The story of 2022 so far is of rising interest rates and falling asset prices. The graph above clearly conveys the Fed’s attempt to pump the breaks on inflation. Former Fed Chair Ben Bernanke began “the portfolio effect” in 2009 after the Great Financial Crisis. His goal was to eliminate any risk-free return and force people to take more risk. He hoped the resulting asset price appreciation would trickle down to the economy.
Current Fed Chair Jerome Powell attempted to undo the policy of trickle-down asset price inflation in 2017-2018, only to reverse course after the stock market fell by -20%. The difference between now and then is inflation. Jay is determined to have his legacy resemble Paul Volcker, the vanquisher of inflation, not Arthur Burns, the creator of inflation.
As illustrated below, the yield curve has risen dramatically since the end of last year. Housing has slowed. The stock market is down nearly 20%. We are still in the early stages of an economic slowdown. The Federal Reserve has a press conference coming up later today. The market expects another increase in the Federal Funds rate of 75 basis points or 0.75%. The current Fed Funds target rate is 2.25% to 2.50%.
Amidst the market earthquakes emanating from the Federal Reserve’s tightening, STAR is doing its job. As a reminder, the mandate of STAR is to limit drawdowns to 10% while generating returns in line with the stock market. In other words, STAR only takes risk when the prospective rewards justify it. In technical terms, STAR historically doubled the market’s Sharpe ratio (return divided by risk).
From June to August, the market attempted to rally, hoping the Fed would throw in the towel and stop raising rates. After decades of the “fed put,” whereby the Fed only acts to rescue a falling market, but does not act to restrain an overly ebullient market, the market continues to expect the Fed to put the market before it’s mission to tame inflation.
Jerome Powell sought to put an end to those unrealistic hopes and dreams in his Jackson Hole speech on August 26, 2022. Fed whisperer Nick Timiraos of the Wall Street Journal recently wrote a great piece documenting how the market rally angered the Fed and caused them to adjust course:
Fed officials thought investors were misreading their intentions given the need to slow the economy to combat high inflation. In a widely anticipated speech, Chairman Jerome Powell decided to be blunt. He scrapped his original address, according to two people who spoke to him, and instead delivered unusually brief remarks with a simple message—the Fed would accept a recession as the price of fighting inflation.
Mr. Powell cited the example of former Fed chairman Paul Volcker, who drove the economy into a deep hole in the early 1980s with punishing rate increases... “We must keep at it until the job is done,” Mr. Powell said, invoking the title of Mr. Volcker’s 2018 autobiography, “Keeping At It.”
The S&P 500 is down -8% since the speech.
The upshot of higher rates is that we can now get paid a higher rate of return on money while we wait for the stock market to adjust to the new economic reality.
According to STAR’s methodology, the stock market remains about 10% too expensive for us to invest based on valuation. But, until the market gets cheaper, we can now generate yields according to the graph below. Some of our portfolio is now in 1-year Treasury Bills earning 4%. Other portions are shorter so that they can be re-invested if the market goes down sufficiently.
Investors today can buy 1-year US-Treasury bills and receive 4%. While this feels high to anyone investing over the last decade, it’s exactly in line with historical averages. 10-year bonds currently pay 3.6%, about 1.3% below the historical average. Vanguard’s latest S&P 500 market expected return was 5% per year over the next decade. STAR’s investments remain anchored around the one correctly priced asset. While waiting for the other two to get cheaper.