We turned the page to a new year, and it seems an entirely new market, as well. Until January, the stock market was buoyed by the knowledge that the Federal Reserve would continue to pump money into the economy. What this most often meant was shallow pullbacks of around 5% followed by “buying the dip” mentality that quickly drove stock prices back to new highs. Even when we had the pandemic shutdown in 2020, the market recovered most of the 35% drop within two months and all the loss within five months. This relentless push upward is what investors have been conditioned to expect.
So what changed and what does it all mean? For one thing, inflation has become a more serious problem. Inflation first appeared in the second quarter of last year, but everyone (including me) thought it was “transitory”. That is, everyone seemed to think the spike in inflation was largely due to comparing a year in which we were returning to normal to a year in which the economy was shut down. The idea was that as we got further into the year, comparisons would moderate, and inflation would come down. That has not happened. The inflation rate has remained at a stubbornly high level for the remainder of the year. This has forced the Federal Reserve to dramatically shift their policy from one of “easy money” – that is, keeping interest rates low and buying bonds from the public to add additional dollars to the economy – to one of tightening. This tightening is a two-step process. The first step involves ending the QE or bond buying program, which is already happening and should be over by March. The second step will be to raise the Fed funds interest rate.
It is the rising interest rates that are directly affecting the markets even though the Fed has not acted yet. How do rising interest rates affect investors? Let’s start with the fact that stocks represent ownership in a business. These businesses earn a profit (or we anticipate they will at some point). Let us look at a very simple problem. Suppose we own a business that earns $1,000 per year. We anticipate it will earn this same amount every year until the end of time. Suppose further someone wants to buy our business from us. What would we be willing to accept to sell this business? Flipping this question on its head, if we could earn 1% interest on an investment, how much would we need to invest today to end up with that same $1,000 in a year? The answer is $990.10 invested today earning 1% gives us the same $1,000 in one year. We could make this same calculation of how much we need to invest to end up with that same $1,000 for the second year and the third year and so on and add them together to get a figure for the value of the company. Simply put, we are discounting the cash flow we expect to earn from our business back to present day. If interest rates are 1% and we expect to earn this amount forever and ever, it turns out we would be indifferent between earning $1,000 each year or receiving $100,000 up front. These two amounts would provide the same outcome.
What happens if interest rates go up? Suppose we can now earn 2% interest on any money we invest today. As you might suspect, doubling the interest rate cuts in half the amount of money we would need to accept today to earn the same set of cash flows. In other words, we would be equally happy with $50,000 in hand today or $1,000 per year forever. Rising interest rates reduce the “present value” of future cash flows. Stock prices represent this “present value” of future cash flows. The cash flows we are discounting are the earnings of the companies. This raises two key questions. The first is when the Fed is all said and done raising interest rates, what will be the prevailing interest rate? 3%? 5%? 6%? No one knows. The second question is what will companies earn? If Apple earned $6.00 per share last year, is that sustainable? Might it continue to grow? Could it shrink if we have a recession? These two questions – the level of interest rates and the future earnings of companies – are leading to the current levels of volatility.
Investors are confused by both the continued growth rates of the companies they own and of the prevailing interest rates we are going to see in the economy. The one thing all investors agree upon is that with interest rates likely to start rising in March, stocks are worth less today than they were in December. The volatility arises from the debate over what stocks will earn and what interest rate is appropriate. If interest rates go up too quickly or too far, stocks will tumble dramatically. If inflation is less severe, interest rates may not rise dramatically, and stocks may have more value. The trouble is, no one knows exactly what a company will earn next quarter, let alone next year or three years or ten years down the road. This means we have no idea what number to use to discount back to today. In addition, no one really knows how far the Fed will raise interest rates. There have been guesses of anywhere between three interest rate hikes this year and seven(!) hikes. The answer to this question depends upon how the rate of inflation responds to the first rounds of interest rate hikes as well as how company earnings respond.
We have not been sitting idle during this volatile time. We have already taken several steps for our clients. Over the past couple of years, we have been a bit more focused on growth largely utilizing mutual funds. These funds typically had a high allocation to tech stocks. Tech stocks will likely be impacted by rising interest rates. To counter that, we have greatly reduced or eliminated our exposure to these mutual funds and will continue to trim as appropriate. This does not mean we are giving up on growth altogether – just that we are paring back significantly to focus on areas that are likely to do better. In addition, we have started dipping our toes in the water or, more appropriately, oil. Oil has been on the rise lately and is a key component of the inflation calculation. There is an ETF, the United States Oil Fund L.P (ticker: USO) that is tied to the price of oil. We have a couple of trades around this security and expect to do more to take advantage of higher inflation.
Another change we have made is to invest excess cash in a bond fund that will benefit from rising interest rates. We view this largely as a short-term place to park cash and less as an investment or a trade. The fund, the Janus Henderson AAA CLO ETF (ticker: JAAA) sports a current dividend yield around 1.10% per year and the price is relatively stable. It is important to note that this is not a money market fund and stable prices are not guaranteed. The fact that the bonds it owns are high quality gives us some level of assurance for the safety of our investment. Further, these bonds are backed by corporate loans that have adjustable interest rates. As interest rates rise over time, so will the payouts on these bonds and our dividend yield should increase comparably. We are not looking to hit home runs here. We are trying to enhance our returns a bit without taking undue risk. All of this is designed to help shelter us during these volatile times. We may have losses on paper as stocks rise and fall, but if we do our job correctly, we will have smaller losses which gives us the chance for quicker return to profitability.