Fed Raising Rates and Aggressive Posture Rattle Markets

Today the Federal Reserve raised the Federal Funds rate by the expected 75 basis points.  We haven’t seen rate hikes like this in several decades, so it continues to rattle both equity and fixed income markets.  Major equity markets were down nearly 2% today, following several weeks of losses.  The Fed is talking a tough game, as they have to do that to dampen inflation expectations.  What ultimately will drive policy decisions is the data and on most metrics, peak inflationary pressure occurred early in this year, and has been showing major weakening.

The reality is that the global economy was shutdown in 2020 by the combination of Covid-19 and lockdowns.  The response was to print money to keep businesses and people afloat from what truly would have been a financial cataclysm like we have not seen in our lifetimes.  The current inflationary environment is the result of these policies, and then sadly has been exasperated with the war in Ukraine creating massive dislocations in key commodities such as oil, natural gas, and fertilizer.  We’ve seen equity and bond prices crash, and we are seeing real estate just begin what likely will be a relatively substantial decline, although the far lower housing supply surpluses, along with much more stringent loan underwriting, should provide a much more mild impact than what we saw in 2008.  Most of these negatives are in the market.  What matters is current valuations and if things can improve over the next 3-5 years, or even sooner in all likelihood.

The S&P 500 currently trades at around a 16.6 P/E, which is around average.  However, the top 10 weighted stocks such as Apple and Microsoft, trade at a P/E of of 24.7, which is quite a bit higher than historical averages.  The remaining 490 stocks trade at a below-average P/E of just 14.6.  It is very possible that even if the market trades down a bit from here, that it would mostly be the result of mean reversion on some of those larger cap names, which still seem like they might be a bit extended in valuation.  Business performance has not declined nearly as much as the stock prices for most stocks.  In fact, many of our largest positions are major beneficiaries of higher rates, which ultimately will show as earnings results come out over these next few quarters.  While that doesn’t necessarily prevent stocks from dropping in the short-term, the vast majority of these losses are likely to be short-term mark to market as opposed to permanent losses of capital.  Higher rates drive higher net interest and investment income for both banks and insurance companies.  Earnings are likely to be quite strong for financials.

The fear in the market is that higher rates and inflationary pressures cause a recession.  Well, many would argue we are already in one with two consecutive quarters of negative economic growth.  On a “real” inflation-adjusted basis, the data is far worse.  Markets shoot first and ask questions later.  In the long-term the fundamentals are what drives performance though so the key to realizing good investment returns is not getting scared out of stocks when they drop in price due to a general market panic.  I’ve made the comparison many times before, but selling stocks just because they go down for a bit, is like jumping out of an airplane just because you experience turbulence.  It is inevitable that if you invest or fly, turbulence is a reality you will deal with.  Our strategy is designed to take advantage of this by selling options with high premiums, or getting exercised at extreme bargain prices when our stocks expire below our strike prices.  We are dollar-cost-averaging in a dynamic manner, so the big key is just being patient and letting the strategy and our underlying investments do what they do.  We have tremendous levels of protection embedded in our strategy which has already helped greatly, but will show in a more pronounced manner as we get closer to major options expiration in late January of 2023.

We have many stocks trading at 4-5x earnings, despite being robustly profitable and paying ample dividends.  These types of valuations have never lasted for long, so while I can’t predict short-term returns, I’m quite optimistic on the next year or three.  We are about 3 weeks away from earnings season starting in mass, which I believe could be a nice catalyst.