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Observations on the Market:

Unread: A Memo From the Fed

Written by Greg Denewiler, CFA®

“Stocks plummet as bond yields rise,” so says Yahoo Finance. The Wall Street Journal chimes in: “Stocks fall as bond yields hit two-year highs.” Headlines from January 18th, what a shock! It was predicted and talked about in great length and detail. Fed Chair Jerome Powell, the guy who can make it happen, has said there will be at least three interest rate hikes in 2022. He has telegraphed this for months. Inflation is higher than expected, oil prices continue to climb, and the economy is running at some version of full employment. These are all signs that the prediction of higher interest rates is going to become reality, so why is the market surprised? The best answer, but maybe not the right answer, is that the investment environment has become so short-term driven that many investors are only concerned with the next few days or weeks and don’t seem to care beyond that. Every investor’s dream is getting the memo that something is about to happen, giving them a chance to react before everyone else. Well… investors got that memo and did nothing about it; continuing to buy growth stocks thinking higher interest rates are something to worry about next month.

 

You might say it is not that simple because the memo didn’t have a date on it. When you are making money, it is hard to leave the party early. This is when you must decide what kind of investor you are: One driven by headlines or one driven by long-term wealth creation. In the summer of 2020, the 10-year Treasury reached a low of about 0.5% and just six months ago it was yielding 1.25%. How has that worked out? If you had purchased the Treasury bond back when they were at 0.5%, (you may remember headlines were suggesting this was a safe alternative), the current value of that bond on your statement shows a loss of about 10%. You will, however, get your money back in eight years. If you were a little more patient and bought the Treasury mid 2021 at 1.25%, your bond is now worth 5% less. That will only take you four years with interest payments to get even. This is all happening with inflation hitting 7%. Even with 3% inflation, buying bonds at their current rate of 1.85% still seems to be a losing proposition. It appears the need to trade outweighs the reality that you are going to lose money. Apparently if the train wreck occurs slow enough, everyone thinks they can get out of the way. The bond market is the slow-moving train while the stock market is more like a bullet train.

 

Growth stocks are the investment most affected by a change in interest rates. When interest rates are higher, investors are more interested in earnings sooner rather than later and they are less willing to wait several years for them to materialize. We now see this in the NASDAQ, (a technology and growth weighted index), which has declined 10% from its recent high versus the S&P 500 which has declined by only 5%. The ARK Innovation fund, (a fund comprised of “disruptive” high growth companies), has declined by 50% from its recent high. Investors were willing to pay up for speculation when interest rates were stuck at 0%, but now that there seems to be a start date to the interest rate hikes, investors are spooked. If you needed more proof that daily headlines are of little value, this is it.

 

Higher inflation is the current elephant in the room – will it persist or is it just temporary? We cannot be sure yet, but oil doesn’t appear to be going back to $50 per barrel any time soon. Even if inflation retreats to 3%, current bond rates just don’t add up to a profitable investment. Companies that can increase prices are one of the best hedges against inflation. They eventually work in all environments but not if you want 25% per year growth. Gold, the old inflation hedge, hasn’t moved at all in the last year. It was $1,847 per ounce in January 2021, and it is at $1,840 today. Market swings are inevitable and predicting short-term economic events is almost impossible (look at the last two years). Your daily market vitamin C is remembering cash flow is more stable and predictable – unless you like to be entertained by news headlines. Vitamin C is about prevention, not waiting for the problem to occur.

 

Observations on the Market No. 367 − Published Jan 19, 2022