The stock market has reacted very negatively to Fed Chairman Jerome Powell’s hawkish interest rate outlook, with the S&P declining by roughly 6% over the last 4 days. Weaker economic data and declining commodity prices gave market participants hope that the Fed might pivot, pointing to less rate hikes, but Powell talked a tough game, and stocks were punished as a result. The housing market has declined substantially with prices in formerly hot markets weakening, and supply building. This will result in builders reducing construction, which will also weaken the economy. Inflation is as much about future expectations as it is about actual price changes, so my personal expectation is that Powell will talk tough, but after this next big hike, I think the pace will slow down substantially. The reason for this is that the economy and the bond market is telling the Fed they are likely to overshoot, so as more data comes in, I’d expect Powell to be more open in waiting to assess how effective the previous rate hikes have become, which takes time for everything to filter through the economy.
It’s not fun going through a bear market, and although we had a nice bear market rally that ended last week, this has indeed been a nasty little selloff. Fundamentally not much has changed, but these types of short-term fluctuations are inevitable. Remember, if we thought stocks were going to rise 15% every year, we would simply buy stocks. Instead, we’ve been very cautious, selling puts at huge discounts to market prices in many cases. In addition, many of our largest positions such as Citigroup and Assured Guaranty, are major beneficiaries from higher rates long-term. These companies are growing intrinsic value per share and are trading at truly extraordinary valuations that imply 50%-plus gain potential in the next 18-24 months, and I don’t think that is an aggressive target whatsoever, as it would still imply material discounts to tangible book value. Many of our large positions have dividend yields varying from 2.5-7%. Our options positions for the most part have double-digit annualized target returns and we feel very good about just about all of them.
There is a very good probability that markets will be much more rangebound over this next decade, which will make the options strategies that much more important. In the recent rally, we were able to lock-in profits on a good number of positions, and deploy that equity into more lucrative new investments. This selloff is creating very attractive opportunities for anyone with more than a 12-month time horizon. Our strategy has outperformed considerably this year and I think that will improve materially as we get closer to our big options expirations. To reiterate, we are not investing with the mindset that the economy or stock market is going to be great. We are instead focusing on individual opportunities and strategies that can capitalize on a rangebound market. Volatility is very high, which makes options premiums lucrative.
If you ever get worried about short-term fluctuations, remember that investing is about the future. No investor is immune to these declines, but the good investors don’t panic, and use the pessimism to their advantage. While issues such as the war in Ukraine, Taiwan, a weakening economy, and inflation have rationally caused stock prices to decline, there is a lot of negativity baked into current prices. Potential positive catalysts can emerge just as quickly, such as inflation declining, a peace deal in Ukraine, a cooling of tension in Taiwan, etc. Usually the best returns emerge out of the times when market participants are the most pessimistic. I’m very optimistic about our positions and I would liken them to a coiled spring ready to explode upwards once we get the right catalysts, one of which is simply time expiring on the options, which is inevitable. Let’s be patient, disciplined and I’m confident that we will be richly rewarded.