From the Mailbag: August Edition

August is winding down, Labor Day is around the corner, and summer’s unofficial end is nigh. What better time than now to dip into ye olde mailbagge for this month and answer your “burning”^[i] questions about the stock market and how to navigate it?

Will wages keep up with inflation?

Overall and on average, and over time? Most likely, with the caveat that it is more about catching up, not keeping up. Wages are a lagging indicator. Contrary to popular belief, changes in wage growth are a delayed reaction to inflation. As consumer prices rise and employees’ living costs go up, businesses have to raise wages in order to retain and attract staff. So inflation moves first, then wages.

Each person’s experience will vary. For people with no income, there is no such thing as keeping or catching up, which is why inflation is hardest on the poorest households. People with low and fixed incomes can also fall behind on an inflation-adjusted basis, too. The middle and higher income ranges are the most resilient. Again, these are generalizations, your mileage may vary.

But overall, wages are already at work in reducing the inflation gap. Exhibit 1 shows the cumulative change in consumer prices and average hourly earnings since the end of 2020. The gap between them was wide in mid-2022, as the inflation rate peaked. But it has narrowed considerably, especially in recent months, when consumer prices mostly cooled as wages grew faster. Society hasn’t regained all of its lost purchasing power, but it is getting closer, which helps explain consumer spending’s resilience.

As a sidebar, we like this question for a simple reason we will expound more on in question two: Rising wages are how developed economies overcome bouts of inflation in time. Not prices returning to pre-inflation levels. Think of the 1970s and early 1980s: The fast rise in consumer prices during that stretch never reversed in any material sense. The pace of prices’ rise simply slowed (disinflation occurred, in econo-speak), allowing wages to recoup lost purchasing power in time.

Exhibit 1: Wages Are Catching Up to Inflation

Source: St. Louis Fed, as of 8/15/2024.

What should investors do if we believe we are in a deflationary environment?

As noted previously, we aren’t in a deflationary environment presently, per the data. We have disinflation. But what to do if deflation comes? Not celebrate, that is for sure! America (and all the developed world) doesn’t do deflation well. Usually, deflationary stretches are a side effect of deep recessions (see: a brief episode during the swift COVID lockdown recession, the 2007 – 2009 recession accompanying the global financial crisis, the Great Depression). Most of them aren’t magical times where a dollar goes farther and everyone is happy. Rather, they are chiefly woeful times when dollars are hard to come by and society is suffering.

But the tricky thing for stocks is that, in general, they lead economic trends. Bear markets usually start falling before recessions begin and end before the recovery does, once stocks have priced the likely damage to corporate earnings, which enables them to then look to the eventual rebound. So by the time you realize you are in a recession, there is a high likelihood stocks are already well into a bear market—potentially far enough into one that getting out of stocks is a riskier proposition than staying in, as it would raise the risk of locking in losses and missing the rebound.

Deflation generally comes late in a downturn. In the 2007 – 2009 recession, the bear market began in October 2007. GDP peaked that Q4. CPI didn’t turn negative on a year-over-year basis until December 2008 (and we didn’t know this until January 2009, when the report came out). Stocks would bottom on March 9, 2009, and GDP would reach its low in Q2. CPI would remain negative year over year through October 2009. Through the whole deflationary stretch, the S&P 500’s cumulative return was 18.3%, illustrating the problems with waiting for deflation to end before investing.^[ii]

Every recession is different. Just as every bear market is different. But using deflation as a trigger to adopt defensive positioning could easily put you on the back foot. We think it is much more helpful to look at the leading indicators for prices and the economy to get a sense of how economic drivers are veering from expectations, and then go from there.

Is there still a lot of money on the sidelines?

This is one of those things that seems like it should really matter … but really doesn’t. Which is a blessing, because it is impossible to quantify. We can easily see household and corporate cash balances, thanks to the Federal Reserve’s quarterly flow of funds data, but it is impossible to know how much of this is dedicated emergency funds, money earmarked for short-term purposes or other funds that would never find their way to the stock market. The level of surveying this would take to suss out doesn’t happen and is rather impractical.

But this is fine, because the whole thing about investors’ dry powder and cash pouring in from the sidelines to pump up stocks? All a myth. Every transaction has two sides, buyer and seller. When Jim and Susie decide to put some cash to work and buy shares in our favorite hypothetical company, Widgets ‘R’ Us, their money goes into the stock … and the seller’s money goes out, as cash. Cash in, cash out. Money in, money out. It all cancels.

So where do returns come from? Not the amount of money swirling around the marketplace, but from investors’ relative eagerness to use that money to pay more for a given share of a company’s future earnings. It is an auction marketplace, and the general egging-on is what drives prices up. And, when the market drops, it isn’t because all this cash is pouring out—people are still buying! It is just that sellers are so eager, they are willing to accept less, and buyers aren’t bidding up.

Would a new party winning the White House in November affect oil’s price?

Maaaaaaybe? Global oil prices hinge on supply and demand. So a presidential administration that is hugely pro-drilling, making it as easy to pump as possible, might lead to higher supply and weaker oil prices. Whereas one that makes drilling as difficult as possible might preside over weaker production growth, which would support higher prices. But it would all depend on global supply and demand drivers. The US is a big piece, but only one piece.

However. The Federal government has a lot less influence over US production than people think, because most drilling occurs on private, not Federal lands. The feds control leasing and permitting on land they own only. This is a big reason why the Biden Administration’s infamous pause on new leases didn’t knock US oil supply and send prices soaring. Not only did it allow extant leases and permits to continue as planned, but it held no sway in privately owned oilfields.

Then, too, even a drill-baby-drill kind of administration may have little bearing on prices. Federal willingness to promote drilling isn’t the only influence on oil producers’ decisions. Oil earnings are sensitive to oil prices, not production volumes. Producers got way out over their skis a decade ago, as the shale boom mushroomed, creating a supply glut that tanked prices and left several smaller producers with high-rate debt they had trouble servicing. It took the industry a long time to dig out of that hole and get its balance sheets in order, and memories are fresh. There are a lot of incentives to keep production targets judicious and keep supply in better balance with demand, which would keep prices more rangebound.

Lesson: In industries as well as market-wide, returns don’t hinge on politicians’ personalities and rhetoric. Policies are a relevant variable, but what matters are all factors affecting supply and demand over the next 3 – 30 months.