For over the last century, the policy of the U.S. Forest Service has generally been to put out forest fires immediately after they're reported. However, over time, environmentalists made the startling realization that the policy was backfiring. The landscapes of the Western US were shaped over millions of years by occasional, low-intensity fires that removed excess brush and kept ecosystems in balance. Immediately putting out every fire didn't mean that wildfires would cease to exist though. What it meant was the amount of dead brush and fuel would continually build over the following decades, and that when fires inevitably did happen, they would be catastrophic.
Just as the Forest Service tried to put out every fire, traders now expect the Federal Reserve to stop every bear market. This policy was originally known was known as the Greenspan Put, named after Alan Greenspan, Chairman of the Fed from 1987 to 2006. The idea is that the Fed will step in to flood the financial markets with money if stocks fall more than 20% or so. With the benefit of hindsight, many observers think that the Fed's continual support of the markets led to a large increase in the amount of waste and fraud in the global economy that culminated in the financial crisis of 2008 and the Great Recession. I think this view is right more than it's wrong, but it's incomplete. I wrote in January that the fault is not the Fed, but in ourselves. Fed policy was fairly restrictive throughout much of Greenspan's tenure, and that stock valuations weren't out of control in the mid-2000s, rather they were extremely cheap in 2009. But there are areas that the Fed does have an outsize amount of control, namely the housing market since it's so dependent on financing. This could be an issue again on a lesser scale with the massive move in housing prices and round-trip in rates (see the early 1990s recession for some precedent).
The challenge for Jerome Powell's Fed here is to do the economic equivalent of a controlled burn program to reduce inflation, but also to eliminate fraud, waste, and zombie companies from the market without causing the broad economy to spiral into recession. Historically, this is hard to do and generally results in a recession. It seems very likely that we will have a recession in earnings. Whether the real economy shrinks is an open question. Stagflation is the risk, where the traditional trade-off between unemployment and inflation breaks and you get both. Consumer sentiment is generally thought to be a leading economic indicator, and it's under 60 points on the widely followed University of Michigan Survey, the only other times it was this low was in 1980 during the Carter Administration, the 2008 recession, and briefly during the 2011 debt crisis.
This makes sense as prices are skyrocketing and wages are flat - the financial situation for the typical American household is steadily deteriorating. Whether the economy can stay afloat on the spending of affluent consumers will determine whether the US goes into recession or not. It's challenging every time you fill up your car, but this process of letting the market work shouldn't be stopped - it's healthy in the long run for the economy. The invisible hand of the market is working to balance supply and demand, pull people into the workforce, and eliminate corporate waste and fraud.
Large-cap US stock valuations look a lot better than they did in January, but they're not cheap by any means. I take a rolling inventory of stocks and crypto that I think are speculative junk and add up their market caps, and it appears that a lot of this has gone away over the last 6-9 months. AMC Entertainment (AMC), Rivian (RIVN), and Dogecoin (DOGE-USD) are sort of my barometer for what the speculative appetite is at any given point. The market caps of all of the stuff are way down, and the S&P 500 is about 10% off its high as of my writing this.
This is enough to make my estimate for S&P 500 returns rise about 0.5% annually, from about 8% to 8.5% annually compounded. It's important to realize that small changes in valuation for stocks don't translate to big changes in long-term expected returns. This is doubly true if the changes in price aren't pure noise but reflect changing expectations for growth. If you pay 18x earnings for the S&P 500 something or 20x, it doesn't make a massive difference in your returns, although getting a higher dividend yield and lower PE ratio always puts you in a more flexible position.
My guess is that the Fed will have to hike rates more than expected to get inflation under control. The war grabs headlines, but it's not likely to have a big impact on the US economy, particularly with the market for crude oil pricing some possibility of peace. The market is pricing in seven Fed hikes for 2022, which would take interest rates to 1.75% at year-end. My guess is that the Fed will take cash rates to 2% or higher by year-end unless the economy rapidly slows on its own. Also of interest will be Powell's comments on quantitative tightening (QT), the process of the Fed selling Treasuries into the market to push interest rates up. QT is probably the most effective tool the Fed has to put the brakes on inflation, and I expect them to make use of it this year and next.
Lastly, I think the Fed is starting to understand the lessons of fire suppression leading to bigger fires. High asset prices may be more of a negative than a positive to the Fed at this point-the economy functioned fine with the S&P 500 at 3200 in 2019-I wouldn't be shocked if it touched there again at some point in the next couple of years. Whether you should wait to buy or buy now depends on your timeframe and what you're trying to invest in. Large-cap US stocks look pricey, but small caps (IJR) and international stocks look a little undervalued. They could get cheaper, but the long run should be fine. However, the idea that the Fed will bail out the Nasdaq (QQQ) or the broad market in any situation short of a full-fledged credit market freeze is a dangerous fantasy with inflation raging.
Also, investors should consider the possibility of a market like 2000-2001 where tech fell but value and small caps did well. They won't say so directly/publicly to avoid spooking markets, but my guess is that the Fed would like to see many categories of asset prices lower than they are to clean out some of the fraud and waste that has built up in the economy since 2020, as well as to achieve their stated goal of stable consumer prices. This doesn't mean that stocks will necessarily go into a deep bear market, but if they do I wouldn't expect a quick rescue.
Expect a lot of volatility before, during, and after the Fed meeting today. My guess is that the market is underestimating the Fed's resolve to fight inflation, traders having "learned" the lessons of the previous environment (the 2008 recession and 2010s low inflation environment). Wait until after the meeting to buy anything, but I believe the most attractive segment of the market currently is international stocks, which can be bought via broad-based ETFs like Vanguard's Developed Markets ETF (VEA) and International High Dividend Yield (VYMI).
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