The Stability Of Big Banks And The Struggles Of Regional Banks With Paul Dietrich, Chief Investment Strategist, B. Riley Wealth

 

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Paul Dietrich is the Chief Investment Strategist at B. Riley Wealth. Join us as we discuss Paul’s unconventional background, his expertise in business cycles, leading economic indicators, behavioral biases, and the biggest risks in today’s market.

In this episode, Zack Ellison and Paul Dietrich discuss:

1. The Domino Effect of Lease Defaults on Banks
2. The Global Impact of China and Taiwan’s Conflict
3. Reducing Exposure in a Downward Market Trend
4. How Market Cycles Influence Earnings and Growth

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The Stability Of Big Banks And The Struggles Of Regional Banks With Paul Dietrich, Chief Investment Strategist, B. Riley Wealth

Background And Transition To Investing

Welcome to the show. We have with us one of the best investors out there, Paul Dietrich, who is the Chief Investment Strategist at B. Riley Wealth. Paul’s got a very different view on the markets that has circuits really well through multiple cycles. Paul, I’d like to hear what makes your viewpoints different and also a little bit of your background and how you got here.

It was a weird background and I was a philosophy major in college and I was certain that someone would pay me a lot of money to just sit and think every day. I realized quite quickly I better get a Law degree or I was going to starve to death. I also was an elected state representative for four years early on in my career and was very involved in presidential politics and having done largely mergers and acquisitions, that was my lead into investing full time, which I started doing about many years ago.

You were a lawyer in your previous career and also were a CEO, if I’m not mistaken, of another investment firm. How did you go from lawyer to investor to where you are now?

Early on, right after the Soviet Union fell, I was doing a lot of mergers and acquisitions behind for large telecom companies and pharmaceutical companies, and other companies buying up businesses in the former Soviet Union. One of the interesting things about the Soviet Union, you couldn’t trust any of their accounting. You couldn’t trust anything. When you were going into value, these companies, you were starting from scratch. I was representing one very famous investor at that time. He said, “I’ve got some fairly large amount of money. I’d like you to invest the same way you go and find value in these companies behind the old Soviet Union.” I did. I started using the same techniques that I use now. It’s been successful for the last 23 years or so.

You’re an expert in business cycles, which I think about a lot. I think a lot of people don’t really understand what that means. Talk a little bit about what business cycles are. What do they mean as an investor? How you might think differently about them than others?

Understanding Business Cycles

I had an economics professor back in college who said, “We make it far more difficult than we need to in investing in the stock market and the economy.” That’s what you’re doing when you invest in the stock market. It’s simply a representation of the real economy, people manufacturing things and selling things, and providing services. He said, “It’s really quite simple. You have two different cycles, just like we live through a day cycle and a night cycle every 24 hours.” We live through a bull market cycle, which usually lasts historically 6 years to 10 years, normally.

That bull market cycle is when the whole economy is growing. Earnings are growing. The stock market is largely going up at its long-term directional trend. That’s what the cycle is. It’s hard to lose money over 6 to 10 years when everything is expanding, GDP is expanding, and the market is largely going up, but then like the day follows night. We basically have these bear market cycles and they usually last 9 to 18 months, sometimes two years. What that is, the whole economy and the stock market is there, and the directional trend is down.

Everything is contracting, growth is contracting, GDP is contracting, earnings are contracting, and the market is going down. Historically, for the last 100 years, the average bear market recession, the S&P 500 index has lost on average 36% in each at a minimum or in each one of these bear market cycles. It’s like playing football. In football, you’re either playing offense or defense, and you have two different teams and two different sets of people. You have different plays for playing offense and defense. It’s a very stupid football coach who thinks he can play his offensive team all the time.

One hundred percent of the time, he’s going to lose. That’s the way I look at it. I have a different playbook for bull markets and a different playbook for bear markets. It seems to make sense to me. In each one, in 2001 and 2002, I went on what was then the financial news network, which is now CNBC. I basically said, my indicators are showing, and I use leading economic indicators showing we’re going into a recession in early 2001.

The market, the S&P 500 index from its peak to the bottom, was down 49% during that recession. I was up about 7% for my clients because I got them out of the market and into bonds. In 2008 and 2009, I went up both Fox Business News and CNBC and said, “My indicators are showing we’re going into a recession.” Got my clients out again. We were down 6%, but the S&P 500 peaked to bottom and was down 57% during that recession. That’s why we did it.

