Market Sideshows, Diversification, and the Fed

Successful investors have an uncanny ability to ignore financial market sideshows, embrace diversification, focus on longer-term goals, and exercise patience when things aren’t working well.  This hasn’t exactly been easy over the past two years, which featured a harrowing 34% drop in the S&P 500 during 2020 and subsequent historic recovery, high-flying meme stocks and crypto assets distracting investor attention, the continued underperformance of international stocks, and a constant deluge of alarming headlines.

2021 might best be characterized as the year financial markets “jumped the shark”.  Consider some of the many market sideshows witnessed last year.  Stocks such as GameStop and AMC skyrocketed after internet message board posters coalesced in an attempt to short-squeeze hedge funds.  The pied piper of these posters was an individual nicknamed “Roaring Kitty”.  You can’t make this up.  Joke-based crypto assets such as Dogecoin were publicly pumped by none other than Tesla co-founder Elon Musk.  Digital pictures of punks and apes sold for millions of dollars, as non-fungible tokens (NFTs) burst onto the scene.  A record number of highly questionable special purpose acquisition companies (SPACs) came to market, essentially a money grab by wealthy venture capitalists looking to take advantage of froth in the market.  A decent chunk of investors found it difficult to look away from these circus sideshows, which dominated financial media attention.

The main show, however – the broader U.S. stock market – continued marching along and registered new record highs.  This was despite a weary country grappling with a seemingly never-ending pandemic, sharper political discourse, and geopolitical tensions with China and Russia, among other events.  Stocks have shown remarkable resilience, bolstered by a highly accommodative Federal Reserve and plentiful government stimulus.  That said, U.S. stocks are on the higher end of historic valuations, which has been the case for several years now.  The potentially game-changing difference moving forward is a shift in direction by the Fed, who has helped support financial markets for the better part of the past 14 years. 

With inflation now running at its highest level in four decades, the Fed’s hand is being forced and they can no longer stand idly by.  The Fed is currently messaging an end to their long-standing asset purchases, in addition to commencing with several interest rate hikes and potentially running down their balance sheet (i.e., selling assets that were purchased previously or simply letting mature).  The goal is to ensure inflation doesn’t spiral out of control, but these actions are not without consequences.  As we indicated last quarter, the Fed will have a tricky balancing act: 

“If the Fed tapers bond purchases and/or hikes interest rates prematurely, they could inadvertently throw a wrench into the economy which might not be fully ready to stand on its own.  Higher rates impact everything from mortgages to auto loans to credit cards.  From an investment perspective, rising rates can negatively impact bond prices, which tend to move in the opposite direction of rates.  Stock prices may also take a hit as investors discount future corporate earnings at a higher rate.  This is particularly impactful for longer duration growth stocks, with anticipated earnings much further out into the future.  Higher yielding bonds could also siphon demand away from stocks as investors look to shed riskier assets in favor of more stable returns.”

The question is whether an economy still impacted by an ongoing pandemic can withstand a more hawkish Fed.  By all accounts, the U.S. does appear healthy.  Unemployment is low, wages are rising, consumer and corporate balance sheets are strong, and corporate profits are at record highs.  However, a one-two punch of higher inflation and rising interest rates could crimp consumer spending and negatively impact corporate earnings.  A reduction in earnings could lead to layoffs, less business spending, reduced investment, and weakening balance sheets – all negatives for the economy and likely the stock market.

As it pertains to potential future weakness in stocks, we would be remiss if we didn’t point back once again to our commentary from last quarter:

“Past attempts by the Fed to take a more hawkish approach – most recently in the fourth quarter of 2018 – were not well received by the financial markets.  The Fed will have to thread the needle, attempting to keep inflation in check without bringing the economy to its knees.”

To recap, the last time the Fed attempted to get aggressive and raise rates, stocks tanked 20%, and the Fed quickly reversed course.

And so, as a new year dawns, investors should be watching to see who blinks first:  the economy and financial markets or the Fed.  It wasn’t just 2018.  Over the past 14 years, the Fed has shown a strong willingness to support both the economy and financial markets at the first signs of turmoil.  Most recently, they responded with unprecedented stimulus following the Covid-induced market crash in March of 2020.  Does the Fed actually have the stomach to tighten monetary policy and rein in inflation, even if that puts the economy and financial markets in jeopardy?  The answer to that question will likely determine the fate of stocks and bonds in 2022.

There’s also a possibility of a less-than-ideal scenario – maybe even a worst case for the Fed – where the economy stalls and inflation remains elevated.  This could be particularly dicey if the reason inflation is currently running hot has more to do with supply-side issues versus consumer demand.  In other words, it’s entirely possible that current high inflation is primarily driven by supply chain bottlenecks – and not robust consumer demand.  Supply chains coming on line could fix the inflation issue, but it might be too late for the economy if the Fed has already embarked on an aggressive tightening path.

So What Does This Mean for Investors?

It’s our belief the time-tested principles of successful investing mentioned at the beginning of this commentary are more important now than ever.  Over the past several months, many of the market sideshows from earlier in 2021 have lost their audience.  Investors who piled into areas such as meme stocks, fly-by-night crypto assets, unprofitable tech companies, and SPACs are watching those “investments” plummet back down to earth.  Markets have a funny (evil?) way of punishing investors who become distracted by the latest “shiny objects”.  No matter how wild and crazy financial markets might behave at certain points, they typically normalize over the longer-term.  Investors who have smartly ignored the sideshows and remained focused on the longer-term are largely sitting back and enjoying the main show.

Regarding embracing diversification and exercising patience when things aren’t working well, we’re reminded of a common investing adage:  If you don’t hate something in your portfolio, then you’re not properly diversified.  However, it’s not always easy sticking with investments that aren’t working at the moment.  That’s where patience comes into play.  Patience is a form of risk management, preventing rash decisions from eroding a portfolio’s core foundation.  In 2021, U.S. stocks once again led the charge.  Bonds had a challenging year as interest rates ticked up.  We previously noted the continued underperformance of international stocks.  The point of diversification is to never get caught off-guard and ensure portfolio resiliency for a variety of market environments.  If the Fed does follow through with tightening, the current mega-cap U.S. stock market regime could shift.  Investors will value diversification in this environment.