Welcome to the End of Free Money

Since the Global Financial Crisis, we have operated in an environment where money has been “cheap”. When the Federal Reserve lowered the funds rate to a range of 0 to 0.25% during the heart of the pandemic, some might have even described money as “free”. Established companies could raise debt at historically low rates for any number of projects. Young startups could access venture capital to fund their operations as they searched for a path to profitability. And private equity firms had capital to lever up their portfolio companies to boost returns and de-risk their investments. Lower interest rates and over $14T in fiscal and monetary stimulus[1] worked together to stimulate the economy. With interest rates approaching near zero, governments, businesses, and consumers had ready access to money whenever they needed.

Please Listen to The Fed!

The US economy is still running hot. The third quarter brought more of the same volatility seen throughout the year. The markets are adapting to The Fed’s medicine: higher interest rates to slow the economy.  On September 21st, The Federal Reserve bank increased the federal funds rate by another 75bps.  This was widely anticipated. However, in his comments, Fed Chairman Powell emphasized that their number one focus is fighting inflation. Until this point, markets had been reluctant to take him at his word with many expecting that he might soon pause or reverse.  Now, the message is clear, the Fed will do “whatever it takes” to beat inflation. 

The Silent Factor

“The ability to distinguish between volatility and loss is the first casualty of a bear market.”      – Nick Murray, Author of Simple Wealth, Inevitable Wealth

US Stocks officially entered a bear market on June 13th when the S&P 500 closed 22% below its January 3rd high. We’ve been here before.  Only two years ago, Covid-19 caused a panic in equity markets which led to a more than 30% market decline. Those losses were (relatively) quickly reversed as investors realized that both Congress and the Federal Reserve were quickly acting in their favor. Easy monetary policy supported what we can now clearly see, in hindsight, was a speculative market bubble that continued for another two years.

What if a Recession is the Cure?

“Most of the time, the end of the world does not happen. “ — Howard Marks, Co-Founder of Oaktree Capital Management

As we close the first quarter of 2022, all signs point to our economy moving into a new stage of the business cycle. We are past the peak and rolling into the earliest stages of contraction. After laying the groundwork for months, the Federal Reserve Bank officially began raising interest rates earlier this year. Their goal is to dampen inflation which has now increased to alarming levels and is affecting businesses and families across the socioeconomic spectrum. The Fed has most likely taken too long to act, and they are removing stimulus that was too excessive and lasted for too long.  While the Fed’s quick action likely saved our economy from the worst possible outcomes during the pandemic, we are now surrounded by inflation that is having real world impact.  

The Hidden Tax

Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair. -Sam Ewing (author)

We ended 2021 similar to how we began, challenged by Covid as the virus continues to alter holiday plans, disrupt commerce and frustrate a world weary of the conversation. Covid was supposed to be conquered by this point, but virus mutations and vaccine hesitancy have allowed this visitor to remain with us.  What is different this time around is the Omicron variant appears to be more prevalent, but less deadly. Hospitalization risk appears to be 1/3[3] that of the Delta variant but, given that Omicron is more infectious and has a shorter incubation period, hospitalizations are going up. We began 2022 with an all-time high of 1 million active new U.S. cases.

There’s a Playbook for That

The S&P 500 is up 14.4% for the first half of 2021. Much of these gains were triggered by companies announcing positive earnings expectations for the second half of the year. A record 64% of companies that provided guidance exceeded Wall Street Analyst projections. Most companies have positioned the pandemic in the rear-view mirror and expect things to get better from here.  Meanwhile, the Market continues to hit all-time highs, while Wall Street seems to be overly conservative on future prospects.  The source of caution stems from expected inflation.

Blind Spots

“Bull markets end when the perception of earnings growth disappears […]. Manias, on the other hand, end when the market runs out of buyers.” – Andy Kessler

2020 ended with the world collectively eager to put a challenging year in the rear-view mirror while looking forward to the light at the end of the tunnel. The US election results are now (mostly) behind us, and we have two approved Covid-19 vaccines being distributed in the US with an additional 5 being used in other parts of the world.  What is most surprising to me is, having witnessed a year where we endured the worst global pandemic in a century, the fastest bear market in history, a global recession, and a contentious presidential election; that I would find myself in the same place I was exactly a year ago: contemplating whether the market accurately reflects the reality of our economy.  

Defying Gravity

Overall, 2019 was quite a year with most indexes increasing by roughly a third.  From a historical perspective, the period from 2010 through 2019 was the first contiguous decade in the history of the market without a recession[1].  During this period, we had only one (2018) negative year.

The gains of 2019 were phenomenal in light of the many headwinds facing investors heading into, and throughout, the year:

Digging Deeper for Value

 

The New Year brought a dramatic market rebound. Performance was driven by a combination of a cautious Federal Reserve rethinking its plan to increase interest rates, and a “relief rally” during earnings season.  First quarter earnings reports weren’t impressive, but stocks rallied as investors realized that earnings, while mediocre, were not nearly as bad as they could have been. This is in contrast to just a few short months ago when markets seemed to be assured of an imminent collapse.

The Market Abhors Uncertainty

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold.” – Warren Buffett

From an investor’s perspective, 2018 was a challenging year that began with a strong first half, only to encounter a sharp reversal and decline.  Looking back to the start of 2018, if we had known that we would end the year with no major military conflicts, a major tax cut, a revised trade deal with Canada and Mexico, 20%+ corporate earnings growth and unemployment at 3.7%[1], any rational investor would have predicted a strong market for 2018.  The reality is that with the Republicans winning the White House in 2016 while already holding a majority of votes in The House and The Senate, the market expected legislation favorable to businesses and lower taxes. Expectations drove the market gains we saw throughout 2016 and 2017. The volatility we are seeing now….is based on investor expectations (and fears) for the year ahead.