Jan 14, 2023: The Consequences of Ever-Changing Government Policy The Federal Reserve has raised the return expectation this year. The risk-free rate is fast approaching 4.50%. It will likely move to as high as 5% in the next few months. For those who own more individual stocks or equity ETFs, the return expectations will have a wider dispersion of potential return or potential loss due to the uncertainty created from higher interest rates.
Last year, growth investors learned that valuations ultimately matter in the end. The Fed popped the speculative bubble by raising interest rates at the fastest pace in history. Stocks that have stable cash flows and can raise prices without hurting demand have had the highest returns over the last year. Berkshire Hathaway, which is widely held in client portfolios, had a positive return last year, despite the average stock falling over -20%. This year, these more value oriented stocks that are “cash cows” have a higher bar to beat the risk-free return. For example, in order for Berkshire to beat the 4.5% risk-free rate, the stock price would have to appreciate from $317 to $333 at some point this year. With all the weekly market volatility ranging from 2%-3% and as high as 5% during earnings season, it’s possible to happen in only a week.
The government has created market instability by changing market incentives and constantly changing return expectations. If you buy a car, house, or stock this year, it’s possible to lose over 15% overnight. However, there has never been a better time to capitalize on falling assets since the housing crisis in 2009. Yesterday the entire automotive world was upended by Tesla when they dropped prices -20% for the Model Y and -14% for the Model 3 in order for those vehicles to qualify for as much as $7,500 electric vehicle tax credits. The Treasury Department and Internal Revenue Service released guidelines late last year that irritated Musk because the Model Y didn’t weigh enough to be deemed an SUV. The vehicle was subject to the $55,000 price cap that applies to sedans, rather than the $80,000 limit for SUVs. The price difference made no sense because if someone buys a Jeep Wrangler with 56 MPGe (23 MPG after the battery is depleted) instead of a Tesla Model Y with 122 MPGe, then the government clearly isn’t doing the most it can to reduce carbon emissions. Musk tried to lobby the government to change but to no avail, so he was forced to cut prices. The broad impact is that if you own a newer car the price will likely depreciate faster than you expected for gas or electric. For example, a Toyota Highlander is now more expensive than a Model Y. After the price drop the Model 3 is priced at $44k, which is now competitive with many other vehicles. GM and F will not be able to compete with the scale that Tesla produces electric cars. Tesla is fast becoming the Amazon of the car industry. They have built bigger factories and can produce more cars at lower margins. The way Wall Street works is that it cares more about market share and revenue than profits. I can’t guarantee much in this business but if there is one thing for certain the rules will change again. The government might have to throw a lifeline to the less efficient car manufacturers so that more cars qualify for the 7,500 tax credit.
The good news is that the price of new and used cars is falling, which could help to lower inflation. Used car prices have already fallen over 10% and now the dealers will have a harder time selling cars over sticker price. There are also other unintended consequences of poor government policy. One of the most obvious is the interest expense on US public debt, which rose to $775 billion over the past year and is at a record high. If it continues to increase at the current pace, it will soon be the largest line item in the Federal budget, surpassing Social Security. Everyone knows that the Fed will not be able to keep interest rates this high for very long because these costs will all add up over time.
There are many industries benefiting from higher interest rates. Banks are still making record profits as they have been slow to raise deposit rates. If you have money in the bank, you could be doing better by earning over 4% in risk-free US Treasuries. Yesterday, Bank of America and JPMorgan beat profit expectations, but at the same time, warned of a mild recession by mid-year. They are setting aside more profit to pay for higher loan losses. This year, it’s best to approach portfolio construction and risk management similarly to how Jamie Dimon and Brian Moynihan are managing trillions of dollars. They are preparing for the worst, but not eliminating all risk. A portion of the portfolio is invested in risk-free assets earning 4-5%. This pool of money will be used to buy underpriced stocks if the market falls like Tesla cars just did overnight. Another part of the portfolio is invested in high cash flow businesses that have a history of performing well over time. Additionally, portfolios are hedged in longer-term bonds because bonds could outperform stocks if there is a recession and interest rates fall. Investment-grade bonds have the potential to earn over 10% this year if there is bad economic data and unemployment rates increase or inflation falls.
The surprise this week came when JPMorgan Chase CEO Jamie Dimon backed off of comments he made in June when he warned of a coming economic “hurricane.” On Thursday, he said, “I shouldn’t have ever used the word ‘hurricane’.” As I recall, that warning helped to cause an immediate drop in the market last year. In my opinion, he should be more cautious when talking about possible future market crashes. However, he is entitled to change his opinion in this fast-moving market. I expect there will be more apologies coming from the Fed if more people lose their jobs. The fate of this market is in the hands of the Fed and how far they raise rates. Inflation data shows that prices are falling and there is a glimmer of hope that the economy can avoid a deep recession if the Fed stops short of 5%. I’ve mentioned this threshold level in other posts as the possible tipping point for the economy. This is why a diversified portfolio in stocks and bonds continues to be the best approach this year.
