Foreword
This is a quick note, which tends to be just off the cuff thoughts/ideas that look at current market situations, and to try to encourage some discussions.
A long time ago, before the creation of this blog, I used to write semi frequent, though not really regular, short notes about what I think about the markets in the near term. That was the model for the “quicknotes” posts in this blog.
A couple of people reached out and mentioned that they missed the discussions around those posts, and were also curious about my take on the market’s behavior so far this year. And so, here we are…
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
Powell
Before we discuss more, we need to talk about my mental model of Powell. Personally, based on his words and actions I think that Powell leans towards the hawkish side of the Fed (I can’t substantiate these, as I’m lazy, deal with it):
- He was on the record in favor of hikes when Yellen was chair.
- He hiked in 2018, despite the markets going down.
- He mentioned Volcker a lot in his speeches. Less so Greenspan.
Now, some people are very quick to point out that Powell blinked and reversed course in 2018, stopping the hikes after the markets turned down. That’s partially correct — he did do that, but I don’t believe he did it willingly.
If you’d recall, (then president) Trump was very upset about Powell hiking, and repeatedly bashed Powell in public, press conferences, Twitter, etc. He also repeatedly threatened (and was rumored to be exploring options) to fire Powell before Powell’s term was up. It was only after a long time of this abuse did Powell relent.
Imagine if your boss, and the president of the United States wanted you to do something, but you did something else instead. And only after being threatened did you relent. Would you be stopping willingly, or not?
From all these, it seems to me that Powell is a pragmatist, a technocrat. He recognizes that low interest rates forever is not a good thing as it distorts markets (1), and he’s willing to let the market take a hit to restore balance.
Federal Reserve
The Federal Reserve (Fed) as an institution has only 2 official mandates — price stability and full employment.
We are currently very near full employment (some may argue too high, given the labor shortages). But we have very high inflation, i.e. no price stability.
When I wrote my first inflation note, I had already seen early signs of inflation for a few months, which was why I was fairly confident that the Fed would have seen it too and would act soon. I mean, if a code monkey like me can see it, anyone who wasn’t blind could… right?
I figured that since it was early, if the Fed stepped in quickly, they could probably get away with just jawboning and maybe 1 or 2 symbolic hikes.
By September 2021, when the Fed still hadn’t acted, despite inflation being super obvious and already reflected in CPI numbers, I decided to flatten my portfolio (2). My thinking then was, the stock markets already seemed to be starting to price in some action from the Fed, despite nothing from them, so everyone must be seeing it. The fact that the Fed aren’t acting yet means that the problem is more likely to get out of hand, which then makes it that much harder to control — recall in my first inflation note that beyond some point, inflation becomes really hard to control without draconian measures (hence the Volcker policies of the 70s). I didn’t like the odds for the market, and so I tamped down my exposure.
At this point, inflation is so high that the Fed cannot simply jawbone it down, neither can they (I believe) just get it down with a few symbolic hikes. At the same time, inflation is so high that they cannot claim “mission accomplished” just by changing the trajectory of inflation (i.e. disinflation) — no, it’s too late for that now — to restore public confidence, it seems like they’ll need to get the absolute level of inflation down to some reasonable level, say 2-3%.
Biden
Finally, the last piece of the puzzle. Recall that in 2018, when Powell wanted to hike, Trump stopped him so as to bolster the stock markets. Well, will Biden do the same if stocks go down?
First of all, Trump was an unconventional president. Biden is quite a bit more conventional. And conventionally, presidents tend to avoid overtly influencing the Fed.
Secondly, Biden is on the record as saying that he believes inflation is too high. Indeed, inflation is currently seen as the most important topic for the midterm elections later this year.
Finally, Biden has expressed that he believes the Fed will tame inflation. I’m not much of a politician-speech expert, but I think that means “Powell, you’re it! Please get inflation down, kthxbai.”
Which is to say, Biden seems like he’s more concerned about controlling inflation, than about stock markets taking a beating or two.
Now what?
Currently, it seems like the 3 entities most able to control the inflation vs stock markets balance are all leaning towards “taming inflation”. Maybe they’ll be able to find a soft landing, maybe not. I don’t know.
Either way, it does suggests that volatility is here to stay for a while.
For reference, historically, the trough of the S&P500 tends to occur when its P/E ratio is from 5-15, or 18 (for the Dotcom bubble): https://www.multpl.com/s-p-500-pe-ratio (3)
A P/E ratio of 5 for the S&P500 implies SPX at around 989. 15 implies 2968 and 18 implies 3561.
I’m guessing the truth is somewhere in there.
Footnotes
- Since it’s mid May 2022, I’m guessing most people have gotten this memo by now.
- “Flatten” here meaning reduce risk, not “sell everything”.
- I’m excluding the post GFC period. Guess why.
Janky Thoughts 