16 May 2022
The worst-case outcomes often do not materialize.
Capital market prices do not rise all the time. We all know this. Furthermore, dislocations of prices are what typically create most investment opportunities. Buy low and sell high is likely the oldest and most basic investment adage. However, during times of volatility, rarely do investors proclaim, “I look forward to volatility, I can’t wait to buy more.”
To help us all along the path of being a long-term investor, the following are perspectives of the current issues that are plaguing investors, but which should also ultimately lead to opportunities.
Inflation – Likely to be less next year than last year?
Inflation is the focal point of the current volatility of both stock and bond markets this year. For inflation to materially compound upon itself, prices need to rise as much next year as they did last year. What is the probability of that?
In the face of falling asset prices, declining economic demand, and higher interest rates, I believe it would be a logical inference to speculate that pricing pressures should wane. We have made a strong point that higher inflation often leads to higher interest rates, recessions, and declining asset prices. All three of these pressures are occurring right now. For these reasons, inflation often does not compound, but mean reverts.
Difficulty of compound inflation: 3-years leading up to peak inflation vs. next 12 months
Interest Rates – Likely already where they are supposed to be?
History and logic have shown that interest rates can also be mean reverting. In the past the higher interest rates go, the worse capital markets perform, and the slower the economy becomes. The slower the economy, the less inflationary pressure. Sooner or later, interest rates rise to a level that slows the economy and inflation, and investors end up with higher yields. Thus, bonds, in turn, become more valuable to investors.
It is our belief that the best estimate of where interest rates should be next year is where they are today. The yield on the 2-year treasury bond is the yield that the one-year bond should be next year.
Under this logic, the 2-year treasury bond yield also represents what the Fed Funds Rate should be next year. If the yield on the 2-year bond is approaching 3%, then this implies that the Fed is expected to raise the Fed Funds Rate to about 3% one year from today. I have made a strong point that the Fed is way behind the inflation curve and that aggressive tightening is needed. If they can get the Fed Funds Rate to 3% over the next 12 months, that would be aggressive! Good luck doing that without slowing the economy, or as we are seeing today, causing asset price dislocations.
If the 2-year bond is priced appropriately, why wouldn’t the 5-, 10- and 20-year bonds be priced appropriately? Investors do not price the 2-year bonds and 10-year bonds in isolation. Investors price all bonds under the same framework. Therefore, where the yield curve is today, likely fully represents investors inflation fears, as well as the Fed’s response. In that regard, the yield curve should be less likely to be surprised by further inflation, and the actual surprise might be a positive surprise of declining inflation.
Yield curve & interest rates – Mostly already priced?
Equities – Looking into the future
During times of fear, when panic gets the best of investors, rare opportunities can arise. I could say more here, but I believe this picture speaks a thousand words.
So far, this time around, the price of the S&P 500 Index is in negative territory approximately 16%, the NASDAQ composite is down about 26%, and Cathy Wood’s ARKK (proxy for post COVID speculation stocks) is down over 70% since their respective price peaks.[1]
Uniquely, during this market environment, it’s not only stocks that are losing money, but so too are bonds. Worried about future bond losses, consider this. As of May 6th, the benchmark 20-year treasury bond has already experienced the worst peak-to-trough loss in its history during this last 2 years. You heard that right, bonds have already experienced more loss during this sell off, peak to trough, than any time in the 1970s!
How then do bonds perform following periods of loss? The below chart clearly depicts that strong future returns can occur after periods of bond market losses. Secondly, it historically has been rare that bonds lose money in sequential years. Again, poor returns often lead to outsize future returns, and often bond returns are mean reverting, not trending.
But we all want to buy hurricane insurance after the storm, because maybe “this time is different”?
These are often referred to as the four most dangerous words in investing, because, so far, it has almost never been different. But what if more dire outcomes occur? A world war, or spiraling inflation? What would that look like?
Of course, let’s not spiral too far down into our brains and dwell on the worst worse case outcome, because I am sure we could all invent scenarios that are so dark that investing won’t even matter anymore. Therefore, the base line is, it’s probably not different this time.
Risk is not knowing what is going to happen. And maximum pessimism often occurs after steep losses in asset prices. No one knows for certain when a market bottom will occur. All we can do is look ahead.
I ask you to imagine what the investing environment could look like when the current issues dissolve. If, inflation eventually abates, interest rates find new higher yields, and stock prices settle down, what are we left with? I think, lower stock prices and higher bond yields, both of which imply higher expected returns. However, we have to get from here to there.
If history is any guide though, we just might be sneaking up on something interesting.
[1] Frontier Asset Management – Price peak – May 10, 2022.
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| INDEX | INDEX DESCRIPTION |
| S&P 500 | Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ. |
| NASDAQ Composite | The Nasdaq composite is an index of more than global 3,700 stocks. |
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Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
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NYU Sterns School of Business: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
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