since the Fed meeting a few weeks ago. I wouldn’t be surprised if inflation remained sticky, if we saw upside surprises, and if we saw particularly positive employment reports. I wouldn’t be surprised if 10-year bond yields rose again and began to approach the 2% mark. Gold: How do you tell the difference between temporary and permanent price increases? Stack: Nearly 40% of the CPI is made up of housing costs and prices, with roughly half of that coming from owners’ equivalent rent [the amount of rent that would have to be paid if an owner’s house were a rental property], which normally tracks housing prices. And, at least dating back to the high inflation period of the 1970s, we’ve seen one of the most significant increases in home prices in the last 12 months. Rent will follow those prices, which means that the numbers that go into the owner’s equivalent rent and then into the CPI will likely surprise to the upside. We developed our Housing Bellwether Barometer in 2005, which indicated that we were in the midst of a home bubble since housing prices were 35 percent higher than the long-term inflationary trend. And, indeed, we were, with house prices falling to, and even falling below, the long-term inflation or CPI index. Today, we’ve surpassed it by more than 43%. To put it another way, we now have a greater upside mismatch between home prices and long-term inflation than we did during the housing bubble of 2005. Gold: I spoke with Redfin’s chief economist, who said that the supply of homes is extremely low because older people are staying in their homes, while there is pent-up demand from millennials who are approaching home-buying age at the same time as people are fleeing cities due to the epidemic. Is there anything unusual about this situation? Stack: You’re clearly witnessing an increase in demand. We live in Northwest Montana’s Flathead Valley, where housing prices have skyrocketed. And it appears like everyone is quitting their day jobs to pursue a career as a realtor. Gold: That’s a signal for you! Stack: It brings back all of my 2005-2006 memories. Gold: Do you have bidding wars and all-cash bids in your area as well? Stack: Definitely. Many high-demand locations of the country, where individuals will want to move or purchase a second property, are seeing many offers above the asking price. When you have a speculative mindset, it tends to spread over numerous asset classes, not only stock market prices, which are consistently above the 90th or 95th percentile by most historical criteria. Stocks are traditionally highly costly, but we’re seeing it in real estate and, of course, in cryptocurrencies, such as bitcoin BTCUSD, -5.17 percent, which soared up to $60,000 and is now trying to keep over $30,000. Over the years, we’ve created a number of tools to try to address or track that psychology. Our Canary in the Coal Mine index was recently created. It consists of 20 of the most prominent speculation targets that have gone parabolic since the pandemic’s low point. If you keep watch of the peaks in that speculation and monitor when they fade, you’ll be able to predict when the trouble will spread to the rest of the market. Gold: Where do you think the most speculative excess is occurring right now? Stack: Today, I believe [speculative excess] is leaking into all new IPOs and SPACs (special purpose acquisition companies). We’re raising funds and have no idea what we’ll do with it, but we’ll buy something that will earn money. Then there are the new NFTs, or non-fungible tokens, or digital art, which I’m not sure I can effectively describe other than to say it’s not a physical object. You own the digital image, but everyone else has the right to see, use, and copy it. I’ll tell you, it’s so far out there that it’s nearly absurd. But it’s not unheard of. We’re starting to see a lot of it today in the meme stocks [so popular with] new young traders, based on what we saw in the late 1990s, when firms might go public and have never made a penny. As you go through these speculative excesses, you learn a few things. First and foremost, bubbles can never be assured or identified until after they have occurred. The second feature is that persons inside the bubble are unaware of its existence. In other words, don’t try to convince someone who is investing in NFTs that they are speculating in a bubble that may be nearly worthless by the time it bursts, because you’ll end up in a fight you can’t win except in the aftermath. Gold: You’re implying that there’s a chance of both inflation and a huge selloff in overvalued asset classes. Given the current market conditions, where do you think people should invest their money and where should they not put their money? Stack: You don’t have to be completely invested now since we’re in one of the most overvalued markets in history and one of the most speculative excess periods in history. We’re short-term bullish on the market because we’re giving it the benefit of the doubt, but we’re still holding a 20% cash reserve just to sleep at night. If you want to invest in today’s market, stay away from SPACs and stocks with unlimited PE ratios, as they have yet to generate profits. I’d invest more money into areas that will profit from rising inflation, or at the very least be resilient to it. If inflation remains sticky, if it continues to climb, and if interest rates begin to rise as the economy normalizes, you should invest in areas such as energy. Now, for the record, we do own these stocks in our Stack Financiers clients’ accounts./n
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