What Drove the Fed's Latest Rate Cut?

In this podcast, Motley Fool analyst Bill Mann and host Ricky Mulvey discuss:

• The rate cut from the Federal Reserve, and what the central bank is responding to.
• New rules from the SEC that aim to make markets more efficient.
• Tupperware Brands filing for bankruptcy protection.

Then, Motley Fool host Mary Long and analyst Anthony Schiavone check in on housing stocks in the first of a two-part series.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our beginner's guide to investing in stocks. A full transcript follows the video.

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This video was recorded on Sept. 19, 2024.

Ricky Mulvey: The Tupperware party is over. The risk party just getting started. You're listening to Motley Fool Money. I'm Ricky Mulvey. Joined today by Bill Mann. What is it Willie Three Sticks on the mike today. Good to see you.

Bill Mann: Glad to be here. Thanks for pulling out my nickname from when I was little. Shout out to my pall Rob DeVane.

Ricky Mulvey: There you go. [laughs] I think we need to get more like radio nicknames gone. It's going to be an initiative for 2025. I thought content planning was going to be easy today. I thought we're going to have a lot of Fed stuff to talk about. You're not as excited to talk about the Fed, but for the first time since 2020, the Federal Reserve, it cut interest rates, the overnight lending rate, the baseline rate at which banks borrow from went down by half a percent to about 5%. The cut was a little higher than some market observers had expected. What's your take? Disgusted, shocked, appalled, excited, neutral.

Bill Mann: I'm ish. We woke up this morning and there was a headline that said, the size of the cut was hefty. That gives Wall Street the jitters. Ricky, I ask you this. Does anybody actually believe this?

Ricky Mulvey: I don't know.

Bill Mann: I think that one of the things that has gone out the window is there's this belief that the Fed drives interest rates. If you asked someone, what drives interest rates? The answer is almost always the Fed. But the Fed is in a lot of ways following interest rates. They are a responsive organization. I know you have never been able to borrow at the Fed funds rate, the risk free rate. I have never been able to borrow at the Fed funds rate, the risk free rate. Mortgage rates, which is maybe the primary way in which American consumers get their exposure to debt, have been dropping in anticipation. What does it actually matter that the Fed dropped rates 25 or 50 basis points?

Ricky Mulvey: What does it actually mean? To me, it is a signal that the risk party might be back on. Traditionally, the Fed cuts rates from my brief economic memory is an emergency measure, and now it seems to be like a little treat. Things are going well, so we're going to lower rates back down.

Bill Mann: Well, sure. But the thing that drives interest rates in general, and we know this because we've lived it over the last few years is inflation and growth, those are the things that drive interest rates, the Fed is simply responding to what the inflation is and what the growth rate is. Obviously, when you have lower rates, that means that dollars earned far years out are worth more today. That's a very logical thing. But the fact that we are so focused on a Fed meeting in which they dropped 25 or 50. Notice that the debt markets barely moved. It's the stock market that responded, and it responded in ways that people wouldn't have thought of. The size of the rate cut was hefty. That gives Wall Street jitters. Come on, two days ago, we were talking about, oh, it has to be 50, otherwise, the market is going to crash. It will be disappointed.

Ricky Mulvey: Why isn't the debt market responding?

Bill Mann: Because the debt market has already anticipated it. The Fed is responding to the debt market. That's what it comes down to. When we talk about a risk party, the risk party's there, and the Fed is just showing up late, and instead of wine, they've got cheer wine.

Ricky Mulvey: I'll give you the third thing that I think the Fed may be responding to is an undercurrent. We've talked about it a little bit. This is just a theory, but it also might be national debt at this point. If you keep interest rates really high, then the amount of money the United States spends on its national debt service becomes extraordinary, especially as we continue to take out tens of trillions of dollars in debt. I think there's this hidden third mandate, control inflation, labor market. Then also, you can't let the debt get out of hand if you keep interest rates really high for really long, and while we've had, Howard Marks has talked about it in his sea change memos, that these ultra low interest rates have been abnormal and not in the historic norm, so has the level of government debt and the Fed might be responding to that for an indefinite period of time.

