When attempting to collaborate on this month’s newsletter, it became very clear that Ross and I have differing views on the market's outlook. Rather than debate in private, we decided to air our laundry in public so the the audience could enjoy the banter, and pick a side.

The Bear Case – by Greg Harrison

In the June Newsletter, I outlined the reasons for potential concern over the aging bull market, citing the distributing figures reported by the the auto industry, the inflated price of gold, and May’s mixed jobs report. I felt these indicators were proverbial cracks in the foundation of the bull market, and I urged investor caution.

Since June, it appears as if the fissures have deepened. Just last week the August jobs report came in lighter than expected and unemployment ticked up. Not a catastrophic event by any stretch, but it adds to the mounting list of things that don’t seem right. This week the political/economic crisis de-jour centered around the possibility that the U.S. could default on its debt obligations as the result of reaching its borrowing capacity. The Second Liberty Bond Act of 1917 limits the amount of money the government can borrow, and this limitation is known as the debt ceiling. The way governments like the U.S. borrow money is by issuing bonds.

The U.S. is required to issue bonds and borrow money any time our government’s spending exceeds the income generated thorough tax revenue (which is pretty much always, notwithstanding these rare exceptions). If the borrowing required exceeds the debt ceiling limit, then Congress needs to raise the ceiling so the country can borrow sufficient funds to repay its loan obligations, or else the U.S. will default.

Were the U.S. to default, the fallout could be catastrophic. At the very least it would put an abrupt end to the bull market, and at the very worst throw most of the civilized world into a massive recession.

The last time the government refused to raise the debt ceiling was in 2011. As a result, the S&P fell 17%, and the country received a credit downgrade. Clearly it’s not something any sane person would want to repeat. In a stunning turn of events this week, President Trump backed the Democrats and agreed to increase the debt ceiling, a reprieve that will last until December of this year. That at least forestalls this particular pitfall for a few months.

Were the debt ceiling the only (or at least the most serious) threat facing our economy, I would be forced to actually agree with Ross and maintain a bullish market outlook. However I see the path forward as being littered with economic and geo-political hazards - too many to avoid cleanly. I discussed several of the pending threats in an earlier blog post, so I won’t repeat them here. Suffice it to say, I am hard pressed to find a plausible scenario that results in a soft landing for our economy.

In spite of the stock market run up this year, some investors are concerned about the market, which has resulted in US Treasury yields hitting a 12 month low. The increase in demand for government issued bonds (like Treasuries) drives bond prices up, and yields down, since bond price and bond yield are inversely correlated.

What’s particularly confounding about all this is that stocks and bonds typically sit on opposite sides of the teeter-totter. When the economy is strong, demand for government bonds is usually weaker because investors can generate greater returns by investing in equities. Conversely, a strong demand for bonds is typically driven by investors fleeing equity markets in search of a safer place to invest cash.

So how are we to interpret a market where both bond prices and equities are rising?

Paul Donovan, chief economist at UBS Wealth Management believes that bond values aren’t being driven by market dynamics as much as an aging population seeking financial safety combined with central bank buying. That's certainly plausible, but if that were truly the case, wouldn't the central bank just ease up on buying? What would motivate the central bank to keep buying if baby boomers are generating so much demand?

As if that weren’t strange enough, somehow the economy’s rate of growth has become decoupled from inflation. Typically, these indicators also act as counterweights to one another, because economic growth spurs demand, which causes price increases and thus inflation. But the U.S. logged 3% annualized economic growth in the second quarter, but consumer price inflation only rose 1.7% from the prior year.

There’s no shortage of theoretical explanations for the dislocation between growth and inflation. Maybe inflation has been so low for so long, it’s become the new normal; or maybe big multinationals are keeping prices low to grab market share; or maybe the economy isn’t as strong as the numbers suggest. Anything is really possible, but nobody really knows for sure.

Stranger still is the fact that this anomaly isn’t just occurring in the U.S. Both Europe and Japan have economic growth rates that are far outpacing domestic inflation. The fact that this fundamental relationship between growth and inflation appears to be broken could have a significant impact on the financial markets. That’s because central banks rely on a healthy inflation-growth correlation to set policy, regulate economic growth, and maintain a target inflation rate of around 2%.

This year the S&P is up almost 10%, and the 10-year Treasury is up 6% forcing yields down to 2%. A 2% yield is typically associated with financial distress, not an economy with a salubrious 3% rate of growth, and 10% gains in equity markets.

With inflation and growth decoupled, the challenge facing world’s central bankers is how to regulate markets when the primary tool at their disposal, namely the raising or lowering of overnight borrowing rates (also known as the Discount Rate), may be wholly ineffective. I don’t necessarily have the answer as to this question, all I can tell you is, it’s definitely not good.

Markets rely on stability and predictability in order to thrive. The country and the world for that matter seem to be careening into unchartered waters, and our nation’s central authority charged with maintaining market consistency may be without its most powerful weapon. That’s a little like the Patriots trying to win a Super Bowl without Tom Brady.

Good luck with that.

Until facts are in evidence that substantiate a more bullish conclusion, I will remain market-cautious. That’s not to say I’m exiting equities completely – because I’m not. Good businesses with superb managers will almost always withstand the market vicissitudes. Investors who maintain a long-term view of the market as I do, will often use corrections as an opportunity to accumulate stock at attractive prices. Right now I'm being very selective, and carefully picking spots to enter new positions or add to existing ones.

