If there were one chart that could explain the stock market right now, it would be this:
The almighty Fed has muscle. It’s so powerful that when its chief says the economy is in trouble, investors don’t run for the hills. Instead, they load up on more stock because they know the Fed will crank up the money presses.
Last week, we discussed how the Fed messes up bond investors who are forced to invest in stocks. Today we’ll talk about how the Fed’s actions exactly affect stock valuations. And why it puts your portfolio in danger—especially when the economy recovers.
Let’s begin with the Fed’s “loosening” and why stocks shot up so much as a result.
How the Fed’s loosening pumps up stock valuations (in theory)
When the Fed is loosening, it’s essentially doing a couple of things.
For one, the Fed cuts the federal fund rate. That leads to two things. First, lower rates slash the interest on all debt—including bank loans, mortgages, and bonds. The result is companies can borrow money to expand their businesses for cheap.
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The second—and lesser known effect of low rates—is that they increase the theoretical value of stocks.
At the most fundamental level, a stock’s value is the present value of all the money the company will make in its lifetime. The more a company is expected to earn, the more we can pay for a share in that stock.
But here’s the catch. The company will make some of that money in a distant future, maybe even 20 or 30 years from now. And a dollar today is worth more than a dollar in the future. So when investors tally up future cash flows, they discount them based on when the company is actually expected to make that money.
The discount rate they use is a whole ‘nother topic. But the measure that affects it most is the risk-free rate—whose benchmark is the yield on 10-year Treasuries. In simple terms, the lower the Treasury yield, the lower the discount rate.
That means when the Fed weighs down Treasury yields (risk-free rate) by slashing rates, it props up 1) the present value of future cash flows; and 2) the theoretical value of stocks.
Here’s what that looks like:
If low rates don’t cut it, the Fed then ups the ante with so-called “quantitative easing” (QE). In a human language, the Fed “prints” some extra money and use it to buy mortgage-backed bonds, Treasuries, and—now—corporate bonds.
QE achieves two things. First, it injects more money into the economy, which is then loaned to businesses and people. Second, it pushes interest rates down, but in a totally different way than low rates do.
As we discussed last week, the Fed’s shopping spree disrupts supply and demand in bonds. Trillions of dollars flowing into bonds drive their prices up. Then, higher bond prices push yields down, dragging along the discount rate we’ve just discussed.
And just like low rates, that cuts borrowing costs and props up the theoretical value of stocks.
The dangerous “hump” in stock valuations
With all this in mind, you can look at today’s stock valuations this way:
The bottom part of stock prices is driven by fundamentals such as a recovering economy and earnings. The upper part is artificially propped up by the Fed’s loose policy. And this is where the biggest danger to your portfolio lies.
If the Fed tips off that it’s backing down, the upper part will start shrinking—even if the economy improves. In fact, not even if, but more likely when the economy improves.
You see, the Fed gave its word to keep rates low until 2023 and to continue buying assets until there’s “substantial further progress.” Nobody knows what exactly will pass for “substantial progress,” but we do know one thing.
The Fed’s job is to keep two things in check:
- Stable prices. In the Fed’s logic, that’s the average inflation of 2%. The average means that policymakers could let it crest a little over the target for some time.
- And maximum employment
When the Fed believes the economy can achieve these two without the handholding, it will take a step back. And analysts think the Fed may start muddying the waters as soon as this year.
UBS’s chief economist Seth Carpenter believes the Feds will begin to taper in September. By that time, their analyst team projects that the U.S. will add 6 million jobs and GPD will exceed pre-Covid levels.
JPMorgan JPM JPM JPM strategists think Biden’s stimulus will be a big economic booster. They predict the economy will achieve “substantial further progress” in late 2021. They are also not ruling out a surprise rate hike sometime in 2022.
Here’s what you can do to shield your portfolio
Preparing for the Fed’s back down is not rocket science. It all comes down to common sense.
The Fed will most likely pull the plug under one of these two conditions: a strong enough economy and higher inflation. So one way to shield your portfolio is to hold stocks that do really well when an economy is growing and inflation is rising.
In the case of a stronger economy (and higher rates), JPMorgan strategists suggest holding value stocks vs. growth stocks. You could cherry-pick individual stocks or invest in broad ETFs such as iShares MSCI Intl Value Factor ETF (IVLU) IVLU
- Investors expect lower future cash flows from value stocks than they do from growth stocks. That means the discount rate is less important here.
- Value stocks are well-established businesses that don’t borrow as much as growth stocks. That means they are more immune to borrowing costs (interest rates) and downturns
- JPMorgan data shows that value stocks often outperform growth stocks in times of rising interest rates. Plus, value stocks have lagged growth stocks for over a decade now, and analysts think the tide is turning.
If inflation ticks up higher, you may want to hold investments tied to commodities, which will keep pace with inflation. JPMorgan strategists are in particular bullish on oil and agriculture.
Problem is, investing in commodities can be tricky and expensive for individual investors. So, probably, the easiest buy-and-hold way to tap into commodities is to buy an ETF of stocks tied to them.
Meanwhile, keep a close eye on the Fed. Because the stock market is not the economy. A lot of it is a side effect of the Fed’s response to the economy.
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