Keeping the theorem in view, today seems very similar to the tech wreck of 2000 with a little bit of 2008 thrown in for good measure. In both cases a robust economy leads into a prior rapid rise in asset prices. In one case it was stocks (the more speculative the better) and the other was the rise in real estate. In both cases, the Fed began raising rates to cool the economy and the resultant decline in asset pricing occurred months later. The tech wreck was bad and economic recovery stifled by 9/11. In essence, A decline with a smashed recovery and elongated down trend. In the case of the 07 thru 09 Real estate lead implosion, it was down 20 percent then another 25 in the last leg. A leg that was fueled by the realization that real estate is a levered asset, owned by the majority, and the economic consequence vast. In both cases, a rising interest rate environment to cool a hot economy was the first domino. From there, how it played out was more than a tad different. Same river but not the same crossing. Today we have rampant inflation. Not being an arm waver but that’s the best description. There is literally nothing that hasn’t gone up in price and by a meaningful amount. The kindling for the fire was set in motion over the past 2 years with excessive fiscal spending, loose monetary policy, excessively long quantitative easing, and late reaction to so called “transitory inflation”. The broken supply chain, relentless rise in oil prices, and the labor shortage are all results from, or causative with, the environment which make it worse. Systemic inflation which must be eradicated.
Similar to 2000 and 2008, we had a lead up rise in asset valuations. Fueled by cheap money, Crypto, meme stocks, speculative issue, covid stocks, SPACS, and growth/tech all lead the charge. The general market rose, but in one man’s opinion, not at a crazy level. On the fixed income/bond markets, the multi-year low interest rates were not long term sustainable. Hence the sharp decline in the bond markets. Basically, the worst bond market in 40 years. Even being conservative wasn’t enough to fully insulate the losses. Last… the jury is still out as to real estate. Yes, the recent rise has been parabolic, but the volume of sales was largely contained and small as a percentage of total homes. If it was a bubble, the damage will be significantly less than 08 for several reasons. Like it or not, that’s where we are. As we ranted before, the damage to the equity and fixed income markets has been fairly deep.
Looking ahead, the Fed can (and ultimately will) tame the inflation genie. Putting it back in the bottle will be a serious challenge. It might take a while but that’s their primary mandate…. price stability. Unfortunately, the only way it happens is by slowing aggregate demand. With all the free money sloshing around, it will take numerous rate hikes to accomplish. The risk is that too much slowing equals recession which is probably the case here. At least that’s what the equity markets are starting to say. On the bright side, the jump in interest rates, although painful in the short term, will allow for a decent yield on fixed income moving forward. A net benefit to most investors.
Playing the “crystal ball game” the belief is (opinion only… not to be wagered upon)… Interest rates have put the worst behind them. While further rise in rates is possible, a lot is already priced in. We were looking for a 3 percent yield on the 10 year and that is where we are. Between 3 and 4 is (in my opinion) an equilibrium level that is sustainable. Mortgages at 5 plus percent and cost of money are back to reasonable levels. The challenge will be current rising inflation readings vs the Federal Reserve speed of inflation fighting moves.
Equities (stocks) have adjusted down to meet the new economic realities. Further downside is possible, and potential exists for another 10 to 15 percent decline. Will probably be the long game over multiple months as events unfold. That being said, there is a lot of reason for optimism. Corporations are lean and efficient post 2020. The adage “what doesn’t kill us makes us stronger” certainly applies here. As with any economic cycle, many stocks will not survive, and creative destruction will be evident. But, and it’s a big but, the market will (in all probability) come back healthier than before. Another critical point of optimism is that business and regular people have the strongest balance sheets in decades with lots of cash and reasonable low levels of debt. Last, because of the labor shortages, companies are adjusting to less labor through increased use of technologies and other efficiencies. Evolution to economic adversity at work.
Not to belabor the writing, but the question of “what does this mean to me” comes up. To reiterate, we have been on the conservative side of all our portfolios going in. While the “losing less” game is never fun, it works long term. The speed and voracity of the rising interest rates did adversely impact everybody (us included) but was minimized with our leaning toward the short end of the yield curve. We plan on staying short on duration but adding some duration if rates increase further. Also adding in some mortgage backed and high yields as the recession theorem becomes more embedded in the pricing. On the equity side we have been tax loss harvesting on non-IRA accounts. A huge value add for the next up cycle. Starting to nibble a little bit across the equity spectrum. Rebalancing at a minimum and adding a few percent to equity in most of our portfolios. If we do get another down leg (third leg down), we will be more accumulative in the buying of stocks. Nothing crazy but moving from our current neutral weighting to a slight overweight position.
As always, thanks for listening and entrusting us as your financial partner. A commitment we don’t take lightly. Don’t hesitate to reach out for any reason or to discuss anything on your mind. Feel free to pass this along to anyone you think would benefit from or enjoy reading. Thanks, and talk soon.