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Stock market set up for ‘one hell of a terrible era ahead’: Strategist

Smead Capital Management president and portfolio manager Cole Smead joins Yahoo Finance Live to discuss meme stocks, Fed policy, inflation, and the outlook for stocks amid macroeconomic headwinds.

Video Transcript

BRIAN CHEUNG: Well, let's get a little bit more on the market action with Cole Smead, Smead Capital Management president and portfolio manager. Thanks so much for joining us this morning. You were probably just listening to our conversation now. Obviously, we want to talk about the broad markets.

But first of all, I mean, the memes have kind of come back in the last few weeks. And I'm just wondering if that tells you anything about the macro environment that we're in. And just kind of whether or not the froth is comparable to what we saw in January 2021, the last time we saw something like this.

COLE SMEAD: Yeah, I mean, we've been for the last two years effectively testing the edges of speculative euphoria in a myriad of places, whether we're talking about meme stocks, or the bond market, or you know, kind of the work-from-home stocks. So I look at this as they're all just symptomatic of a mania. And they just don't end overnight, to your point.

And is this seem as crazy as, you know, early '21? The answer is no. At the same time, to watch a company go from a really high price to then talking about, you know, possible solvency issues, it just shows you how speculative this era and this market has been. And it just doesn't speak well for the stock market in general.

BRIAN CHEUNG: Now, when you talk about that speculative type of approach that we're seeing in the markets right now, that's very interesting because it's coming at a time, which is-- let's just-- it's coming out of 2022 that's been extremely rough, right? We've seen some bounce back. But you just see from the market sell-off today headed into that Fed's Jackson Hole meeting later this week, that investors are still very jittery.

So tell us about kind of your assessment of the volatility in this market right now. Have we reached the bottom, given the rebound that we've seen over the last few months? Or are we at risk of perhaps falling even further?

COLE SMEAD: It's a great question. And use the volatility as a guide. If you look at history-- the history of the stock market, when we have low volatility markets-- much like we did during the 2010s-- you're gonna get higher returns. When you have a lot of volatility, you're gonna get low returns. It's just the nature of markets.

And I point that out because, you know, everyone's looking at this high volatility and it's very hard to find strategists on Wall Street saying, gosh, this is gonna translate into much lower returns as we look forward. Now, that isn't the only single factor to low returns. But the volatility is a big historical, you know, note that I would mention.

To your point, the other thing going on is just the liquidity is disappearing. Stock and bond market returns are negative for the year. Therefore, there's less money sitting out in those parts of, you know, capital allocation. And you look at the economy, money is being sucked away by labor. Labor costs are going up. The cost of goods, in general, are going up.

So watching liquidity disappear is not good for the stock market, either. I mean, this is set up to be one hell of a terrible era ahead. And like we've-- you know, as we get into talking about Jackson Hole, it just doesn't get any better.

BRIAN CHEUNG: Yeah, well, I mean, let's expand a little bit on that. If it's gonna be one hell of an era here, we know that the Fed is gonna continue to raise interest rates. Apparently, they didn't get the message after the July meeting because we saw markets rally after the Fed reiterated that point. What do you expect to hear from Powell later this week? And what type of risk do you think that comes with if you're invested?

COLE SMEAD: Yeah. Powell is going to look as hawkish and sound as hawkish as he possibly can because he has to for political stability. If he doesn't sound like a hawk or look like a hawk, the question is, does the Fed have any credibility? OK? And so I think that's the overwhelming thing we'll get out of Jackson Hole.

Now, just to give your listeners some framework because it's really tough to think about the precedents of what we're looking at. The framework I would be using is I would be looking at the end of-- from the end of 1971 to mid 1974, the Federal Reserve began raising interest rates in the middle of strong inflation. Obviously, inflation trailing had been stronger in the late 1960s and this is when the Fed finally got serious about raising rates.

We took Fed funds rates from 3 and 1/2% to 13% over a two and half year period, OK? Now, I'm not saying that the Fed's gonna have to go to double-digit, you know, short term rates. But I pointed out because they did that right into one of the worst bear markets in the last 50 years. And that is exactly the kind of framework I'd be thinking about.

This is nothing more than a dead cat balance or a bear market rally that we witness here because liquidity is going to continue to disappear away from the stock market. Exactly the opposite of what we saw during the 2010s, which is liquidity was just there every day of the week, any day of the week, and never went away.

And so I think the real question, in terms of how much damage this could do to assets, not necessarily the economy, is if the Fed can't-- if the Fed takes away stimulus and now goes to tightening, will it kill aggregate demand?

BRIAN CHEUNG: Yeah, and you know, you make an interesting point. We're not going to 13% on the short term rate. But if we go up to, let's say, 4% that some are calling, does that imply how much further from here on this dead cat balance? Are we gonna maybe see another 10% of declines?

COLE SMEAD: If the Fed ends up at 4%, this will be the easiest tightening cycle from these kind of-- you know, from an economic standpoint ever. The likelihood is they're gonna have to go above 5%. You know, they could even have to wake up at 6%. And these markets are just not anywhere near that.

You know, to your point earlier, the meme stock traders don't even know what that means. Wall Street doesn't want that because it sucks to be in investment banking, if you have to do that. So you know, again, there's too many incentive structures for people to not want to have to deal with reality. And the problem is stock market failure is gonna come with that and they're gonna have to deal with it.

So do you want to set your life up in a way where you hope, rather than you can play a game where if disappointment shows up, you're ready for the next series of cards that come out and play that hand.

BRIAN CHEUNG: All right, we'll have to see what cards pop up. Smead Capital Management President Cole Smead, thank you so much for joining us. Have a great week.