Concerns about bond and stock collapses will intensify. The cause is rising interest rates – the key determinant of both bond and stock valuations.
However, there is good news. When interest rates approach their true levels, as determined by the capital market, the bond and equity markets will reach solid foundations. Investment analysis and strategies are also becoming more informed as the currently ingrained low-interest version of thinking, evaluating and forecasting is finally overturned.
Call this shift a return reality capitalism and capital markets.
Note: I explain the dynamics in “Investors: Federal Reserve inflation fight moves from ‘passive’ to ‘active’ Tightening – Powell’s promised pain”
Why are today’s cheaper equity and bond markets unattractive?
Because these three perspectives on the markets will change and make the current prices too high:
Think – That the Federal Reserve’s interest rate setting is capitalism at work and that it is an investor’s best friend
Appreciation – This investor demand alone determines the valuations
forecast – The future growth of some (earnings, sales, assets, customers, patents, etc.) is at the heart of a stock’s appeal
Think Currently being revised as the Fed fights inflation and ends its protracted low interest rate policy. The overhaul will be complete when the Fed achieves its new, obvious targets: a short-term interest rate of around 6% and an inflation rate of around 4%.
(Note: while 2% inflation remains the stated end goal, the Federal Reserve is likely to pause if the 4% [perhaps 5%] level is reached. If the economy has slowed noticeably by then, the Fed could allow conditions to calm down.)
Appreciation on the basis of classic methodology will again replace wishful thinking and clever-sounding schemes. Valuation is the discounting of projected financials, particularly payments to investors. And that discounting will be based on higher interest rates to come. (That is, if interest rates rise, the valuations of future payments will fall.)
forecast will take a more realistic stance and diminish visions built on exciting but unlikely or highly uncertain possibilities.
Several characters show the movement
Now here: Trimmed expansion and hiring plans. Redundancies. closures. Reduction. Management restructuring. debt reduction. Focus on capital expenditures vs. share buybacks.
Soon: Refocused Strategies. acquisitions. consolidations. spin-offs. disposals. bankruptcies.
These changes and reversals from a year ago are healthy steps to laying a solid foundation for the future. They are also the ingredients for great upheaval, especially on Wall Street.
Wall Street as catalyst and signpost
Wall Street firms that are already cutting back will reinvent themselves. The highly competitive world of finance is always quick to ditch what’s not working and adopt new winning strategies, even if it means turning things on their head
Most importantly, once Wall Street changes, it becomes a driving force for market analysis and action; corporate structuring and strategies; analysis models for evaluation and forecasting; economic and financial prospects and probabilities.
Avoid unreliable sources of information during this time
Most media business and investment reports come from reporters who lack the experience, knowledge and insight to understand major changes. Instead, the coverage is based on simplistic, dramatic – but meaningless – observations like “the worst in twenty years”.
Website-dependent investors use here-and-now jabber to find potentially superior stock returns. They expect quick action from “enlightened” high-return investors who focus on the newest and brightest ideas. The problem is that their confidence is built on fleeting success hubris (pride, arrogance). The latter driver is not new – and not durable either. It always dies out completely with the fad that created it. (And that’s where the speculative craze of 2021 is right now – in its final stages.) This exciting way of investing will return some time later, but in an entirely different form, as a new speculative spirit collides with a new, exciting fad.
Bottom Line: Be optimistic, but take a conservative, realistic approach to investing
Conservative means ensuring that you receive a return (or probable potential return) that is commensurate with the risk taken and that the risk is reasonable for you personally. (Most importantly, this means you don’t always have to be fully invested. Cash reserves are a perfectly acceptable investment, especially now that they can generate a decent return.
Realistic means not expecting anything like a Fed pivot (rate cut) or a return to speculation in 2021 to push stock and bond prices back higher. Being realistic means accepting that both stocks and bonds are trending downwards. Therefore, be careful with investments that depend on capital gains – an increasing price.
For bonds, don’t compare 4% to last year’s 0.25%. This low rate (and the many others over the past fourteen years) is so unusual that it will not be repeated for years (decades?) to come. Instead, focus on past interest rate levels, determined by capital markets (and common sense) for decades. These rates were at least as high as inflation (to compensate for the currency’s loss of purchasing power), but were often higher.
Imagine you earn a real (Inflation Adjusted) Return by Holding a 3 Month Treasury Bill or Money Market Fund. That day is coming, but interest rates must continue to rise (4.5% expected in December). The best strategy therefore seems to be to stick with money market investments and at the same time expect higher interest rates and falling inflation rates again.
Disclosure: The author is fully invested in money market investments