<March 23, 2023>
It was the first day of first grade and things were going smoothly. I was introduced to my teacher, classmates, and classroom. There were four first grade classrooms connected by a common area that included two sinks and a water fountain. New desks filled the rooms and were labeled with each student’s name. For 1977, it was considered a modern classroom and school.
Lunchtime approached, and we lined up for our trip to the cafeteria. As my teacher and classmates walked out, for some reason I was overcome with mischief and decided to remain in the classroom and rearrange the name tags on the desks.
When we returned from lunch, the students went to their seats and our teacher began a new lesson. She asked us questions and of course called us by the wrong names! My classmates and I all laughed each time she got a name wrong. It didn’t take long for our teacher to discover she had been “punked.”
After asking who was responsible, I raised my hand. Unfortunately, my guilty plea didn’t go far, and I was sentenced to the maximum penalty for a first grader—a paddling in the common area! Approximately one hundred first graders witnessed my painful and humiliating punishment. What a way to start a formal education! On the bright side, my stint as class clown was short-lived, and I’d never be paddled again.
Similar to my experience in first grade, it’s usually investors’ first market cycle when they get into the most mischief and learn many valuable lessons. During my first cycle (1993-2002) I learned several lessons, including: avoid combining operating and financial risk; normalizing is preferable to extrapolating; and don’t confuse the tailwinds of a strong profit cycle with investment acumen.
Considering my first cycle ended in a devastating bear market (2000-2002), many of the lessons learned centered on risk management. What about the current market cycle? Given its sharp rise and extended life, instead of learning about the risk of losing capital, investors have more likely learned about the risk of missing out on meaningful gains on capital!
Excluding the brief COVID-induced meltdown, the current market cycle has been one for the ages. With the cycle extending over 14 years, the S&P 500 has returned 658% since March 9, 2009 (through March 15, 2023). The perception of the cycle's invincibility has been bolstered by central banks and their aggressive responses to sporadic periods of financial instability. As much as we detest the drivers of this cycle, it’s hard to argue that its gains and duration haven’t been impressive.
What’s been interesting this cycle is it hasn’t been investors involved in mischief that have been punished, it’s been the valuation conscious and prudent. Those that have refused to run with the crowd and overpay have been penalized and paddled into submission. In effect, the paddle formerly used to discipline mischievous speculators has been used on investors that don’t conform and contribute to maintaining inflated asset prices. It’s as if the central bankers stole Mr. Market’s paddle!
We were reminded of the Fed’s theft of Mr. Market’s paddle during Chairman Powell’s November 2, 2022, press conference. While it’s been over four months, we believe its importance has not faded. During the press conference, Powell went out of his way to remind investors who was holding the paddle. Specifically, after being asked about the risks of overtightening, Powell responded, “Again, if we over tighten, and we don't want to, we want to get this exactly right, but if we over tighten, then we have the ability with our tools, which are powerful, to, as we showed at the beginning of the pandemic episode, we can support economic activity strongly if that happens, if that's necessary.”
At the time, many investors interpreted Powell’s press conference as hawkish; however, we believe his reminder of the Fed’s “powerful tools” superseded any of his tough talk.
We read Powell’s response as if they get things wrong, the Fed will flood the markets with more money, reinflate asset prices, and artificially stimulate the economy. In effect, the Fed’s hawkish tone and actions should be considered temporary, and at any point they may resume their past policies of easy money and intrusive market manipulation. For investors considering selling and sitting out this phase of the Fed’s latest bubble, this wasn’t just a reminder of the Fed’s tools—it was a threat of a future paddling.
Since the November press conference, several Fed members have commented on how surprised they’ve been by the bullish response to the current tightening cycle. In effect, Fed members believe investors haven’t been taking the Federal Reserve’s inflation fight seriously.
San Francisco Fed President Mary Daly was one of the first to question investor behavior, saying, "To be honest with you, I don't quite know why markets are so optimistic about inflation. I think of them as priced for perfection." Similarly, St. Louis Fed President James Bullard said, "It could be that inflation starts to go in the other direction again, and then the Fed would have to react to that. I don't think there's enough pricing being put on that possibility." Summing up the Fed’s concern, the Bloomberg article “Defiant Bulls Stand Up to Fed With Trillion-Dollar Stock Rally” noted the sharp increase in asset prices was “fueling an unwarranted easing in financial conditions” that complicated the Fed’s fight against inflation.
Frankly, we’re surprised the Fed is surprised. The Chairman of the Federal Reserve made it very clear that the Fed would backstop financial markets in the case the Fed overtightens and asset prices and the economy experience a hard landing. By reminding investors of the Fed’s “powerful tools,” Chairman Powell was reassuring investors that the “Fed put” hasn’t gone away and it was safe to take risk—the Fed has your back! And for investors concerned about expensive valuations and an oncoming profit recession, get in line or risk being paddled and humiliated in front of your peers!
Fed members also appear confused by the relationship between the Fed’s powerful tools and concerning macroeconomic trends, such as inflation, wealth inequality, and the declining labor participation rate. Chairman Powell recently commented on the labor participation rate, noting rising retirements were contributing the decline. Based on his comments, it appears Powell is unable to connect the dots between the Fed’s powerful tools and retirement-enabling portfolio and home values. Instead, he blames COVID and doesn’t consider the linkage between the Federal Reserve’s bloated balance sheet, asset prices, and labor availability.
How many workers have retired or switched occupations to “asset flipper” during the current market cycle? I don’t know the exact number, but I know several. In fact, a good friend recently quit his full-time job to trade stock options. We spoke a couple weeks ago after he made $10,000 trading options in one week. I said, “Wow, annualized that’s over $500,000 a year without breaking a sweat! You’re making more than a teacher makes in a decade by simply clicking a mouse. Why work?” He replied, “Exactly! You can’t blame a brother for trying to make a living.” And no, I don’t blame him. He’s simply taking advantage of the Fed’s powerful tools and consensus view that large losses will be insured by additional bailouts.
The belief that the Fed will protect capital allocators from losses was supported last week when the Fed announced it will create a new Bank Term Funding Program (BTFP). The program will offer loans to banks while allowing them to maintain par value on underwater collateral. While marking assets with losses to par may prevent bank failures in the near-term, we view it as another example of how the Fed’s powerful tools are used to monetize mistakes and socialize losses through inflation.
If Mr. Market had his paddle, we suspect he would use this opportunity to teach bankers and investors a very valuable lesson. However, with the paddle firmly in the Fed’s hands, the Fed published a statement reminding us of its tools and willingness to paper over losses that its zero interest-rate policy (ZIRP) encouraged. Specifically, the Fed said, “The Board is closely monitoring conditions across the financial system and is prepared to use its full range of tools to support households and businesses, and will take additional steps as appropriate.” We’ll place this statement with the others—in the Fed’s bulging moral hazard file.
As we approach the end of the current profit and market cycle, we are witnessing more instances of Mr. Market attempting to regain possession of his paddle. Once the paddle returns to its proper owner, we expect Mr. Market will resume teaching valuable lessons to investors that overpaid, bankers that overlent, and central bankers that kept rates too low for too long (again!). Will Mr. Market get his paddle back in 2023, or will another Fed-funded bailout keep the paddle in the Fed’s hands for another year? We’re not certain, but we know where the paddle will eventually land, and given the amount of mischief that’s accumulated this cycle, we wouldn’t want to be on its receiving end.
Eric Cinnamond
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Definitions:
ZIRP: A zero interest rate policy (ZIRP) is when a central bank sets its target short-term interest rate at or close to 0%.
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