Bill Mann: That very well could be. There's a great investor named David Einhorn, and he once made a jelly doughnut metaphor when it comes to interest rates and debt, like, one jelly doughnut gives you a blast of energy, and it makes you feel really good. But the second third and fourth jelly doughnut, which I do not recommend trying do not have the same effect. They have the exact opposite effect, and I think that's what Howard Marks is talking about. But, ultimately, when we're talking about that, you're talking about government spending, which is also not something that the Fed has a whole lot to do with. Once again, they are being responsive to market forces that already exist. I think it is by and large, something that the media gets really excited about because it gives us something to cheer for, and and maybe that doesn't help us pick good stocks, but it sure helps the media attract eyeballs.

Ricky Mulvey: Bill, I know you'd rather talk about this esoteric SEC rule change in a second. But there are a couple of highlights from the Fed press conference from Jerome Powell that I'm going to hit. You can respond, or we can just move on. One is that we are, "Moving toward a more neutral stance." Then the second, I think, is a fairly interesting picture of the economy, saying, "The upside risks to inflation have diminished and the downside risks to employment have increased." Either one of those you want to talk about, you can take one, two, both or pass.

Bill Mann: This is where I come back and I talk against what I've been speaking about before. Keep in mind that the Federal Reserve has been trying to bring about inflation from about 2012. From 2012-2022, they were more worried about deflation than inflation. What they're saying here, and you're talking about their ability to bring either billions and billions of dollars into the market or out of the market. They are saying here, and I think that this is exactly right, that inflation is actually the thing that they are worried about more, and I think that's real.

Ricky Mulvey: Let's move on to this change from the SEC that you probably haven't heard about. I'm talking to the listener right now, not you, Bill, because you said we wanted to do this story this morning. The SEC has a new rule that's going to allow many popular stocks to trade in half cent increments between the bid and the ask. Right now, stocks are priced to the penny, and SEC Chair Gary Gensler has prepared remarks. He looked back on the history of spreads, which I didn't realize this in the 1990s were quoted in one 16th of a dollar and discussing how investors benefit when these quoted spreads are tighter. A penny is not a lot of money. Isn't that enough? What's the SEC doing this for?

Bill Mann: It's a penny per share. In very infrequently, do you buy a single share, and there are billions of shares traded each day. You have a bid and an ask spread, and the brokers get to capture some of that spread. The exchanges get to capture some of that spread. What's essentially happening here is that they are saying that, look, this is benefiting the brokers much more than it is helping liquidity in the market. So we're going to lower the increments, and hopefully, close down those spreads just a little bit. If you trade a lot over time, that is a little bit of a form of a tax on your overall returns, and they are trying to lower that tax.

Ricky Mulvey: Is it meaningful to a long term investor who is buying some shares and holding them hopefully for 3-5 year periods?

Bill Mann: Less so. But, in any case, we have talked a lot about going to, and obviously, we're at a time now in which most brokers don't have commissions, but there used to be commissions that were eight bucks and 12 bucks, and they went to zero in most cases. Look, it's your eight bucks. It's your 12 bucks. It is your money that's being captured by the spread. Any amount of efficiency that's added to the market, I think it's a good thing, even if you are buying and holding for a long period of time.

Ricky Mulvey: Another rule that was announced is will cap rebates that exchanges pay for less liquid stocks to encourage trading. This plays into your small cap land, Bill. This is going from 0.3 cents per share to one tenth of a cent per share. Thank you for picking a story with so many fractions. [laughs] 0.3-0.1. The exchanges are not happy about this because they like their 0.3 cent rebate. What's the impact of this here?

Bill Mann: It turns out when you're talking about 0.3 cents or 0.1 cents, that, as you've noted, is not a lot of money. But if you multiply that by billions of transactions and billions of shares traded, it does add up. What they're talking about here is the capacity for the market structure to make payments going back to off exchange market makers, companies like Citadel. These are ways that we're hopefully going to shift trading volumes and make it more efficient, because ultimately, in an incredibly liquid market, we don't need an incredible amount of liquidity in the larger cap space, and in the smaller cap space, it's still going to be essentially the same thing.