Leading Economic Indicators And Recession Forecast

Quick interjection. What are some of those leading indicators that you felt were most helpful in making those calls? What should we be looking at now?

There’s a group called the Conference Board. They maintain what the Federal Reserve set up the Conference Board in 1990 when they were created as a research entity. They look at all the leading economic indicators and then they put together a composite of those leading economic indicators. Every month, the Conference Board publishes the ten or so leading economic indicators. What they are is the S&P itself is a leading economic indicator, but like new orders, manufacturing new orders would be a leading economic indicator.

New manufacturing orders can serve as a leading economic indicator. They tend to decline before earnings start to decrease. Share on X

They go down before you start seeing earnings going down because people aren’t even ordering it. We saw in 2022 when people weren’t ordering inventory, which is a leading economic indicator. Somebody at Macy’s was saying, “I don’t think we’re going to sell as much this Christmas season.” We’re not even going to order it. If you look at those, it’s not for 7, 8 months later that you’ve started seeing earnings were down. You could have told, you would have known that earnings were going to be down in the fourth quarter of this year.

As we were down, I think 4.7% of earnings declined. You would have known that was happening way back in February and March of last year when people were simply ordering new inventory and new manufacturing was starting to go down. I think almost ten months of new manufacturing orders are down. All of these things are leading economic indicators. I watched them very closely. The conference board basically has, for 100 years, basically given a 6 to 9-month signal in advance before we’ve had a recession. It’s not like you should be surprised.

In terms of where we are, the big picture in the cycle. Where do you think we’ve had over the next couple of years?

Right now, we’re not in a recession yet, but we may be in a recession this quarter. We were in one by the second and third quarters of 2022. We got 9 to 18 months of a recession. It’s interesting, historically, the stock market, being a leading economic indicator, usually bottoms out about 70% through the recession. If the recession starts at the end of this quarter or the second quarter of the year, that means that the bottom of the market would be sometime at the end of this year or the first quarter of next year. The recession may go on for another into the middle of next year, simply because the bottom usually hits 70% through the recession.

Behavioral Biases In Investing

Paul, one thing that I always think about is how the long-term fundamentals really dictate this performance. Over the short term, fundamentals don’t really matter. It’s more about behavioral psychology. We’ve talked a little bit about that offline. Are there behavioral biases that investors exhibit that you think are hurting them now, recency bias? For instance, or others that maybe they’re not thinking about or aware of?

This happens all the time. It’s almost a disease in our industry, especially for short-term investors, people who are trying to buy the bottom and time the market. I’ve never found that to be a successful strategy. You’re lucky every once in a while, but not over the long-term, especially not when the fundamentals of the underlying economy are changing so dramatically, going from zero interest rates to 5% in a relatively short period of time and keeping them there. We haven’t seen that in 40 years since the Reagan administration and the 1970s during the Carter administration.

We’re going through some massive fundamental changes in just how the underlying principles of the economy. That’s one thing. I think part of the problem is that so many investors are focused on the stock market and stock market indicators. They’re looking at moving averages and price-earnings ratios, for which we see a decline in earnings in the last quarter of 2002. We’re in the first quarter of this year. We’re expecting an even larger decline in earnings. We’re in an earnings recession right now, and it’s projected to go through at least the next two or three quarters of this year.

Part of the problem is that many investors are focused on the stock market and stock market indicators. People need to focus on the economy. Share on X

I think that people need to focus on the economy because you don’t have to be a brain surgeon to figure out that things are not going well in the underlying economy. If things are not going well in the underlying economy, I don’t care what happens next week in the stock market. I care what happens long-term and where the directional trend is going. If I know that the directional trend in the stock market is going down, I don’t want to be in the stock market.

I don’t want to have that exposure because there is no way that you’re not going to lose money for your clients if you think you could be long in the stock market when we’re in a directional trend down. It’s never happened. All you have to do is look at the history of the S&P 500. The whole definition of a bear market recession is that the market is going down, and it’s very hard to make money when the whole economy is trending down. I think looking at the stock market indicators and not paying attention to the fundamentals of the economy can make stock market investors do all sorts of stupid things.

