June 2022
Over the past decade, I have developed a habit of putting on several pounds of “seasonal” weight. I call it holiday weight, but it arrives in the Spring. From November to February, I must navigate the food gauntlet that is Thanksgiving, holiday parties, the college football playoffs, countless birthdays, the NFL playoffs and Valentine’s Day. From March to October, the temperature heats up, caloric intake falls and the pounds come off. Then the cycle repeats.
The market goes through these cycles as well. In fact, we have been watching its shift from feasting to moderation this year, and it has not been pretty. The market’s most recent season of celebration started with the exit from the Financial Crisis and never really took a rest. There is not enough room herein to list all the parties that attributed to the aforementioned girth, but a few noteworthy ones are:
- Bailing out banks and systemically important corporations during 2008;
- Anchoring the Fed Funds rate at near 0% between 2009 – 2017 and again between 2020-2022;
- Instituting historic tax cuts with an economy at full employment in 2017; and
- Keeping the historic pandemic stimulus in effect during all of 2021.
As a result, the market has had quite a bit of weight to lose. We do not mean to sound critical. It is hard to argue these actions were not beneficial to the economy in their time. While some were necessary to stave off economic disaster, others were arguably gratuitous. Ultimately, though, all of these programs had the same intent: to encourage consumers and businesses to spend their way out of a low growth and low inflation environment by driving the cost of money down to zero.
Free money is a terrific catalyst for a great economic party. Stock prices rise, home values appreciate, and jobs are plentiful. During the pandemic, the feasting became so extreme that all sorts of goofy things started to happen. People were selling used cars for more than new ones. Some worked multiple jobs without their employers knowing, while others got paid to not work at all. Stock and real estate savants were commonplace. Cryptocurrency savants were less common, but what they lacked in numbers they made up for with enthusiasm. The apex savant piled into NFTs and bought a digital picture of an ape or a rock (we regret to inform you that we have no such genius on staff).
The Feast is Over
Unfortunately for investors, the Federal Reserve has decided it is time for a diet and the market is suffering from low blood sugar. Why the change in tune after years of leniency? Inflation is running hot, as those of you who use food, gas or shelter can attest. Some Fed members now say that they should have pulled the punch bowl away sooner. Tone deaf? Perhaps. Accurate? Definitely.
The first-order effect of this new stance is that interest rates are moving higher (note the average rate on a 30-year mortgage has surged from 3.1% to 6.3%1 this year). Whether you are a consumer buying a house or a company buying a new piece of machinery, you are going to pay more interest on any new loan. The second-order effect is that demand for said purchases begins to decline in response to higher interest rates. Last week, mortgage demand dropped to the lowest level in 22 years on a seasonally adjusted basis. The third-order effect is that prices for goods/services will start to fall.
An Inexact Science
As you can tell, prices are not yet falling, but that would be a welcome outcome for a Fed trying to fight inflation. Unfortunately, it is an inexact science. Those who are cutting calories know the weight loss will come, but when and how much is uncertain. Historically, it takes the economy 6 – 18 months to respond to monetary policy. Though the economic effects take time to surface, the market tends to work like your mind when dieting – with immediacy. A dieter may think, “I’m starving. How am I not down 5lbs?!” Similarly, the market is thinking, “Interest rates are rising and security prices need to be lower!” Balanced U.S. investors (those who hold both stocks and bonds) have few places to hide. Interest rates are soaring, which is crushing bond prices. Stocks are falling due to higher interest rates and an expectation of an impending global slowdown. Most of the “savantish” investments of the past few years are having a particularly rough go of it – unprofitable technology companies, SPACs, cryptocurrencies, and even the digital pictures of rocks and apes. (Can you believe it?!)
Frustratingly for us, even our high-quality stocks and bonds are down roughly as much as the broad markets. Typically these companies fare better during large market drawdowns; however, downside protection isn’t the only reason we hold these securities. Financial and operational resilience are bigger benefits to investors in times like these. If this high interest rate environment persists for years and corporate revenues begin to fall, we are not worried about the companies we own going out of business or our bonds defaulting. By and large, these companies have been around for years and have shown the ability to maintain profitability throughout a variety of economic environments. As a result, when the market environment stabilizes, these companies should be around to benefit, while many of their competitors may struggle to stay in business, much less retain the talent and capital necessary to thrive. Hence, we believe avoiding investments that go down and stay down is one key to successful long-term investing.
Like you, we would prefer to see month after month of gains. Yet, we recognize that these market cycles are inevitable and ultimately healthy as they restore “normalcy.” While looking at the losses is painful, we caution investors not to make rash decisions. Though it has been a rough road recently, the market’s diet has quickly adjusted valuations. The 2-year Treasury yielded 0.7% at the start of the year and now yields 3.4%. The S&P 500 traded at 21x forward earnings to start the year and now it trades at 17x. Had we told you last year that high-quality bonds offered strong yields and stocks traded at attractive valuations, you would likely have been encouraged and wanted to invest more money. While we cannot say that the coast is clear, valuations, particularly for bonds, are more attractive than they have been for most of the past decade. There may be pounds to shed still, but if nothing else, we are starting from a healthier place.
All market data is sourced from Bloomberg unless otherwise noted. (1) Source: Mortgage News Daily 6/14/2022.