It cuts both ways. It was the mantra for years since the end of the Great Financial Crisis (GFC). Don’t fight the Fed. It worked brilliantly for years when the fight was pointing definitively in one direction. Now that the tide has decisively turned, investors should not suddenly forget the refrain that served them so well.
Don’t fight the Fed: dovish edition. It was the relentless tailwind at the back of investors for most of the last thirteen years. In order to overcome the GFC, the U.S. Federal Reserve lowered interest rates to 0% and plunged into once extraordinary Quantitative Easing, where the Fed went out and began buying various riskier assets such as longer term U.S. Treasuries, mortgage backed securities (MBS), and even some of the financial detritus left behind by certain financial firms that got out so far over their risk management skis that they nearly collapsed the global financial system. In short, the Fed was as easy, dovish, accommodative as they could possibly ever be.
Don’t fight the Fed! On one side of the monetary policy coin, if the U.S. Federal Reserve is engaged in easier monetary policy that includes lower interest rates and large scale asset purchases, particularly in a chronically disinflationary/deflationary pricing environment, not fighting the Fed means taking on greater risk and accumulating risk assets. This includes buying stocks and other correlated securities like high yield bonds regardless of the valuation or loan covenants (or lack thereof). And buy investors did throughout most of the 2010s (save some short stints of breath-taking volatility including the spring of 2010, the summer/fall of 2011, mid-2015 to early 2016, and 2018 Q4) and buy even more in the immediate aftermath of the COVID outbreak from April 2020 through the end of 2021.
A couple of key characteristics defined this extended stretch.
Good news was good news. This is because it meant the long anticipated sustained economic recovery was finally getting underway, bringing with it the robust earnings growth that would justify steadily increasing valuations. If it was the first half of the year, so it was said that the sustained economic recovery was coming in the second half of the year. If it was the second half of the year, the sustained recovery was coming with the start of the New Year. The sustained recovery was always right around the corner. Except it never came in any meaningful way. Which leads us to the next key characteristic.
Bad news was good news. This is because it meant that if the economy or the markets stumbled in any meaningful way, even if it was a handful of percentage points on the S&P 500 over a series of weeks, that the Fed would come rushing in with “whatever it takes” to restore and maintain supposedly fragile market confidence. Heaven forbid anyone experience loss anymore, the Fed was here to help.
This fostered an environment where investors could buy their favorite stock themes regardless of their valuation, thus fueling a boom in the more aggressive segments of the growth style including momentum and growth at any price strategies. It also encouraged investors to pursue their favorite sexy stock themes regardless of the financial health, operational performance, or profitability of the company in question.
For example, who cares about Tesla’s dubious financials and its CEO that mouths off on Twitter about among other things considering taking his company private at $420 with funding secured ($420, really. . .)? He’s making cool stuff!
Thus, as long as inflationary pressures remained in check and the Fed had the flexibility to keep interest rates historically low if not pinned at 0%, not fighting the Fed meant buying stocks and other related risk assets regardless of how well or lousy the economy and corporate profitability was going at any given point in time. In fact, as long as growth remained anemic, it encouraged companies that might otherwise deploy free cash flow…
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