Ricky Mulvey: Are there any sign curves or wave functions you'd like to briefly describe for our listenership after your discussion on fractions? I'm saying this it's somewhat tongue in cheek, but I am genuinely curious now. I'm taking the sarcastic hat off. Why are these seemingly small changes interesting to you?

Bill Mann: The SEC chairman Gary Gensler actually had a a proposal for much more sweeping overhaul of trading, and they wanted to end payments to off exchange market makers. This is a little bit of an agreement between the Republican and the Democratic appointed commissioners at the SEC and they've all voted for it. They are viewing this as a way to bring about a much more efficient market. Again, we're not meeting at the buttonwood tree, and you go to the exchange floor in Wall Street, and it's pretty much empty. Everything is being done by computers now, and so this is a way to take away a little bit of friction from the market. I think ultimately that's going to improve price discovery.

Ricky Mulvey: It's also probably why the exchanges are not terribly happy about it means their cheddar is getting sliced into a little bit as these rebates go away and the spreads get tighter.

Bill Mann: That's right. They want to pretend that we're still by the buttonwood tree, and they really need to make liquidity in areas where they just don't.

Ricky Mulvey: Final story of the day. Tupperware Brands. Happy trails kind of. They're having a reorganization filing for Chapter 11 bankruptcy. Bill, until this morning, I did not know that Tupperware Brands was a publicly traded stock. I think I have some in my kitchen cabinet. There's a lot of off brand Tupperware going around as well. How did Tupperware fall so much? It was a household brand that's been around for decades and decades.

Bill Mann: Unfortunately, Tupperware has ended up in the same place that Kleenex has, where what you probably have in your house is not Tupperware branded plastic, food, containers. It's Rubbermaid, or it's Glad, or it's something else. Tupperware did something, which I think I would agree with as being a better way to go about business on some levels, where they tried to protect their sales channels. The Tupperware parties, 90% of Tupperware sales still came by it through direct sales. They only opened up an Amazon storefront in 2022, way too late. They did something that was almost the opposite of what Apple has done, where Apple routinely just takes out some of its best streams of revenue. When they brought about the iPhone, that was the end of the iPod and that was a huge business for them. In Tupperware's case, they did not want to up end their direct sales model. It might have worked, I don't think COVID helped them at all, but it ended up taking the company down. They didn't change with the times fast enough.

Ricky Mulvey: The company right now is saying it is planning, "No current changes to the agreements." It has struck with independent sales consultants. On the other side, you have people who own Tupperware debt. They may have a different perspective. We'll start with the non debt holders, Mary Ann, in the Facebook group, titled I O Love Tupperware, Gateway Rockers Party Sales, said, "In spite of the news that is being flooded over the airwaves, we are still going strong. Tupperware, we are tough, Tupper Strong." Bill, how are you balancing these perspectives?

Bill Mann: I think we're defining down the words tough and strong just a little bit by adding Tupper to them. I think that Mary Ann is probably closer to right than we might think, because ultimately, when companies go bankrupt, it's not because they're unprofitable. Generally speaking, they go bankrupt because they don't have enough cash to service their debt. The Mary Anns of the world are going to remain very important to these debt holders in terms of maximizing the amount of cash they're going to receive, for the debts that they hold. I think that Mary Ann is probably closer to right. She is part of the solution, not the problem. But I would suspect for Mary Ann that she's going to be competed with in a lot of different ways in the future.

Ricky Mulvey: Your email inbox is about to look a little different in a couple of days. In July of 2024, we're going to talk about the debt. Lenders were purchasing Tupperware debt for 3-6 cent on the dollar. According to the bankruptcy value, they essentially bought most of the company's $800 million worth of debt for 15-30 million. We talked about the debt side for a little bit. But can regular investors, how should they check in on the debt with the companies that they own to see if there's trouble coming before the debt starts selling for five cents on the dollar?

Bill Mann: You can get quoted debt. You can even do it in a lot of cases through your brokers. Usually a full service broker can give you a quote on the debt. Whenever you see debt that's trading what's called below par, which is a dollar, it is essentially broadcasting that the debt holders or the debt market believes that the company is impaired in some ways. Now, 3-6 cents, those are, I guess you would almost call them undertaker investors. Those are investors who are assuming that the equity is worthless and that they are going to be able to benefit by just simply recovering more than three cents on the face value of the debt.

