Don’t Fight The Fed | Seeking Alpha

It cuts both ways. It was the mantra for years since the end of the Great Financial Crisis (GFC). Don’t fight the Fed. It worked brilliantly for years when the fight was pointing definitively in one direction. Now that the tide has decisively turned, investors should not suddenly forget the refrain that served them so well.

Don’t fight the Fed: dovish edition. It was the relentless tailwind at the back of investors for most of the last thirteen years. In order to overcome the GFC, the U.S. Federal Reserve lowered interest rates to 0% and plunged into once extraordinary Quantitative Easing, where the Fed went out and began buying various riskier assets such as longer term U.S. Treasuries, mortgage backed securities (MBS), and even some of the financial detritus left behind by certain financial firms that got out so far over their risk management skis that they nearly collapsed the global financial system. In short, the Fed was as easy, dovish, accommodative as they could possibly ever be.

Don’t fight the Fed! On one side of the monetary policy coin, if the U.S. Federal Reserve is engaged in easier monetary policy that includes lower interest rates and large scale asset purchases, particularly in a chronically disinflationary/deflationary pricing environment, not fighting the Fed means taking on greater risk and accumulating risk assets. This includes buying stocks and other correlated securities like high yield bonds regardless of the valuation or loan covenants (or lack thereof). And buy investors did throughout most of the 2010s (save some short stints of breath-taking volatility including the spring of 2010, the summer/fall of 2011, mid-2015 to early 2016, and 2018 Q4) and buy even more in the immediate aftermath of the COVID outbreak from April 2020 through the end of 2021.

A couple of key characteristics defined this extended stretch.

Good news was good news. This is because it meant the long anticipated sustained economic recovery was finally getting underway, bringing with it the robust earnings growth that would justify steadily increasing valuations. If it was the first half of the year, so it was said that the sustained economic recovery was coming in the second half of the year. If it was the second half of the year, the sustained recovery was coming with the start of the New Year. The sustained recovery was always right around the corner. Except it never came in any meaningful way. Which leads us to the next key characteristic.

Bad news was good news. This is because it meant that if the economy or the markets stumbled in any meaningful way, even if it was a handful of percentage points on the S&P 500 over a series of weeks, that the Fed would come rushing in with “whatever it takes” to restore and maintain supposedly fragile market confidence. Heaven forbid anyone experience loss anymore, the Fed was here to help.

This fostered an environment where investors could buy their favorite stock themes regardless of their valuation, thus fueling a boom in the more aggressive segments of the growth style including momentum and growth at any price strategies. It also encouraged investors to pursue their favorite sexy stock themes regardless of the financial health, operational performance, or profitability of the company in question.

For example, who cares about Tesla’s dubious financials and its CEO that mouths off on Twitter about among other things considering taking his company private at $420 with funding secured ($420, really. . .)? He’s making cool stuff!

Thus, as long as inflationary pressures remained in check and the Fed had the flexibility to keep interest rates historically low if not pinned at 0%, not fighting the Fed meant buying stocks and other related risk assets regardless of how well or lousy the economy and corporate profitability was going at any given point in time. In fact, as long as growth remained anemic, it encouraged companies that might otherwise deploy free cash flow into productive activities such as capital expenditures and fixed investment to instead pour into share buybacks, which more than offset the chronic net outflow from domestic equities by retail and institutional investors throughout nearly all of the post GFC period according to the Investment Company Institute (ICI) to help further propel stock prices higher.

Don’t fight the Fed: hawkish edition. There is, of course, another side to this coin. It’s just that we haven’t seen it for a really long time. When the economy is either running hot, is suffering from supply shortages, or both, and high inflation subsequently descends on the U.S. economy as it has today, the U.S. Federal Reserve starts raising interest rates to contain pricing pressures. After all, if you have too much money chasing too few goods and you effectively take money away from people, they can’t spend it. And with ever less money chasing goods, pricing pressures will eventually cool. Today, the Fed is already in for 150 basis points since March 17, and is expected to pour on another 75 basis points coming out of its next meeting on July 27 and another 125 basis points through the remainder of 2022 according to CME Fed Fund Futures. Overall, this is a breath-taking amount of monetary policy tightening happening in a very short period of time, which is a dramatic departure from the ginger 25 basis point baby steps the Fed struggled to carry out in the decade plus after the GFC.

