Will the Fed pivot or more importantly does it matter? We’ll see…
There lived an old farmer who had worked in his fields for many, many years. One day, his horse bolted away. His neighbors dropped in to commiserate with him. “What awful luck,” they tut-tutted sympathetically, to which the farmer only replied, “We’ll see.”
Next morning, to everyone’s surprise, the horse returned, bringing with it three other wild horses. “How amazing is that!” they exclaimed in excitement. The old man replied, “We’ll see.”
A day later, the farmer’s son tried to mount one of the wild horses. He was thrown on the ground and broke his leg. Once more, the neighbors came by to express their sympathies for this stroke of bad luck. “We’ll see,” said the farmer politely.
The next day, the village had some visitors – military officers who had come with the purpose of drafting young men into the army. They passed over the farmer’s son, thanks to his broken leg. The neighbors patted the farmer on his back – how lucky he was to not have his son join the army! “We’ll see,” was all that the farmer said!
The preceding Chinese proverb illustrates the idea that no single event can necessarily be judged as good or bad as the full picture unfolds only over time. Life and markets are complex systems with feedback loops that George Soros termed ‘Reflexivity’. Reflexivity is a theory that positive feedback loops between expectations and economic fundamentals can cause price trends that substantially and persistently deviate from equilibrium prices. In other words, investors base decisions on their perception of reality, which impacts prices, further distorting perceptions. Additionally, human emotions color these perceptions, especially during periods of turmoil, causing markets to deviate on the upside and downside well beyond what fundamentals would dictate. As such, attempting to predict future price levels is futile at best.
An example of distorted perception may lie with the fact that most investors are currently focused on when the Fed may pivot from interest rate hikes. This narrative suggests that when the Fed eventually pivots, stocks will rise, and we are once again off to the races. Past cycles demonstrate a more complicated picture and investors may want to be careful of what they wish for. Historically in bear markets, the most severe down leg occurs after the Fed begins cutting interest rates.
By the time the Fed cuts interest rates, an economic deceleration has begun and takes time to play out. Revenue decelerates, companies reduce costs, and profits fall causing a reflexive downward spiral. In this cycle an unprecedented rise in interest rates, in response to rampant inflation, adds additional pressure on asset prices and valuations. This is a toxic cocktail in a global economy with debt levels higher than those that preceded the global financial crisis. In addition, real estate transaction volumes have slowed precipitously as high interest rates push most buyers to the sidelines. The real estate industry permeates nearly all aspects of the domestic economy so a sharp slowdown will reverberate with yet unknown repercussions.
This economic cycle is unique in that there are few analogs to help us contextualize what may unfold and how. Attempting to predict the ultimate low in prices is likely to be penalized with lower prices. If you’re involved in the markets long enough, you recognize that there are no certainties, and anything can happen. Is the pivot upon us and a bull market anew? Unlikely but we’ll see…