The next question is, what are the biggest risks that you see, and how can we avoid them?

Fundamental Changes In Inflation And Supply Chains

I see fundamental changes taking place. Think about the early 1970s, when we had spent massive amounts of money on the Vietnam War and on President Johnson’s Great Society spending programs, and we printed all of that money. Guess what happens after you print a huge amount of money and don’t back it up by either increasing taxes or cutting spending? The only way we can deal with that is to devalue the dollar, which we did throughout 10 years of the 1970s. Also, in 1973, we had the Arab oil embargo.

We had an energy shock. Does that sound like what we’re going through today? We’ve spent $6 trillion in COVID, $4 trillion under Trump and $2 trillion under Biden. We have the Russia-Ukraine war, which has changed all the shipping patterns and selling patterns of energy. A very similar situation. We added basically 26% to the money supply with that $6 trillion. The only way, since the Republicans are never going to vote to raise taxes, the Democrats are never going to vote, cut spending.

The only way we can deal with this is to devalue the dollar. We are doing that. It’s called inflation. We are doing that. Probably last year in 2022, we haven’t gotten the final figures yet, but with the various inflation, we probably devalued the value of the dollar by 6% or 7%. We did 5% or 6% in 2023 with the dollar, but that doesn’t get us to 26%. It’s going to take us five years of devaluing the dollar. That’s a fundamental change. That affects earnings. All the things I’ve been reading, everything I could read from biographies of the Fed chairman back in the ‘70s, Arthur Burns and Paul Volcker, and all of that.

I could just see everything playing out now, but most people weren’t investors in the ‘70s. You’ve got to be old like me. I was a young attorney in the Reagan era, but most people don’t remember what it was like. The first home I built had a 70% mortgage. We’re going through fundamental changes. I also think that, with what we learned from COVID, you can’t have just-in-time manufacturing. You can’t just have one supply chain source. You need multiple sources. What that does is it’s not going to be as cheap as it was.

To have part of your supply chain, such as Mexico, Canada, or China, is going to be more expensive. That means more inflation and it just changes the fundamentals of everybody’s business. With more reshoring, which I am seeing where manufacturing is coming back to the United States, or at least the final phase of it, that’s going to be more expensive. It’s also going to be, in some ways, less efficient. All of these things are happening. Energy is changing. The energy distribution is changing with the war. If we get a war and you ask about what keeps me up at night, in the short term, it’s what I believe is a coming collapse in commercial real estate and office buildings because 70%, 60% full.

Now they’re having to come back and refinance, which in office buildings is done every 5 to 7 years, and they’re no longer getting 0% or 1% financing. They’re going to have to pay more. They have empty space leases for office space that are being let go by people because their workers are working from home. Some of them are not getting the same amount of money as they did in the past. We’re seeing a lot of building owners just walking in and dropping the keys in the bank. This is going to affect banks. The banking crisis is not over. Those leases are considered assets of the bank. A lot of people are believing that we’re going to see a 21% default rate.

The other thing is China and Taiwan, if that happens, that’s a disaster, and it will take China into a depression. It will take us certainly into a recession and maybe a depression. It would completely disrupt the world economy. Those are the things. I think if you had asked me this a few years ago, I wasn’t losing any sleep over it. Every analyst I talked to on Wall Street. Those are the two things that come up over and over again.

Then there are lots of other risks. I haven’t seen as many risks in the market even before the last two recessions. They were specific risks, but not the multitude of risks that we face in the market now. I don’t think a lot of businesses have been as transparent, certainly not in the banking business, for that, they’ve got it. Their whole business models have changed over the last 40 years and nobody realizes it yet.

Do you think the banking system is still at risk?

Risks In Commercial Real Estate And Banking

I don’t think it’s at risk of collapse, which we quite frankly had in 2008 and 2009. Federal Reserve has come in, and I think big banks are in much better shape than regional banks and smaller banks. Smaller banks make up 70% of the lending, especially for small businesses and local businesses, and a huge percentage of commercial office space in most economies. You look, there’s some commercial real estate like restaurants and 7-Elevens. They’re going to be fine, but all the retail investing is that they’re in bad shape.