Ricky Mulvey: I was going to make a joke. We'll call it the end of a cigar. Bill Mann. Thanks for being here. I appreciate your time and your insight.

Bill Mann: Thanks, Ricky.

[MUSIC]

Ricky Mulvey: We don't have enough new homes in America. My colleague, Mary Long, caught up with Motley Fool analyst Anthony Schiavone to check in on some housing stocks. Part 1 runs today, part 2 runs Monday.

[MUSIC]

Mary Long: We're talking about a couple of different housing stocks today. But before we dive in, let's set the table for a second. We're recording this Wednesday, September 18th. We got an update to the US housing market index yesterday. For those that don't follow housing number super closely, what does the housing market index measure?

Anthony Schiavone : The housing market index, it's an index designed by the National Association of Home Builders in collaboration with Wells Fargo. The purpose of the index is to gauge the sediment of single-family home builders, so that NAHB surveys home builders by asking several questions related to current sales, expected sales and traffic of prospective buyers. The index essentially measures sentiment on a scale of 0-100. Zero means sentiment toward home building conditions are extremely low, 50 means it's normal, and a 100 obviously means that it's great. The index has ranged anywhere 8-90 over the last this century, and the index currently sits at, like you said, 41 today. I would say home builder sentiment is generally neutral, and it's good to see it moving in the right direction.

Mary Long: With that kind of setup, we're going to talk about an actual home builder, a stock company that's playing in that space. Dream Finders Homes is a home builder, but it's not quite like the other home builders. They employ an asset light business model, so they build homes, but they don't own any land and instead use only options contracts. How does that work exactly?

Anthony Schiavone : Like you said, most home builders typically acquire land, they put it on their balance sheet, and then develop that land before actually constructing the single family house itself. Instead of owning and developing the land, Dream Finders typically negotiates with land developers to have the option to purchase the finished lot. How it works is Dream Finders will pay an upfront deposit, generally around 10%-20% of the total agreed upon purchase price. They pay that to the land developer to develop the land. Then Dream Finders has the right to either purchase the lot, or if macro conditions weaken, they can also walk away from the deal, and all they lose is their deposits. By using this asset light land option contract model, Dream Finders avoids the long capital-intensive process of land development. They also mitigate risk because the economy takes downturn, they can simply walk away from the deal without having all this land and the associated leverage that comes with it, sitting on their balance sheet.

Mary Long: That setup has worked pretty well for the company. Their stock is up over 70% since 2020. But hearing you explain this asset light model and seeing how well it's worked for Dream Finders, why don't other home builders use the same strategy?

Anthony Schiavone : When you think about traditional home building, it's essentially two businesses. You have land development, which is a subpar capital-intensive business, and then you have home building, which is a much better higher version business. Today, actually, a lot of the publicly traded home builders have actually shifted their business to incorporate the asset light land option model. With DR Horton, for example, which is the largest publicly traded home builder. About 75% of their land is optioned today. Ten years ago, that number was less than 30%. The land option model is much more prevalent today. But I think what's interesting about Dream Finders and another publicly traded home builder called NVR is that these companies do not own any land on the balance sheet. They're all the options model, the asset light model. Whereas some of the other home builders typically have a combination of owned or optioned land.

Mary Long: I'm glad you mentioned NVR because in looking at Dream Finders, I came across a lot of comparisons to NVR. You mentioned that they both employ this asset light model, so there's a similarity between the two. What is Dream Finders doing better than NVR or what could Dream Finders learn from NVR?

Anthony Schiavone : Well, I think Dream Finders has the potential to be great company, but I don't think it's even close to being the business that NVR is today. NVR is not only one of the best home builders out there, but it's also one of the best stock. Has been one of the best stocks that own this century. If you invested $10,000 in the NVR at the beginning of this century, you're sitting on more than $2 million today. The reasons why that is, is because NVR pioneered this asset light land option model. It's also one of the largest home builders, so they can procure labor and materials better than its competitors, so it has scale advantages. Their distribution and the prefabrication of parts of the home allows them to turn over inventory at an extremely high rate. They generate high returns on capital, high returns on equity.

