We believe 2022 is a transition year. A transition away from Covid as a novelty and into Covid as an endemic disease. A transition away from money creation and aggressive subsidies by the federal government. A year to reconcile inflation and interest rates. A year where asset prices adjust to rising interest rates.
We think these are the themes for the coming year:
- Inflation: how bad is it and how long will it last? Well, we have the highest inflation in 40 years, with prices climbing 7% on average from last year.(Bloomberg) We also had very high growth rates in the economy, driven by more consumption than normal. We expect both growth and inflation to trend towards normal over the course of the year.
- Which raises the question, how much does the Federal Reserve need to raise interest rates? Changes in rates may have a big impact on investment prices. For instance, we have the highest mortgage interest we’ve had in 18 months, per the Washington Post. However, that still puts the average 30 year mortgage at under 4%. That’s still pretty cheap money. But you can see how home price growth could slow if financing costs go up. Maybe that’s actually desirable.
- What about stocks? Stock prices, actual company earnings, growth in revenues—all these factors are affected by rising interest rates. When we had a 1% interest rate environment, the market could justify pretty high prices on stocks. First, what are the alternatives? Secondly, if you’re not getting much interest on your money now, it’s reasonable to try to get higher returns that might take awhile to realize. So, companies that aren’t profitable yet become more attractive by comparison. (Yeah my biotech stock isn’t profitable yet, but hey, neither are savings accounts.)
When interest rates rise, prices on everything else must adjust. If you could earn 2-3% on lower risk investments (instead of 1%), that will at least maintain purchasing power in most years. And that means the amount of risk the market is willing to take—or the price the market will pay for riskier assets—is likely to decline as rates rise.
Because inflation is so high, the conventional wisdom is that people need to get their money out of cash and into literally anything else. We disagree. Rising interest rates may lead to a good bit more price volatility than we had last year. Or in other words, opportunities to pay less for investments, both stocks and bonds. The linear logic is: inflation is 7%, so a sure way to fall behind is to hold cash. But I can tell you another way to fall behind inflation—to overpay for investments that later fall in price.
Now, the longer term realities are that our system create a lot of money, and prices tend to rise over time. Inflation (and dividends) are important components of returns on stocks.
However, we go through some periods where the availability of money temporarily contracts. When that happens, prices tend to fall. Recently in the second half of 2018, the Fed raised interest rates 3 times – for a total of .75%. If you’re curious, go back and look at stock prices or crypto prices in that time frame. In general, the most aggressive investments suffered the biggest price declines when monetary conditions tighten.
Unlike most of our clients, we like it when prices go down, especially if we’re not in a recession that could destroy wealth and employment. That’s because “Investing” is a verb. It’s a thing we constantly do. We talk about “investments” as if they are *Things. But investments are opportunities to participate in the way the world is changing. In all practicality, we and our clients will need to make investment decisions with money for decades to come, for ourselves and for the family that will be here after we are gone.
People tend to make mistakes in these environments. It’s human nature to think in binaries—to be aggressive when markets are rising or to sell stocks when markets are falling. All the way in or all the way out. However, in our view, those reactions don’t stack the odds of success in your favor.
Should you be your own portfolio manager? Our experience tells us that clients can be pretty good at identifying good investments. But in general, humans are not good at thinking in probabilities or managing portfolios, where risks are balanced and where cash can be valuable as a store of future opportunity. So, here’s our perspective on the year ahead:
- We have economic growth and pretty full employment. Don’t mistake price volatility for wealth destruction.
- The Fed may raise interest rates 4 times over the coming year, starting in March.
- But we don’t think they’ll actually need to hike short-term rates that much, because growth and inflation are already beginning to slow, and they may normalize without as much intervention as people want. On balance, maintaining growth and employment are pretty important too.
- In the meantime, we can watch the market try to anticipate (guess at) how much interest rates will rise and how much S&P 500 earnings will grow.
- That guessing process is leading to some larger price swings than last year when the biggest peak to trough decline on the S&P 500 was less than 6%.
- If prices come down enough, we may be able to buy growing companies at attractive valuations that don’t exist right now, or we may be able to buy bonds at lower prices and higher yields.
- Hence, having *some cash and cash equivalents in portfolios makes more sense to us than to be fully invested.
- Short-term risk factors include rising prices, rising interest rates, the risk that the economy could slow more than expected, the risk that the Democrats spending bill won’t pass and the risk of geopolitical conflicts like Russia invading Ukraine.
- Politics will generally not help you make better investment decisions, because politics divides the world into false binaries and manipulates you through your fear of loss. Ironically, it’s the people on your team who can be contributing the most to your anxiety. You’re the market for their product.
- Cable news is making people scared-er and dumb-er. Turn it off and be happy. If you’re reading this, you’re probably in a cushy situation sitting near the top of the American mercantile empire. Like me you’re probably too fat because you’ve stuffed yourself like a Christmas goose. Try to enjoy if for a change rather than thinking it’s all about to fall apart.
- Indexing makes less sense now than last year. The top 5 companies in the S&P 500 are almost 22% of the entire index, and they’re clustered in similar industries. In our view, they’re good businesses. Should they be 22% of your portfolio? Perhaps it’s time to diversify and find other sources of growth to balance out those risks.
- The most aggressive assets may face the biggest selloffs in compressed periods this year. The period of huge, covid-inspired money creation is ending. During monetary expansion, all kinds of risky investments get funded. Some of them will pan out, but I’ve never in my life seen so many scheisty get-rich-quick schemes or outright scams. That phenomenon is indicative of the broader conditions—there’s money everywhere. But it’s when conditions tighten that the quality shows. And it’s when conditions tighten that high-quality investments might be purchased at good prices, not when the market is roaring.