The Fed Is Crushing Stocks

Just about everybody I know is bearish on the markets. This is the point of a bear market where I try to remind those that bear markets are typical and should be expected. On average, they occur every 3.6 years and last about 9.6 months.

This is also a great reminder to take a step back, take a breath, and remember that as an investor, you should be in this for the long haul. Remember, market volatility is the price one must pay if one wants attractive market returns. There is no other way around this simple fact.

That being said, it doesn’t mean that bear markets are fun. They are just simply a part of life. The markets (including both stocks and bonds) are forward-looking indicators. Right now, stocks are pricing in an eventual recession (and no, we are currently not in a recession).

Stocks are not always right and often provide false positives. Economist Paul Samuelson famously quipped:

Though, I suspect that the stock market might be correct this time as more accurate leading indicators are predicting a recession will occur by March 2023.

DON’T FIGHT THE FED

Market participants were also reminded last month of the importance of the aphorism, “don’t fight the Fed.” In most circumstances, the Fed’s actions function as a market tailwind as the Fed is more often than not accommodative.

However, the Fed is currently not accommodative. Quite the opposite. They have been trying to convey to the market for quite some time that they intend to raise rates until inflation levels come back down to 2%. For some reason, many investors did not believe the Fed, and they were betting on the fact that the Fed would reverse its hawkish position once data showed a weakening economy. This led to the July and mid-August market rally.

However, this rally halted last week when Fed Chairman Jerome Powell bluntly stated that bringing down some inflation would require “some pain.” Here is what he means by that.

The Fed is attempting to bring down inflation levels by limiting the money supply growth rate (M2) and by raising the discount rate, a key interest rate that influences just about every interest rate in the global economy. By raising interest rates, the Fed slows the economy as borrowing costs (and other opportunity costs) rise.

Essentially, the Fed is willing to aggressively raise rates to break the inflation rate, even if it pushes the economy into a recession. Powell is taking a page from Paul Volcker’s playbook from the early 1980s. That is what it took to break the inflationary cycle then and Powell seems to be taking the same approach. The good news is that once the high inflationary cycle is broken, we get a healthy economy back.

DON’T LET FEAR BE YOUR GUIDE

It is tempting to sell stocks in an environment like this. However, mountains of data tell us not to do this. The simple reason is that you could be wrong. Or you could be correct, but then you will not know when to get back into stocks (data shows us that the vast majority of investors get back in way too late, if at all). Or the Fed could unexpectedly pivot. Or inflation could suddenly drop due to waning demand (or deflating asset prices, which is a serious possibility), and deflation fears might mount (suggesting a more accommodative Fed – which is a tailwind for stocks).

The bottom line is that we simply don’t know how things are going to progress. Trying to guess the outcome from an infinite number of variables is a recipe for disaster.

FOLLOW THE DATA

Therefore, the intelligent thing to do is to follow the model (which we have done) and to stay invested for the long term. We have stayed invested in stocks, though we have allocated to defensive sectors, such as consumer staples, utilities, and health care. These tend to perform well in environments like this, though we are keeping a close eye on key indicators to reallocate to specific asset classes that outperform during market recoveries.

In the meantime, ignore the chatter and fear-mongering. There is a lot of that out there. Instead, follow the data. After all, the data tells us that staying invested in growth assets produces…..growth!

As always, if there is anything we can do to assist, please do not hesitate to contact us. We are happy to help.