You go into any town and you see all the retail clothing stores and things like that. They’re empty and there are large percentages of emptiness in all these places and office buildings specifically are. They’re just a disaster. Right before Easter, we saw eight big New York buildings where the owners just said, “Have at it. The building is yours because we can’t afford it.” It makes no sense with what we’re getting for rents with the office buildings and with rising interest rates, which means higher financing rates for the next 5 to 7 years.

They make no sense. The business model makes no sense. This is all over the United States, especially in office buildings. That’s going to have an effect because every time a lease goes into default, guess what happens? You try to renegotiate the lease. The owners cannot, cannot make it. Usually, the banks have to eat that problem. That’s why I don’t believe the regional banks are going to continue to be in trouble.

To summarize, inflation is a huge problem. It’s going to cause a rethink of how everybody does everything. Supply chain issues remain, and commercial real estate is a huge risk. Banking, especially regional banks, are at risk. Of course, there’s a geopolitical risk with China and others. That’s a lot to keep.

Sticky Inflation And Energy Prices

A lot of the inflation we’re seeing is sticky. We saw it come down, and it will probably continue to come down a bit. If you look at a chart of core inflation, either the PCE or the CPI, which the Federal Reserve looks at, it’s just going sideways. Now, with Russia and Saudi Arabia pulling back on production, we can see energy prices go up. I would not be surprised by the end of the summer if we saw inflation going up not going down and what’s that going to do to the stock market?

We’re running out of time and I want to leave on a positive note because we’ve talked a lot about risks and how we’re not going to be sleeping much over the next couple of years. In terms of core investment principles that you live by, what do you think is most relevant work today as an investor? The last question will be what you’re most excited about as an investment opportunity going forward.

I always tell my clients that the best money they’ll ever make is the money they don’t lose in a bear market recession. I’m a big believer that the mantra of investment managers and financial advisors should be capital preservation. Don’t risk the money and the investments that they have because the market’s going to be going down, and I just think you either have to hedge or get out of the stock market during these periods of time. The reason is that they don’t tell you on Wall Street is that it’s called the mathematics of loss, that it takes so long to get back to break even after you’ve lost money in these bear market recessions.

The best money you'll ever make is the money you don't lose during a bear market recession. Share on X

If the market goes down 50%, you have to go up 100% to get back to break even. The market, in general, only goes up 10% or so a year. On a compounded basis, it takes you 7 to 8 years to get back to break even. You don’t want that for people’s retirement savings. It’s the one thing nobody talks about, but it’s the one really big reality. What I’m most excited about is that I look at leading economic indicators and I follow these business cycles and we are going to get out of this business cycle sometime.

The leading economic indicators will start rising as they did in January and February of 2009. The bottom of the market was March 9, 2009. I was able to get back around June when my indicators showed that we were really starting to move up. I was able to get in early. I know I’ll be able to do that again this year because the underlying economy just doesn’t lie. It’s either starting to go up again or it’s not. When it does, we’ll see all these leading economic indicators going back up. I’m anxious to get back in early. After the market bottoms, as I said.

It’s a good note to leave it to Paul. Thanks so much for joining. It’s been great having you. I feel like we could talk a lot more. I’d love to learn more about the behavioral side of things. Maybe we bring you on again and talk more about that in depth. Everybody, thanks for reading the show with our guest, Paul Dietrich, the Chief Investment Strategist at B. Riley Wealth. See you next time.

 

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About Paul Dietrich

Paul Dietrich currently serves as Chief Investment Strategist with B. Riley Wealth Management, Inc., where he focuses on managing investments for private investors, retirement funds and private institutions throughout the United States. He previously served as CEO and Chief Investment Officer with Fairfax Global Markets, LLC, and as CEO and Chief Investment Officer of Foxhall Capital Management. He also worked as an international corporate attorney with Squire, Sanders & Dempsey (now Squire Patton Boggs) and Jones Day. He is a frequent on-air commentator and regularly contributes his market analysis to business and financial media.

Securities and advisory services offered through B. Riley Wealth Management, Inc., Member FINRA/SIPC. These statements, or any other opinion posted on this site, are my opinion only and neither represent nor are indicative of B. Riley Wealth Management’s overall opinions. For important disclosure information, please visit https://brileywealth.com/legal-disclosures/