Market dynamics are shifting, which means your expectations should, too. With increasing interest rates, high inflation, and the changing focus of the Federal Reserve, you should revisit your expectations.
The Fed Put
Over recent decades, investors have come to rely on the "Fed Put." The name derives from an options contract similar to an insurance policy. The holder of a put has the right to sell the asset at a given price within a specific time frame. The put buyer can sell the stock at the option's stipulated price (called the exercise price), even if the asset price is less than the exercise price in the open market. Deploying a put is a way to hedge or manage downside risk.
Likewise, many investors have grown accustomed to the Federal Reserve deploying cheap money at the sign of significant economic uncertainty and a quick reversal in market fortunes. When the Fed floods the market with cash and credit, it helps buoy markets and, more importantly, market expectations, acting much like a put option.
In 2018 and 2019, the Fed Reserve cut rates seven months after the late 2018 market crash. And in 2020, the Fed cut rates to the lower bound in response to the pandemic. In the most recent example, the language "V shape recovery" became common among market observers to describe the quick reversal of the markets.
Adjusting Our Expectations
However, recent market recoveries should serve more as an exception than a rule for investors' expectations.
The chart below illustrates bear market pullbacks for the S&P 500 Total Return Index since World War II. Bear markets are 20% or worse drops in the market. During this time frame, the average bear market fell by 35.8% from peak to trough, taking about a year and a half to bottom out. Recoveries from these levels usually take two years and five months. The recovery from the 2020 crash required only about six months.
It is easy to conceive of a world where markets take longer to recover with changing market dynamics. As the past illustrates, market recoveries tend to take longer than six months.
What is Changing?
Why is the Fed Put ending? The Fed Put is expiring because the central bank is most concerned about inflation. Although inflation decelerated a little in April to 8.3%, as measured by the CPI, such inflation levels may require the Fed to increase rates to induce a recession. Doing so, in theory, rebalances supply and demand, reduces the amount of cash moving through the economy, and ultimately pumps the breaks on inflation. The Fed Put is likely coming to an end because the Fed is more concerned about inflation and not growth.
Chairman of the Board of Governors of the Federal Reserve, Jerrome Powell, has gone on the record stating inflation is his top priority, and controlling inflation may "include some pain." Ideally, he would like to see inflation fall back to the 2% target without a recession. An inflation correction back to 2% with no recession is often called a "soft landing." Powell acknowledged that a soft landing would be difficult to contrive but reiterated that the Fed looks closely at the data. The Fed anticipates a series of 50 basis point rate hikes this year. And the Fed will monitor the impact of rate increases as they filter through into the economy.
What to Do About It
First, revisit your expectations. The market provided above-average returns from 2020 to the end of 2021. Additionally, stock indices recovered quicker than average historical figures in the recent past. Adjusting our expectations to match slower recoveries and average returns is critical.
Next, you should have a financial plan. Your financial plan serves as the blueprint for building your wealth. The plan dictates portfolio changes. Dollar-cost averaging and chipping away at your goals remain critical. Keeping a long-term perspective and not chasing returns continues to be a cornerstone of any well-designed plan.
Third, you should purchase assets that align with your financial plan. Current vehicles I find appealing when designing client plans during this increasing rate environment are:
High yield savings accounts.
Inflation-linked Treasury bonds (such as I-Bonds and TIPS).
Quality short and intermediate duration bonds.
Value equities.
I also remind clients they need to maintain proper international, emerging, and real estate market exposure for diversification.
The Takeaway
Record stimulus from the past two years is retreating from the economy as the Fed takes action to control inflation. The Fed has been transparent; inflation is their top concern. As a long-term investor, it is essential to stay the course, keep volatility in mind as you consider changes to your portfolio, and prepare for higher rates if you haven't already done so.
Are you trying to figure out what to do with your financial plan? At Pursuit Planning and Investments, LLC, I help you think through your options. I ultimately help you make the best decisions for yourself, your family, and your money. Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your goals and begin best optimizing your financial plan in that meeting.
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