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The Federal Reserve has raised the return expectation this year. The risk-free rate is fast approaching 4.50%. It will likely move to as high as 5% in the next few months. For those who own more individual stocks or equity ETFs, the return expectations will have a wider dispersion of potential return or potential loss due to the uncertainty created from higher interest rates.
Last year, growth investors learned that valuations ultimately matter in the end. The Fed popped the speculative bubble by raising interest rates at the fastest pace in history. Stocks that have stable cash flows and can raise prices without hurting demand have had the highest returns over the last year. Berkshire Hathaway, which is widely held in client portfolios, had a positive return last year, despite the average stock falling over -20%. This year, these more value oriented stocks that are “cash cows” have a higher bar to beat the risk-free return. For example, in order for Berkshire to beat the 4.5% risk-free rate, the stock price would have to appreciate from $317 to $333 at some point this year. With all the weekly market volatility ranging from 2%-3% and as high as 5% during earnings season, it’s possible to happen in only a week.
The government has created market instability by changing market incentives and constantly changing return expectations. If you buy a car, house, or stock this year, it’s possible to lose over 15% overnight. However, there has never been a better time to capitalize on falling assets since the housing crisis in 2009. Yesterday the entire automotive world was upended by Tesla when they dropped prices -20% for the Model Y and -14% for the Model 3 in order for those vehicles to qualify for as much as $7,500 electric vehicle tax credits. The Treasury Department and Internal Revenue Service released guidelines late last year that irritated Musk because the Model Y didn’t weigh enough to be deemed an SUV. The vehicle was subject to the $55,000 price cap that applies to sedans, rather than the $80,000 limit for SUVs. The price difference made no sense because if someone buys a Jeep Wrangler with 56 MPGe (23 MPG after the battery is depleted) instead of a Tesla Model Y with 122 MPGe, then the government clearly isn’t doing the most it can to reduce carbon emissions. Musk tried to lobby the government to change but to no avail, so he was forced to cut prices. The broad impact is that if you own a newer car the price will likely depreciate faster than you expected for gas or electric. For example, a Toyota Highlander is now more expensive than a Model Y. After the price drop the Model 3 is priced at $44k, which is now competitive with many other vehicles. GM and F will not be able to compete with the scale that Tesla produces electric cars. Tesla is fast becoming the Amazon of the car industry. They have built bigger factories and can produce more cars at lower margins. The way Wall Street works is that it cares more about market share and revenue than profits. I can’t guarantee much in this business but if there is one thing for certain the rules will change again. The government might have to throw a lifeline to the less efficient car manufacturers so that more cars qualify for the 7,500 tax credit.
The good news is that the price of new and used cars is falling, which could help to lower inflation. Used car prices have already fallen over 10% and now the dealers will have a harder time selling cars over sticker price. There are also other unintended consequences of poor government policy. One of the most obvious is the interest expense on US public debt, which rose to $775 billion over the past year and is at a record high. If it continues to increase at the current pace, it will soon be the largest line item in the Federal budget, surpassing Social Security. Everyone knows that the Fed will not be able to keep interest rates this high for very long because these costs will all add up over time.
There are many industries benefiting from higher interest rates. Banks are still making record profits as they have been slow to raise deposit rates. If you have money in the bank, you could be doing better by earning over 4% in risk-free US Treasuries. Yesterday, Bank of America and JPMorgan beat profit expectations, but at the same time, warned of a mild recession by mid-year. They are setting aside more profit to pay for higher loan losses. This year, it’s best to approach portfolio construction and risk management similarly to how Jamie Dimon and Brian Moynihan are managing trillions of dollars. They are preparing for the worst, but not eliminating all risk. A portion of the portfolio is invested in risk-free assets earning 4-5%. This pool of money will be used to buy underpriced stocks if the market falls like Tesla cars just did overnight. Another part of the portfolio is invested in high cash flow businesses that have a history of performing well over time. Additionally, portfolios are hedged in longer-term bonds because bonds could outperform stocks if there is a recession and interest rates fall. Investment-grade bonds have the potential to earn over 10% this year if there is bad economic data and unemployment rates increase or inflation falls.
The surprise this week came when JPMorgan Chase CEO Jamie Dimon backed off of comments he made in June when he warned of a coming economic “hurricane.” On Thursday, he said, “I shouldn’t have ever used the word ‘hurricane’.” As I recall, that warning helped to cause an immediate drop in the market last year. In my opinion, he should be more cautious when talking about possible future market crashes. However, he is entitled to change his opinion in this fast-moving market. I expect there will be more apologies coming from the Fed if more people lose their jobs. The fate of this market is in the hands of the Fed and how far they raise rates. Inflation data shows that prices are falling and there is a glimmer of hope that the economy can avoid a deep recession if the Fed stops short of 5%. I’ve mentioned this threshold level in other posts as the possible tipping point for the economy. This is why a diversified portfolio in stocks and bonds continues to be the best approach this year.