This Document Is the Closest Thing Investors Have to a Crystal Ball

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Today we are going to talk about the Federal Reserve.

While I am aware that certain percentage of you have now clinched your fists in rage and are mumbling about the vast global conspiracy, the Illuminati, and the trilateral commission, and another segment of you are yelling about gold standards and the evils of fiat currency, let’s table all those conversations for another day.

The Federal Reserve may not be the best way to manage our nation’s money supply, but it’s what we have and what we will have for a very long time to come.

Whatever you think of the Fed and their policies, you cannot debate this one thing: when it comes to collecting and distributing economic information, they are unsurpassed by anything on the planet.  They have tremendous resources, and they do not hesitate to share all that data with taxpayers.

I pay very close attention to reports from the Fed for the simple reason that they have more data than anyone else. Reading the Beige Book and other informative releases from the central bank gives a much better picture of the US economy than all the talking heads and pen-wielding experts combined.

We can listen to the chorus of doom and gloom or the cheerleaders who predict easy money and vast fortunes ahead, or we can pay attention to what the actual data is telling us. 

The data is giving us a crystal clear overview of how banks, as well as individual and business loans, are fairing.  

So let’s take a look at how we should divvy our finances, given the banking data from this important document the Fed just released…

New Fed Document Reveals Banks Look Great and Individual Finance Is Rosy

Last week, when the Fed issued a new report, The Financial Stability report, I was one of the first in the electric line to download a copy. This new report looks at the financial system and all the players therein and evaluates the stability of the financial system.

Measuring the quality of lenders and borrowers alike, as well as actively hunting for excesses in the system, can help us avoid another credit crisis, or at least contain the proportions of the next one.

Watching loan quality, the types of loans in the system, and how those loans are being funded can tell us a lot about how safe, or unsafe, the financial system is at a given point in time. As we discovered in 2008, riding out a recession is not that big a deal but enduring a financial system meltdown feels catastrophic in nature.

So how do we look today? Not bad, my friends, not bad at all.

The banking system is in remarkable shape. Banks have plenty of excess capital on hand to deal with any problems that may pop up in the economy. The larger banks (the ones most prone to making stupid mistakes) have enough capital to remain functional even in another 2008-2009 scenario.

Insurance companies and brokerage firms are also lowering the amount of leverage they use to conduct their operations as well. There is little sign of the type of leverage and therefore risk that we saw in the system back in 1999 or 2007.

The economy is growing at a fast enough pace that individuals are paying their loans and credit quality is as good as it has ever been. That consumer debt problem we have been hearing about appears to be something of a myth. According to the Fed, “Expansion of household debt has been in line with income gains, and, for the past several years, all of the net increase in total household debt has been among borrowers with prime credit scores and very low historical delinquency rates.”

Contrary to the very dramatic headlines suggesting another debt-driven housing implosion, the mortgage market is actually in fantastic shape. The amount of leverage in the housing market is back to 1990s levels, and delinquencies remain very low. The only signs of potential trouble are in auto and student loans, and even that is manageable for the time being.

Despite Growth, Trouble Is Brewing in the Business Sector

There does appear to be trouble brewing on the business side of the loan world.

Total debt of nonfinancial corporations in the US are at 20-year highs, and it’s the wrong companies doing the borrowing. According to the Fed report, “An analysis of detailed balance sheet information of these firms indicates that, over the past year, firms with high leverage, high-interest expense ratios, and low earnings and cash holdings have been increasing their debt loads the most.”

For now, low interest rates and reasonable growth in the economy are holding the devil at bay, but should the growth slow down, or rates move higher, the bill could come due with painful consequences.

The biggest problem in the financial system right now is that things have been pretty good and interest rates have been low for some time now. As a result, asset prices are high across the board. I have been saying this for some time, but it is nice to have the highest monetary authority in the land agree with me.

The Fed reports the following: “Asset valuations appear high relative to their historical ranges in several major markets, suggesting that investor appetite for risk is elevated. Spreads on high-yield corporate bonds and leveraged loans over benchmark rates are near the low ends of their ranges since the financial crisis. Equity price-to-earnings ratios have been trending up since 2012 and are generally above their median values over the past 30 years despite recent price decline.”

Commercial real estate and farmland are also trading at very high valuations right now. Housing prices have recovered, and some parts of the country are reporting affordability issue, but we are nowhere near the ridiculous levels we saw in 2007.

While those of us who were buyers a few years ago love the fact that asset prices have risen, the current valuation levels present a potential problem. As the Fed explains, “Elevated valuation pressures imply a greater possibility of outsized drops in asset prices.” If something goes wrong, be it geopolitical or economic in nature, the fall from today’s lofty peaks will be incredibly painful.

The problem for us as investors is that any risk event occurring is going to lead to ferocious declines in the stock and bond markets. Prices are very high pretty much across the board, and a reversion to the mean is going to hurt. High yield bond markets look especially vulnerable in light of the Financial Stability Report – not only are valuations high, the borrowers are pretty weak. That feels very late 1980s to me.

Valuation Is Elevated. Here’s Why We Shouldn’t Panic and What to Do

What does all this mean when we put it together?

First, there is no need for any sort of panic or embracing doom and gloom right now.

The banking system is the glue that holds everything together, and it is in the best shape of my lifetime.  Households are in good shape as most of us are paying our bills and living within our means for a change. Most of the risks to the system come from outside the system including geopolitical events like Brexit, the trade war with China, or an economic downturn in Europe.

What do we do?

As the late great Hunter Thompson once observed: “When the going gets weird, the weird turn pro.”

We will defy our instincts to either panic or party and pay slavish attention to what the numbers are telling us. We will move slow, hold some cash, and stay smart.

Above all, we will remember that if things go south for a period of time, it could be the greatest thing that ever happened.

Buying junk bonds after that market blew up after the crash of 87 was the source of more than a few fortunes. Buying tech stocks in 2003 made a bunch of courageous souls very wealthy. Buying banks and real estate after the credit crisis implosion has kept me from having to get a real job for over a decade now.

It’s not time to panic, but it’s not time to just throw money at the markets either. Those of you who do the “smart thing” and buy index funds at these levels will be very sorry indeed.

Sincerely,

Tim Melvin

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