Then lastly, NVR their capital allocation has been phenomenal. Their share account is down about 70% over the past quarter century. I'm not sure Dream Finders will ever quite measure up to NVR. But the good news is, if you're a Dream Finder shareholder, I don't think it has to to deliver good returns to shareholders. Market I think is big enough for both of them. What I think Dream Finders can improve upon is scale, which I think will come over time. But I would like to see them focus a little bit more on reducing their leverage. They have a lot more leverage than MVR, so reducing that leverage so that they can be aggressive during market downturns instead of protecting their business during market downturns.

Mary Long: The debt alone for Dream Finders is not necessarily a concern in and of itself, but it's when you compare it to its competitors where that debt becomes maybe more of a worry. It has a debt to equity ratio that's about four times that of D.R. Horton and NVR. What would you like to see Dream Finders do to bring that down?

Anthony Schiavone : They have made a couple of acquisitions over the past couple of years and that's added to their debt load, and the debt for Dream Finders, it's not a problem necessarily until it is a problem. If you look at the home building market today, we have a massive shortage of homes. The economy is doing good for the most part. People are employed and large home builders are doing pretty well. But this is still a cyclical industry. I think if Dream Finders can focus on lowering their leverage, maybe not being so aggressive on the acquisition front, as long as the returns aren't there, and maybe repaying some of their debt. I think that could be better for the company in the long run. But what's interesting is they actually have a lot of insider ownership too. Their CEO owns about 65% of the stock. I think insiders in total own about 70% of the stock. That helps you sleep a little bit at night knowing that their interests are aligned with mine, and they know the company better than anybody. I trust that they know the right amount of leverage that Dream Finders can use without jeopardizing the company's financial position.

Mary Long: CEO Patrick Zalupski is also the founder of the company, and as you said, he owns about two-thirds of Dream Finders Homes. What's his deal? How central is he to the larger thesis here?

Anthony Schiavone : I think essentially, is the thesis or Dream Finders homes. He founded the company in 2008. The company built 27 homes in 2009, and they built more than 7,000 homes last year, and he's been there through it all. He's been there when they've made acquisitions. He's been there when he went public, obviously, a couple of years ago. With this asset light model that Dream Finders has, they generate a lot of cash in the business, and that cash has to be allocated appropriately. He's the one who's doing that. He's super important to the thesis. The company has only been public for a few years, like I said, but so far he's done a good job, and he's only in his 40s. There's a good chance that he's going to be with the company for decades to come.

Mary Long: Dream Finders is currently trading at less than 12 times forward earnings. That seems pretty compelling, especially when you line it up against competitors, fellow builders, NVR, Lennar, and DR Horton. Is this a solid deal? Is this a buying opportunity for this company? What say you?

Anthony Schiavone : Yeah, the shares are up about 50% or so of the past 12 months. But like you said, it still trades a reasonable 12 times earnings. What's interesting is, Dream Finders actually bought back a small amount of stock during the second quarter at about $26 per share. Patrick Zalupski, he prides himself on being a good capital allocator. That's repurchasing shares, going out making acquisitions, making organic investments. To me, that's a pretty good sign that Dream Finders is a good investment at 26, and it's still probably a good investment where the stock is today at 37. Even if we just look at that share repurchase they made last quarter, so far it's been a pretty good cap allocation move with the stock now around $37.

Mary Long: Thanks so much for joining us today and talking a bit about Dream Finders homes. I really appreciate having you on the show.

Anthony Schiavone : Thanks for having me.

Ricky Mulvey: As always, people on the program may have interests in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow.

Wells Fargo is an advertising partner of The Ascent, a Motley Fool company. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Anthony Schiavone has positions in Dream Finders Homes. Bill Mann has no position in any of the stocks mentioned. Mary Long has no position in any of the stocks mentioned. Ricky Mulvey has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon, Apple, Dream Finders Homes, Lennar, and NVR. The Motley Fool has a disclosure policy.