In the early spring of 2022, Fed Chairman Jerome Powell made public comments that he would be halting the Fed’s Quantitative Easing (QE) program along with releasing the Fed’s hold on the 0% Fed Funds rate. That was our signal to lower the risk profiles of our client’ accounts as the Fed were going to “remove the punchbowl from the party”. The damage of an artificial 0% interest rate forced many Americans into more risky assets and to to take on more debt as it was essentially “free”. The Federal Reserve’s balance sheet (QE) ballooned from $4.1 trillion in 2020 to more than $$8.96 trillion at it's highest in March of 2022. 95% of the balance consists of 2/3 U.S. treasuries purchased from the market and the remaining 1/3 being mortgages. Purchasing these securities forced 10 yr. rates to .56% in early 2020 and 30 yr. mortgage rates to a wonderful 2.75% in early 2021. Of course, encouraging an economic orgy in the stock market and real estate market will eventually lead to a terrible hangover.
I believe the party has ended and the hangover is about to begin. The party has lingered due to the Fed bailing out several banks in early 2023 with more borrowed funds. Unfortunately, the appetite for future bailouts seems limited in the Fed’s eyes. More banks are facing losses on their books which contain long dated treasuries and mortgage assets purchased at those insane interest rates of of two years ago. With the 10 year treasury rising over 1% to 4.3% in the last 4 months and the 30 year mortgage hitting 7.23% last week, banks are writing down their investments at a historic pace. Adding to banks pain, their commercial real estate investment losses have been exacerbated by corporations’ response to Covid with many office buildings remaining less than 60% occupied.
Stocks remain overvalued in our opinion. The Schiller P/E (Price/Earnings) ratio of the S&P 500 is still undoubtedly overvalued at 30.53. For context, while it has dropped from its high two years ago of 37.5, the only two prior marks that were higher were during the 2000 Tech Bubble and the 1929 Crash. Its historic average is 17. With rising costs of labor and a slowdown by consumers, the earnings of companies are feeling pressure, making these valuations much worse.
In the past 22 years, we have seen our government react to economic slowdowns with brute force, pumping over $8 trillion of new money into our markets and unnaturally forcing interest rates to near 0% several times. As we have just seen massive inflation that has been stubborn to die, and a federal deficit that has grown to $32 trillion, we can now expect the Treasuries cost of debt to be over $1 trillion at the end of this fiscal year. In 2020, the U.S debt service was only $338 billion. Where will Congress get the funds to pay this unexpected expense? We are not expecting the Fed to come to the rescue this time. We are already expecting a fall budget fight in Congress and with an election year coming, neither side may want to budge going into primary season.
We maintain our extremely cautious outlook and are working to protect client assets for the time being. When Fed Chairman Powell warned of his intended path to defeat inflation, he mentioned the word “pain” 19 times in his speech. We have not felt pain, YET.
In order to garner historical returns in the stock market, we feel we need to find a more attractive entry point in which to recommend clients’ take on more risk. The “hangover” should get us to this point, but as they say, “patience is a virtue”. Our goal at Black Diamond Financial Solutions is to help clients maintain a comfortable lifestyle throughout their retirement. The lessons we learned from 2001 and 2008 have led to our current cautious approach. When an investor loses 50% of their portfolio, a rebound of 50% does not make them whole, they now need a 100% return just to breakeven. Taking the gains from an inflated two year time unmatched in history is prudent, but don’t be too anxious to give it all back.
