“Money for Nothing (and the buybacks for free)”
I hope this finds everyone well and enjoying (or cringing at) these summer temps that finally kicked in! This update is going to be on the shorter side for a couple of reasons. For one, we could literally copy and paste what we wrote last time around and nothing much has changed. More importantly, you likely have much better things to do with your summer months than sift through these commentaries! All of that said, the 1st 6 months of this year have included some important confirmations that will be the focus of this writing…..
Let’s start by reiterating a comment that we made in our outlook for this year, expressing why we were cautiously optimistic on most asset classes heading into 2019:
“We interpret the latest Fed-speak as confirmation that their fear of disrupting Wall Street outweighs any other data they may choose to consider. As such, we find it highly unlikely that the Fed will raise rates even once during 2019. In our opinion, not a single other factor – technical or otherwise – outweighs what the Fed says and does. This was proven repeatedly over the past decade, and once again only last year.
We should note that our use of the word “cautious” above pertains more to the conviction of our stance, rather than the potential strength of the moves. If we are correct in all of our assumptions above, it would be more than plausible – maybe even likely – that stocks could have an exceptionally good year. It would be tough to sell the same for bonds, mainly because yields are so low to begin with.”
Ding, ding, ding – jackpot! Well, except for that last comment on bonds – much more on that later. We can summarize the first half of this year in one sentence – virtually everything went up in value. Our good friend Chairman Powell and his flock of free money bandits followed through on their market-induced, panicked remarks from last year – and asset prices responded accordingly. And while they have not yet officially cut rates this year, all indications point to at least one and likely two rate cuts during the second half of 2019.
So let me be honest as to why I couldn’t see the exceptionally good year for bonds coming. It’s very simple – I didn’t believe that they would actually cut rates. We (thankfully) lengthened duration and added more treasury positions for clients because we then fully believed that they would not be raising rates again anytime soon. But lowering rates? The first time I heard someone mention it I literally laughed out loud. Unemployment numbers are the best we’ve seen in forever. Inflation isn’t (currently) a threat on either side. We just handed a trillion dollars to the nation’s largest employers in the form of tax cuts – and these companies still can’t find anything better to do with this money than buying back stock. And whatever interest rates that currently exist have only barely nudged from zero. Why in God’s good name would anyone be talking about lowering rates from here?
Let’s start our analysis of this recently re-discovered love affair between the Fed and near-zero interest rates by stating the obvious – it has been awfully good for investors so far this year. Even the most conservative portfolios are seeing 6 month returns that I would never have dreamt possible, given the environment with which we started the year. So none of us are complaining……yet.
We have spent thousands of words in previous analyses spewing about the dangers of keeping rates too low for too long. And I promised you a shorter analysis, so I will encourage you to review past writings for additional thoughts on the topic. Today, we are going to focus on just one – the Fed’s ability to assist the next time “things get bad”. This analysis will also allow us to try out Round Hill’s latest investment for the 1st time – a research tool (y charts) allowing us to easier research everything from individual investments to economic trends, then put everything into graphical form. We are already loving it, and hoping the rest of you will as well!
To begin, lets look at the Fed Funds Rate over the past 30 years – highlighting periods (shaded areas) where the US was in recession:
So we can see that following the last two “major recessions” in this country, the Federal Reserve felt it necessary to lower their federal funds rate by approximately 570 and 525 basis points respectively to get the economy back on track. In other words, “short term interest rates” fell from approximately 6.7% in 2000 down to 1.0% in 2003, then from 5.25% in 2007 down to “zero” by the end of 2008. We can also safely assume that the Fed would have cut rates even further during the “great recession”, but that damn number zero got in the way. The reason I am confident in this assumption is that the Fed then turned to “quantitative easing” (manipulating longer term rates) once they hit zero on the Fed Funds rate.
If this writing was purely meant as a commentary on the economy, we could probably stop at this one. But since we are focused mainly on what all of this means for our investments, let’s take it a step further. Same chart as above, but we will incorporate the S&P 500 index into this one:
Wow, we could write a 100+ page dissertation on this chart alone. As promised, we won’t. But we cannot express any more clearly than this one chart as to why we believe that the Fed matters far more than anything else when it comes to your investments in this world in which we currently live.
So you might then say to us “Hey dumbass, why don’t you have all of my money in stocks if the Fed is about to cut rates again?!” Well first off, it’s not nice to call us names. Much more importantly, I would ask you to go back to that last chart and tell me exactly what looks different from the year 2010 through this writing. (1) The purple line (Fed Funds Rate) stays mostly flat. (2) The yellow line (S&P 500) goes “straight up”. And (3) there is no shaded area where the US is in recession.
Let me summarize that graphically:
The last 2 recessions included a drop in the S&P 500 of approximately 50% each. Circling back to our previous discussion, we know that the Fed felt the need to cut the Federal funds rate by more than 5% each time – at which point the markets recovered (and fairly quickly in both cases). But the Fed only has about 2.5% left to work with based on today’s levels. If the Fed follows through for the markets over the rest of this year, we will be down to only about 2% left with which to cut when the next recession occurs. After that, we are talking about negative interest rates (“you pay the bank interest instead of the other way around”) or quantitative easing rounds 4-infinity…..or both.
It is for this reason that we believe the recent / current Fed policy to be so dangerous – and we choose (and have chosen) not to ignore it on behalf of our clients.
To close on a positive note, we feel even stronger about our positive outlook coming into the year – and for all of the same reasons. It would not surprise us at all to see this free-money party keep on rocking for the second half of this year – compliments of your friendly neighborhood Fed Chairman. We are not certain that we can keep the same torrid pace – and wouldn’t be shocked if “market gravity” alone led to a less than stellar 2nd half - but we continue to feel that the risk is to the upside based on the information currently at hand, and assuming the Fed does not wake up one morning and finally acknowledge that they agree with our premise (deep down, they already do I am sure).
The major risks for the remainder of this year remain (1) the Fed not following through on their promises to markets (in other words, acting responsibly), (2) trade tensions escalating (an outcome we still believe will be largely averted for political reasons) or (3) geographic tensions flaring. 2020 “puts a whole different paint job on things” however (20 bucks to anyone that can successfully identify that reference), as we have a rather large election to look forward to. Fortunately, that is a topic for a future update….but most certainly not an insignificant one.
Wishing everyone a safe and ultra-enjoyable rest of the summer - and as always, to all of our clients, we can never thank you enough for the trust and confidence you have placed in Round Hill!
Douglas Brymer David Swanson
President & Wealth Advisor Principal & Wealth Advisor
The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Statements of forecast are for informational purposes and are not guaranteed to occur. Trends discussed are not guaranteed to continue in the future.
All performance referenced is historical and is no guarantee of future results. Investments mentioned may not be suitable for all investors.
Equity investing involves risk, including loss of principal. No strategy – including tactical allocation strategies - assures success or protects against loss.
Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time. There is no guarantee that any investment will return to former valuation levels.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
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