Here’s my postulate. The current market is a contradiction of early 70’s inflation on steroids and the bursting-bubble conditions of 2008, and the way your investments are structured will play a critical role in how you fare over the next two years. This is Part 1 of a 2-part series. Part 1 reflects on 50 years of Fed history and implications for today’s investors. Part 2 will delve into investment structures appropriate to the times, producing high returns with a defensive bias.
Right up front let me say, I will not predict stock prices. My mantra is “Do not predict; prepare.” My own preparation relies on a risk-assessment algorithm to sidestep serious downturns, but this article is not about that; it’s about how the current investment climate is likely to evolve.
The financial impacts I’ll discuss are likely to be reflected in market prices eventually, but markets stammer to new equilibrium levels; they do not move in predictable straight lines, especially today given cross currents of serious inflation and the beginning stages of bursting bubbles. Markets are a comingled mess of emotion and valuation logic, and fundamental assessments are a poor timing device.
But if you believe that Fed policy will produce outcomes much like past policies, then preparation requires an understanding of likely price environments and a strategy to deal with them in a risk-cognizant manner.
So, we’ll set a backdrop here in Part 1. And then, in Part 2, we’ll look at how a portfolio can combine high returns with a defensive bias appropriate to that backdrop.
Early 70’s On Steroids
We’ve gone from a 2% CPI to a 7.5% CPI in just months. This is how the notorious’ 70’s CPI evolved; it took years to reach 7%.
Whether or not today’s early-70’s analogy grows into the late-70’s catastrophe is a very big question, but the important thing is that to stop it, the Fed will need actions approaching a Voelker-like tightening. The earlier they act the less draconian the required action, but they’re already 9 months behind the curve. They have finally abandoned the transitory meme, but they are still buying assets and expanding the balance sheet until March.
Can we count on them getting this right?
The Fed Is A Hot Mess
Let’s start by looking at Fed policy from the ’70’s through the late’ 90’s as reflected by the fed-funds rate; it might seem like ancient history, but it’s important to understand that their policy of more recent decades has not been normal. So as the Fed reverses direction, no one really knows how to do so gracefully.
Inflation became a big problem in the 70’s, and rates rose early that decade in a failed attempt to stem it until the OPEC-driven recession put an end to Fed rate increases. But ultimately Voelker’s Fed responded by tightening substantially. The fed funds rate rose to about 20% and that killed the inflation. Today that is generally viewed as a heroic response to a persistent problem which had become a crisis, but it’s not my primary focus here.
Notice, in the chart below, that there were five recessions over those three decades and the Fed’s response never drove the fed-funds rate below 3% +/-. You can also see that from 1982 onwards, fed funds rate changes were gradual and occasionally proactive; the short 1990 recession was the only economic downturn for almost 20 years.
Now, let’s focus on how the last two decades contrast with that. The following graph shows the fed-funds rate from the year-2000 tech bubble to recent months.
Aside from the very sharp COVID crater of early 2020, the 2008 great financial crisis (“GFC”) and the 2000 bursting tech bubble represent the serious market declines of recent decades. In many ways those two events look much like the current-and-prospective period beginning with the COVID crisis and carrying forward to the likely Fed tightening of the next two years.
Notice how steeply rates were driven down in response to each of the two recessions and how almost immediately, rates were dropped to 1% in 2000, and later nearly zero.
In 2004, the Fed got religion and started a 3-year campaign to reign in excess, raising the Fed funds rate from 1% to 5%. The bubble created in the early 2000’s inflated housing prices, and combined with other policies and lack of oversight, led to the mortgage-derivative abuses that burst with the great financial crisis. The Fed then followed that with another radical collapse in rates to near zero, and it maintained that posture until 2015 when it began a weak attempt at restoring normalcy. The quest for normalcy topped out with a 2.5% fed-funds rate which was below the bottom rates of earlier decades. Rates were already dropping again when COVID became an issue and rates plummeted to zero.
My first observation is that I can think of no other endeavor that is managed with this kind of schizophrenia, but such has been Fed policy for 20 years.
Clearly, the Fed’s largess of 2001 was driven by a desire to prop up asset values in the face of collapsing tech prices. We could discuss the relationship of asset prices, the wealth effect, and everyman’s economic results, but regardless of their intent, I would make the same asset-inflation case regarding 2008 and 2020/2021. Stated simply, using whatever rationalizations might be available, the Fed creates and then bursts bubbles.
If you doubt that, consider the relationship of M1 and its velocity. M1 measures money supply in liquid assets and velocity of M1 measures the use of money – how that money supply is turned over in economic activity.
Since the GFC, M1 has grown while the velocity of that money, it’s deployment toward economic activity, has steadily declined. Both trends went hyperbolic with COVID. The velocity of money has fallen from a 10X ratio to about 1X. In simple terms, more and more money has had little effect on how robust the economy is, except for the asset bubbles created. And bubbles always burst.
Another thing worth noting, from June 2004 when the Fed began its tightening, it took until August 2006 before they stopped, and stock prices rose through that tightening and much of 2007 before collapsing in the GFC. This chart shows those trends, and I show it to illustrate how selling stocks on a tightening Fed posture could forego substantial gains for years while waiting for the inevitable bust. Fundamental assessments are a poor timing device.
So here we sit, much like 2004, with the Fed, having pumped unprecedented amounts of money into asset inflation, announcing that tightening is coming. Will momentum carry forward for a year or two, or maybe January’s losses portend a more rapid decline? These days everything happens at triple time. I do not have an answer, but I can prepare for either outcome using appropriate structures and risk analyzes. That will be explained in Part 2.
One more bit of background material is important to set the stage.
If you’ve ever wondered why stock prices fall when interest rates rise, or why growth stocks fall more than others, consider one factor: how the arithmetic of discounted cash flow (“DCF”) works. These calculations are a simple illustration of how valuations might work; they’re simple because we could argue all day about whether DCF should use earnings or dividends, or liquidation values, and numerous other effects, like taxes, etc. Further, even if it were a perfect representation of valuations, markets do not follow pure logic.
Having laid out the disclaimers, the perception of DCF valuations does impose a very real influence on stock prices, and the following arithmetic is indicative of how it works. The exhibit below shows a sample calculation on the left using a 3% earnings growth rate and alternative discount rates of 1.6% and 2%. The calculation on the left side shows how the price of a typical 3% -growth stock would decline 5% and the PE ratio would move from 29.1 times earnings to 27.6 times as rates moved up.
It might or might not be coincidence that those left-side numbers closely reflect characteristics of the S&P in January. And as institutions began competing as to rate-increase forecasts, the decline continued in February. One might argue that the real-world price declines of 2022 reflect an initial adjustment from a 1.6% ten-year treasury yield expectation to a 2.0% yield expectation and then still higher rates.
The right side shows sensitivities, sensitivities of price decline and PE to interest rate changes for various underlying growth characteristics. An ultimate change from a 1.6% discount rate to 5% would produce a 31% decline for a 3% -growth stock and a 47% decline for a 20% -growth stock.
I suspect those numbers are not far from realistic if the Fed were to go so far as to produce a 5% ten-year treasury but I also expect they will not get that far. The bear market impetus will shift from rate-increase concerns to recession concerns. Interest rates are only one element in the story; the real market responds to both Fed actions and economic realities.
So, if you are looking for a soft landing from the excesses of the two-year COVID response, good luck. The Fed builds and then bursts bubbles, and I see no reason why they’ll do better this time.
That’s the environment we face with all its unknowns. Part 2, coming next, will deal with how to generate high returns with downside protection, strategies particularly appropriate to the current investment climate. Thanks for reading.