The economy appears stable. The threat of recession appears to have lifted for now. Inflation is historically normal. The stock market is rising. What more could we want? It is times when conditions are good that it is important not to be complacent. Understand your risk, especially as stock market levels again reach all time highs.

The Economy

The Federal Reserve continues to unwind the residue of its previous policies. Its short-term federal funds rate dropped by 1/2% to 4.33% during the last quarter. The Fed has also been soaking up some of the excess liquidity that was generated in response to the pandemic, reducing its assets by $161B over the last three months while the nation’s money supply also decreased by $270B. This would normally slow down economic growth and the stock market, but the excess had been so great that money availability is still well above normal.

As the monetary environment normalizes, the economy itself can be characterized as stable, with a consistent 3.1% growth rate of GDP. Annual inflation is holding the 2.7% mark for now, aided by lower energy costs. Unemployment is unchanged at 4.2%. The services sector of the economy continues to expand while manufacturing remains slow.>

An unexpected effect of the recent short-term interest rate reduction was a rebound in long-term rates. It is as if the market is suggesting that the Fed’s policy shift may have been too early, potentially resulting in increased economic activity and a rekindling of inflation. The decrease in short-term rates and the increase in long-term rates finally caused the yield curve to no longer be inverted. In the past, this has been the point where recessions happen. An inverted yield curve has been a very reliable indicator of a coming recession. Time will tell whether this time was different.

The recent increase in long-term rates has also affected mortgage loans. The thirty-year fixed rate mortgage is now 6.85%, increasing .77% from last quarter. Not surprisingly housing became less affordable as well. Home prices are up 4.6% over the last year despite a decline of about 5% since their peak last June.

The Markets

The Magnificent 7 group of stocks came roaring back in the fourth quarter, out-gaining an “average” S&P 500 large company stock by 21.5%. This performance restores its rarified price/earnings ratio to about 50, compared to the P/E of an average stock in the S&P 500 of 19.8. Even this value is above the 20 year average P/E of the S&P 500 of 16.2, but much closer than that of the favored few.

Since October 1, an “average” S&P 500 stock lost 1.9% during what is typically the best quarter in the year. Bonds also resumed their lackluster ways by losing 4.4%. While the Magnificent 7 is in a world of its own, the performance of the remainder of stocks and bonds may be reflecting headwinds from changes in the Federal Reserve policy.

Deja Vu All Over Again

This phrase, attributable to NY Yankee Yogi Berra, seems to be appropriate to the current market. Once again, the Magnificent 7 is reaching new heights. Once again, speculation is rising as evidenced by interest in Bitcoin driving its price to over $108,000 each. Bitcoin has no intrinsic value other than possibly privacy or as a hedge against government monetary failure. Once again the S&P 500 is reaching or surpassing old peaks in market valuation.

One prominent measure of long-term market valuation, Robert Shiller’s Cyclically Adjusted P/E Ratio, is at the same level as it was in 2021 at the end of the prior bull run. It could go higher, but it is nevertheless in rarefied air. Likewise, the Market Value/GDP ratio, said to be Warren Buffet’s favorite indicator, is above the 2021 level.

These extreme measurements are influenced by the Magnificent 7 stocks, but that does not discount their importance. In 2000, the overvaluation was heavily influenced by the excessive P/Es of the “dot.com” internet stocks. In the late 1960s, it was the “Nifty 50” that affected the market P/E. Rather than minimizing the importance due to the high-flyers, it was the high-flyers that led the market down into deep and extended bear markets.

In the short to intermediate-term of several years, stock prices can rise or fall unpredictably. The level is based upon investor emotions, the degree of speculation, political, monetary and seasonal factors. These all have an influence and can appear to be almost random. But, long-term observation of the markets clearly shows that asset prices do not stay high forever. They may continue to rise for what seems to be an inordinately long time, but they eventually fall and reestablish the lower values in the range of normal long-term fluctuation.

Typical stock market returns are often quoted as 10% per year. This expectation is valid only if the current price is midway between historic highs and lows. If the current market price is less than average, over the long-term, future returns will likely be higher than the historical average. If prices are above the average, future returns will be less. Right now, prices are at the top of their historical range at almost 3 times the value of this long-term middle price, so future returns can be expected to be considerably less than average. John Hussman, a fund manager who works extensively to quantify these concepts, suggests that the return of the S&P 500 may actually be negative over the next 10 to 12 years.  This effect could be why the average stock has performed no better than Treasury Bills for the three years since 2021. A historically low return can occur in two different ways. There can either be a long period of lower than average annual returns, or there could be high volatility cyclical bull and bear markets that rise and fall dramatically, but go nowhere in the aggregate.

While both of these types of markets have occurred before, there are few investors today that are seriously considering what the possibilities are, having only been exposed to the unusually supportive Federal Reserve policies since 2009. Growing government debt and rising interest rates in the face of Fed easing suggests that there can be limits to that support. Eventually the laws of financial nature will take control. To the extent that the valuation levels are not able to be rectified by the market, it could be a continuing process of déjà vu all over again with a generally flat trend and moderate corrections like 2022 until the overvaluation is sufficiently corrected. One of the potentially unfortunate aspects of the government bail-out policy is that it has reduced the perception of investor risk, especially among new participants. The combination of automatic index fund investing and under-appreciation of risk could lead to a wipe-out of retirement savings that would be completely unexpected by many.

What does a person or family do to prepare for the future in this environment? It is a cardinal rule of finance to match an investment with when the money will be needed. If you know you will need cash in a year, then you buy a 1 year CD. If you are young and saving for a house in 10 years, perhaps a 10-year bond is appropriate. If you are saving for retirement in 40 years, an allocation to stocks is rational. Volatility risk is directly related to how long it takes to get your money back (“duration”). The longer the duration is, the higher the volatility risk is, and vice versa.

In this environment, younger people saving for retirement can withstand volatility risk, because they will not need the funds for many years. With a weak investment environment, they will continue to contribute and will take advantage of the lower prices that will eventually occur near the market average. This is not the case for those near retirement. It is important that they understand their risk exposure. Some retirement plan investors may be surprised when their target date funds are more volatile than they expected in a market downturn. Understanding and matching risk to one’s personal situation is likely to be more effective than trying to maximize returns over the long run.