Before I hand this over to Ross, I would just like to mention that while I lost my bet on the winner of the Mayweather v McGreggor fight, I won the “will go” bet, which was 9 full rounds. So net-net I made money.

Sending thoughts and prayers to those in Texas, Florida, the Caribbean and Mexico. Stay safe.

The Bull Case – by Ross Silver

Thank you Mr. Harrison for your eloquent and articulate outline of why we should be mortified and stuffing cash in our mattresses, you should give CNBC a call as they would love to have you on air discussing doom and gloom a favorite topic of theirs. I am on the other side of the coin and believe the market moves higher near term primarily due to the fact that the Senate is a black hole. Whatever goes to the Senate vanishes and that is good for the market because the market hates change.

One of your points was how the market is rising and so are treasuries and they should not move in tandem yet in opposite directions. Well, investors are trying to play two hands of poker in a game that only allows for a player to play one hand, thus one hand will have to be forfeited but investors aren’t sure which hand they want to forfeit. What that means is there is a mega straddle on. What is the straddle? Well, institutions don’t want to get caught with their pants down when the music eventually stops so they are playing safety and risk at the same time. My question to you is, when they stop straddling (which is a type of trade for those comedians getting a kick out of my use of straddle), what happens? My guess is the market goes higher rapidly and interest rates run when the straddle is taken off assuming the big money bets on equities, if the bet on safety and treasuries, the market retreats. If you were to walk into any major fund management firm, someone will have the slogan “Don’t Fight the Fed” on their desk or wall. Well, if the government is doing nothing to alter commerce, the Fed isn’t raising rates and companies have another quarter of banner earnings like we just had, equities are going higher Kemosabe. As such, there is no reason not to stay bullish from my goggles.

On a separate note, 52% of Americans don’t participate at all in the stock market. I mention this because the NY Fed Chairman was being interviewed recently and spoke of how the economy was improving based on “how well the stock market has done”. Based off his comment, the 52% of Americans with no money in the market are prospering, how exactly is that? Oh politicians, please never change!

When Greg and I were in Vegas before he made that bet on the “fight”, I told him to instead donate it to charity as there was no way on Earth, Floyd Mayweather was losing. The media morons who don’t understand boxing thought McGregor performed admirably for lasting until the 10th round and stated he really took it to Mayweather in the early rounds, INCORRECT. That “fight” was about as fun to watch as grass grow. McGregor had no idea what boxing angles are, for that matter neither did Floyd for the first 6 rounds, McGregor threw sloppy punches in that he did not utilize his hips, telegraphed his punches and he never seriously hurt Floyd. McGregor landed a clean uppercut to Floyd and Floyd didn’t flinch. Total circus, not a fight but man was Vegas an awesome party afterward I heard. Of course I was busy watching my three kids and pregnant wife who is due in two weeks and was not able to make the circus. Greg is in the same boat as me; his wife is due any day now. Pray for us both!

Good grief it has been a long summer. Del Mar and Saratoga were a nightmare for me as it was longshot central at those joints this summer. I usually clean up at Saratoga and cash a few six figure Pick 5’s but not this year. I missed a monster six figure Pick 5 at Del Mar a few weeks ago when a horse on my ticket was disqualified, the horse was a 15-1 shot. That hurt! More on horse racing in November when the Breeders Cup rolls around, I can’t wait!

Most importantly, FOOTBALL IS HERE!!! I was able to watch some college games last weekend and Oklahoma State looks legitimate, they have one of the best college offenses I have ever seen, they will be heard from in the Big 12. Ohio State looked like a pile of horse (four letter word) in their opener against Indiana until they woke up. I have the Buckeyes to win the National Championship at +350 in Vegas. I think their defense will get nastier as the season rolls on but their QB play is terrifying. That QB for Ohio State either looks like a Heisman candidate or a fifth stringer for Nowhere St. Bama took care of business against the Noles which was somewhat surprising. I have not bought into Jalen Hurts at QB and as a result think he could keep Bama out of the playoffs. He may prove me wrong but he looked pretty good against Florida State.

The NFL kicks into high gear this weekend and the teams I have to reach the Super Bowl are Hotlanta at +1100 and gulp, the Chiefs at +1400. The Chiefs and Falcons both have nasty defenses but their offenses are question marks, more so with the Chiefs. While I think Tom Brady is a wonderful ambassador for the NFL, I can’t stand Pats fans; they are the most annoying fans on Earth. While Brady thinks he is in the best shape of his life and can play another 5 years at least, it isn’t happening folks. Brady is a 350lb beast DT falling on him, from a season ending injury. I am 40 and I am sore the next day when I play with my two sons who think I am a trampoline and climbing tree. Brady is getting hit by 6”4 260 lb guys that run like deer, those hits will render him worthless at some point in the near future unfortunately. Pats fan of course think Jim Giraffe-alo or however his name is spelled will continue to drive the Porsche but he is not Tom Brady. Enjoy your moment Pats fans because it is not happening this season! Oh, I can’t wait to get an email form Andrew in RI scathing me for that, he is a lifelong Pats fan and season ticket holder. Notice I have said nothing about my Raiders, and I will not do so until appropriate. I fear jinxes and jinxes are real. I will close with that.

Be safe people in Florida and be well people of South Texas!