The Federal Reserve raised interest rates by 75 basis points this week and Fed Chairman Jerome Powell reiterated its intention to get inflation back under control no matter the consequences to short-term economic growth or asset prices. After all, inflation affects 100% of the population while capital market assets affect a much smaller cohort globally.
During the summer stock market rally, the narrative shifted to the idea that the Fed would need to reverse course and cut rates in short order as it would not want to induce a severe recession. Fed Chairman Powell seems to have invalidated that argument entirely with recent action and comments.
After a thirteen-year bull market in assets from stocks to real estate, it appears it will take a severe decline to remove the indelible belief that markets only go up and every dip should be bought with enthusiasm. History shows that extended periods of artificially low interest rates produce malinvestment and unrealistic assumptions asset values. Leverage, used to amplify returns in a declining interest rate environment, becomes destabilizing when interest rates rise rapidly. Regarding residential real estate, in an echo to the first housing bust of the millennium, these assets have been driven higher almost exclusively by interest rates. Incomes have not kept pace with asset value growth leading to the illusion of wealth and perpetual prosperity.
When building investment portfolios, we look at two broad categories: convergent strategies and divergent strategies. Convergent strategies assume the world is stable and growing, investors always behave rationally, and over time the price of an asset will converge with its intrinsic value. Alternatively, divergent strategies assume that the world is not always stable and growing, investors do not always behave rationally, and periodically markets experience severe dislocations. The majority of an investor’s portfolio should be positioned in convergent strategies; however, divergent strategies have their role in adding ballast in volatile times. Investment returns are not symmetrical so keeping drawdowns shallow in turbulent times can allow compounding at higher rates of return over time.
A buy and hold strategy using the S&P 500 over the last 13 years (representative of convergent investing) compounded at nearly 14% per year; this is more than 40% above its long-term average rate of return. On the other hand, divergent strategies, as measured by the Barclay Hedge BTOP 50 Index, compounded at 2.45% since 2009; this is 70% below their long-term average rates of return. If history is any guide, divergent strategies will outperform in the coming decade while stocks will likely underperform as both revert to their long-term mean rates of return. In the current economic cycle, there are few analogs to help contextualize how market trends will unfold. Divergent strategies stand to benefit by capturing the dislocations caused by a normalization of interest rates and the inherent consequences of a highly leveraged economic system that relied upon them.
Having experienced the Asian contagion in 1998, the dot com bust in the early 2000s, the Global Financial Crisis, and the Covid 19 bear market, I have yet to see signs of severe panic which leads me to believe that there is much more downside pressure to come until a final bottom is reached. Can the Fed cut rates, surprise markets and once again kick the can further down the road? Absolutely. As a student of markets, one quickly realizes that anything can happen. But I wouldn’t bet on it.