My dad passed along a note from his wealth advisor about the current investing environment, and I thought I would share my response to him right here as well. I was feeling a bit fiery.
The [wealth advisor] thoughts are probably a great summary of market consensus, which is not a particularly helpful way of looking at things…and sometimes leads to disastrous investment outcomes.
[The wealth advisor mentioned the 10yr rate as suggesting the market was expecting inflation to recede.]
First of all, the bond market does not signal anything anymore. It is not a market price. It is an artificial price set by the federal reserve (also known as the largest buyer of bonds). So you can glean nothing from that interest rate.
Interestingly, the federal reserve is openly saying that they are going to “normalize” monetary policy to cool inflation. Let’s look at this scenario.
If we assume that inflation recedes to a consistent, say, 3% over the next two years, then that would suggest a “normal” 10 year treasury yield of maybe 5% (that is my conservative number, the reality could be far higher). The 10yr treasury yield is currently 1.8%. If the federal reserve stops buying bonds (and potentially starts selling them to reduce their balance sheet), it seems plausible (if not probable) that the 10yr will begin to move towards fair value (5%).
What does [wealth advisor] think will happen to growth stocks over the next 2 years if the 10yr yield increases by >300bps?!?
I just ran that scenario in my model: assuming strong earnings growth (10% annualized) and the 10yr rate at 5% -> the S&P500 will decline by 35% over the next 2 years.
By continuing to favor growth stocks, [the wealth advisor] is implying that either: the federal reserve is not going to (attempt to) normalize monetary policy, or inflation is going to drop to pre-covid levels (sub 2%) and remain there. If you believe the former then gold is the clear bet, and if you believe the latter, well, it is possible but I would love to play poker against you.
Now the scenario I described assumes the Fed normalizes monetary policy AND inflation comes down. This doesn’t account for the part of the probability distribution where inflation settles at a consistently higher number like 4 or 5%, and I won’t even start on the non-trivial possibility that inflation settles in the high single digits for multiple years. If the higher inflation scenarios play out, gold will double or stocks will drop 50%, or potentially both.
The point is: in the base case growth stocks and fixed income are BOTH poor investments. And in my opinion the risks of inflation surprising to the upside are far greater than the risks of inflation surprising to the downside – i.e. the expected value of owning fixed income or growth stocks is even worse than the base case.
[The wealth advisor] mentions favoring growth stocks over fixed income. This is a false choice. Most wealth managers seem to be overlooking the likelihood that in the next down-cycle (whenever it may come), stocks and bonds will go down together, which has not been the case since the stagflationary 70s.
So how are you supposed to position in this macro environment? It is exceedingly tricky, but the only things that are very clear in my mind:
- You should minimize equity exposure barring idiosyncratic bets/themes. In general the outlook for stocks is BAD.
- You should have 0 fixed income exposure, and potentially should be very short fixed income.
- You may want gold exposure, but probably as part of a portfolio that is short fixed income.
- Real estate and commodity exposure is probably ok, but given price increases those investments are really dependent on the idiosyncratic situations.
Noah's (Life) Ark 