Here is my premise. Today’s market is a contradiction between the inflation on steroids of the early 70s and the bubble burst conditions of 2008, and how your investments are structured will play a critical role in how you fare in the future. over the next two years. This is part 1 of a 2 part series. Part 1 looks back at 50 years of Fed history and its implications for investors today. Part 2 will look at investment structures suitable for the times, producing high returns with a defensive bias.
First, let me say that I am not going to predict stock prices. My mantra is “Don’t predict, prepare”. My own preparation relies on a risk assessment algorithm to avoid severe slowdowns, but this article is not about that; it’s about how the current investment climate is likely to evolve.
The financial impacts I will discuss will likely eventually be reflected in market prices, but markets are teetering to new equilibrium levels; they do not move in predictable straight lines, especially today given the cross-currents of severe inflation and the early stages of bursting bubbles. Markets are a jumble of emotions and valuation logic, and fundamental valuations are a poor stopwatch.
But if you believe the Fed’s policy will produce results similar to past policies, preparation requires an understanding of likely price environments and a strategy to manage them with risk in mind.
So we’ll set the context here in part 1. And then, in part 2, we’ll see how a portfolio can combine high returns with a defensive bias appropriate to that context.
Early 70s on steroids
We went from a CPI of 2% to a CPI of 7.5% in just a few months. This is how the famous CPI of the 70s evolved; it took years to reach 7%.
Whether or not the current analogy of the early 70s turns into the disaster of the late 70s is a very big question, but the point is that to stop it the Fed will have to take action close to a tightening Voelker type. The sooner they act, the less drastic the action required, but they are already 9 months behind the curve. They eventually ditched the transient meme, but they’re still buying assets and expanding the balance sheet through March.
Can we rely on them to do things right?
The Fed is a hot mess
Let’s start by looking at Fed policy from the 1970s through the late 1990s, as reflected by the federal funds rate; It may seem like ancient history, but it’s important to understand that their politics over the past few decades have not been normal. As the Fed changes direction, no one quite knows how to do it gracefully.
Inflation became a big problem in the 1970s and rates rose early in that decade in an unsuccessful attempt to stem it until the OPEC-induced recession put an end to the rate hikes of the Fed. But eventually, Voelker’s Fed responded by tightening considerably. The fed funds rate went to around 20% and that killed inflation. Today, this is generally seen as a heroic response to a lingering problem that had become a crisis, but that’s not my main focus here.
Notice in the chart below that there have been five recessions in those three decades and the Fed’s response has never driven the fed funds rate below 3% +/-. You can also see that beginning in 1982, changes to the federal funds rate were gradual and sometimes proactive; the short recession of 1990 was the only economic downturn in nearly 20 years.
Now, let’s focus on how the past two decades contrast with that. The following chart shows the tech bubble fed funds rate from the year 2000 to the last few months.
Besides the very acute COVID crater of early 2020, the 2008 Great Financial Crisis (“GFC”) and the tech bubble burst of 2000 represent the severe market declines of the past decades. In many ways, these two events are very similar to the current and prospective period beginning with the COVID crisis and continuing through the likely Fed tightening of the next two years.
Notice how steeply rates fell in response to each of the two recessions and how almost immediately rates fell to 1% in 2000 and then to almost zero.
In 2004, the Fed became a religion and launched a 3-year campaign to reign in excess, raising the Fed funds rate from 1% to 5%. The bubble created in the early 2000s, house price inflation, combined with other policies and a lack of oversight, led to the abuse of mortgage derivatives that erupted with the Great Financial Crisis. The Fed then followed this with another radical collapse in rates to near zero, and it maintained this position until 2015, when it began a weak attempt to restore normalcy. The quest for normality peaked with a federal funds rate of 2.5%, which was below the lowest rates in previous decades. Rates were already falling again when COVID became an issue and rates dropped to zero.
My first observation is that I can’t think of any other company that is run with this kind of schizophrenia, but that has been Fed policy for 20 years.
Clearly, the Fed’s largesse in 2001 was motivated by a desire to support asset values in the face of collapsing technology prices. We could argue about the relationship between asset prices, the wealth effect and each other’s economic outcomes, but regardless of their intent, I would make the same case of asset inflation regarding 2008 and 2020/2021. Simply put, using every rationalization available, the Fed creates and then bursts bubbles.
If in doubt, consider the relationship between M1 and its speed. M1 measures the money supply in liquid assets and the velocity of M1 measures the use of money – how this money supply is transformed into economic activity.
Since the GFC, M1 has increased while the velocity of that money, its deployment to economic activity, has steadily declined. Both trends have become hyperbolic with COVID. Money velocity has gone from a ratio of 10X to around 1X. Simply put, more and more money had little effect on the strength of the economy, except for the asset bubbles it created. And the bubbles always burst.
Another thing to note, from June 2004 when the Fed started tightening, it took until August 2006 before they stopped, and stock prices went up during that tightening and a big part of 2007 before collapsing into the GFC. This chart shows these trends, and I show it to illustrate how selling stocks on a Fed tightening stance could forego substantial gains for years while waiting for the inevitable downfall. Fundamental valuations are a bad timing device.
So here we are sitting, much like 2004, with the Fed, having pumped unprecedented amounts of money into asset inflation, announcing that tightening is coming. Will the momentum continue for a year or two, or perhaps January’s losses portend a faster decline? These days, everything happens in triple time. I don’t have an answer, but I can prepare for either outcome using proper structures and risk analyses. This will be explained in part 2.
A little more 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 discounted cash flow (“DCF”) arithmetic works. ). These calculations are a simple illustration of how valuations might work; they are simple because we could argue all day whether DCF should use earnings or dividends, or liquidation values, and many other effects, like taxes, etc. Moreover, even if this were a perfect representation of valuations, the markets do not follow pure logic.
Having laid out the disclaimers, the perception of DCF valuations imposes a very real influence on stock prices, and the following arithmetic is indicative of how this works. The illustration below shows an example calculation on the left using an earnings growth rate of 3% 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 decrease by 5% and the PE ratio would drop from 29.1 times earnings to 27.6 times when rates increased.
It may or may not be a coincidence that these numbers on the left closely mirror the characteristics of the S&P in January. And as institutions began squabbling over rate hike forecasts, the decline continued into February. Arguably, the 2022 real-world price declines reflect an initial adjustment from a 1.6% 10-year Treasury yield expectation to a 2.0% yield expectation, then rates even higher.
The right side shows the sensitivities, the sensitivities of the price decline and the PE to changes in interest rates for various underlying growth characteristics. An ultimate change from a discount rate of 1.6% to 5% would produce a decline of 31% for a 3% growth stock and a 47% decline for a 20% growth stock.
I suspect these numbers are not far from realistic if the Fed were to go so far as to produce a 5% 10-year treasury, but I also expect them not to go that far. . The bear market momentum will shift from rising rate concerns to recessionary concerns. Interest rates are only part of the story; the real market responds to both Fed actions and economic realities.
So if you’re 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 for it to do better this time.
This is the environment we face with all its unknowns. Part 2, which will follow, will discuss how to generate high returns with downside protection, strategies particularly suited to today’s investment climate. Thanks for reading.