Don’t fight the Fed! On the other side of the monetary policy coin, not fighting the Fed means scaling back on risk and shedding risk assets when the Fed is engaged in monetary tightening by raising interest rates and shrinking their balance sheet. This includes reducing allocations to stocks and other correlated securities like high yield bonds. For those remaining allocations, discounted valuations, financial health, and strong earnings predictability are paramount. In short, the exact opposite of what we have been living since the GFC up until a few months ago.

A couple of key characteristics are likely to define the stretch that lies ahead.

Bad news is bad news. If the economy is falling into recession, too bad, so sad. The Fed would like to lend you a hand with your steadily declining stock prices, but they are busy fighting a scorching inflation problem that is the main priority right now. In fact, the Fed probably doesn’t want to lend you a hand with your steadily declining stock prices right now, for falling stock prices help dampen inflation pressures by reducing the wealth effect (i.e. if investors are losing money on their stock portfolio, they are less likely to sell their shares to go out and buy stuff). So if the economic and/or market headlines are bad at any point in time, it’s likely the full broadside of the news will be felt on investor portfolios. It turns out that fundamentals and valuation may matter after all.

Good news is bad news. Strong monthly jobs report? Robust readings on economic growth? Unexpectedly good economic data points? This is all fine and may help give stocks a jolt in the arm on any given trading day, but if you are the Fed and engaged in trying to snuff out a raging inflation problem, these headlines give you one more reason to tighten monetary policy and raise interest rates even further than you might otherwise.

This is fostering an environment where stocks that were once flying toward the sun are now falling back to earth under the weight of lofty valuations that are suddenly no longer justifiable. Momentum is long over, and growth at any price names are falling by integers under the weight of their extreme valuations. Maybe the quarterly earnings and forecast will be most favorable for some of these companies in the coming weeks. In many cases, it won’t matter, because the valuation remains too overextended in an environment where real earnings yields are deep underwater and investors are rotating toward stocks that offer deep value, financial health, and sustainable operational performance and profitability regardless of the economic and market environment.

Thus, as long as inflationary pressures remain high and the Fed is forced to continue to raise interest rates and/or shrink its balance sheet, not fighting the Fed means scaling back on stocks and other related risk assets regardless of how well the economy and corporate profitability might turn from here. In fact, as the U.S. economy is pushed toward recession due to increasingly aggressive monetary policy, it encourages companies that up to this point have been shoveling money hand over fist into share buybacks (we reached a new record high in quarterly corporate share repurchase activity in 2022 Q1 at $281 billion). History has shown that when share repurchases decline, U.S. stock prices as measured by the S&P 500 Index quickly follow. And if retail and institutional investors resume the selling of domestic equities at a time when share buybacks are waning, this is a series of downside pressures on stocks all pointing in the same negative direction.

Bottom line. I hear troubling investor complacency from certain market segments. Many continue to take the stance that recent market declines are temporary and that fresh new highs on the S&P 500 are waiting right around the corner. If anything, these investors may be contemplating adding to positions following the pullback so far in 2022.

Such an approach served investors so well for years in the post GFC period. Don’t fight the Fed!

But underlying conditions have diametrically changed. Gone are the days of monetary policy support from the Fed amid any sustained market downturn. And gone are the days of endless easy money from the Fed at the first sniff of stock market weakness.

In its place is an economy plagued by high inflation and a Fed that is tightening monetary policy aggressively in response. And this is likely to take a more prolonged and sustained toll on stock prices as long as this inflation problem persists and quite likely for a while after it’s gone, as the Fed is likely to be far more deliberate with easing monetary policy going forward now that they have officially unleashed the inflationary beast after so many decades in slumber. Still don’t fight the Fed!

One final point for consideration. The latest Atlanta Fed GDPNow reading for 2022 Q2 GDP growth is -1.5% as of July 15. If this reading holds, the U.S. economy would meet the typical textbook definition of a recession with two consecutive quarters of negative GDP growth. Not a good sign to start. Now consider that today is one of the only times in history that the U.S. Federal Reserve is tightening so aggressively in an economy that is already in recession (we could quibble about the monetary policy surrounding the double-dip recession of the early 1980s). This is likely to bring additional risks to the economy and markets that are largely unchartered waters throughout financial history. This is all the more reason to don’t fight the Fed in the current market environment.