Today we got the latest update on the Consumer Pricing Index (CPI) and it was a doozy, showing annual inflation of 7.5%. As you can see on the image above, the Real Fed Funds Rate (Fed Funds Rate Minus CPI) is now a negative 7.4%, which is the lowest since 1974. This means that money not working for you is dramatically declining in purchasing power, as inflation eats it away. While some of these increases in price will indeed prove to be transitory, other such as rent and wages are likely longer lasting.
To combat inflation the Federal Reserve will almost certainly start raising rates in March. Bonds are already feeling the pressure, with many showing losses on the year and despite the recent rally, equities have been down as well. Interest rates are a force akin to gravity on financial markets. The lower they are, the more people are generally willing to pay for assets. The higher the rates, the less they are usually willing to pay, which pressures valuations on some of the glamour stocks that have reached nonsensical prices in this bull market. There are tremendous numbers of stocks down 40-75% over the last few months, but even now, many still wouldn’t be classified as cheap. During the Tech Bust, once high-flying stocks traded at obscene valuations that were once deemed impossible, so we certainly aren’t quite there yet. Some companies that benefited dramatically from the pandemic such as Pinterest, Facebook, Peloton and Etsy, have seen their stocks decimated as those tailwinds have dissipated with life normalizing a bit. Further lightening of restrictions could provide further economic growth, which is fantastic, but it would likely also put more pressure on inflation as well.
I’m not trying to make market calls, but I do believe that the scope of this bubble is very big. Most of the large indices haven’t actually hit the bear market threshold yet. This volatility is indeed turning up sensational opportunities, particularly with options. We’ve been able to sell puts way below current prices at fantastic returns. Importantly, the risk-adjusted returns we are seeing are some of the highest we have seen. The risk-adjusted metric is important to keep in mind, as we are building huge cushions before we would take any losses upon the expiration of options. We were very aggressive with this strategy as volatility peaked the last few weeks. Many of our financial and energy investments have performed exceptionally with most very near their 52-week highs. There is still tremendous upside on these names and others in the portfolio.
Price increases over last year (CPI report)
Used Cars: +40.5%
Gas Utilities: +23.9%
New Cars: +12.2%
Overall CPI: +7.5%
Food at home: +7.4%
Food away from home: +6.4%