LAST WEDNESDAY, the Federal Reserve’s policymaking committee concluded its quarterly meeting with two big announcements. First, the Fed is going to scale back its monthly purchases of Treasury securities. Because these multi-billion-dollar purchases have helped keep interest rates low, the Fed’s objective here is to let interest rates begin to rise. That was the first announcement.
The second is that the committee expects to raise its benchmark rate by nearly a full percentage point next year. Since the Fed usually raises rates in increments of a quarter-point, this implies at least three rate increases in 2022. This is a significant turnabout from the ultra-low-rate policy the Fed’s been pursuing since the pandemic started last year. Because other interest rates across the economy are indirectly tied to the Fed’s benchmark rate, the objective is to nudge rates higher.
Why the Fed’s sudden shift—which some have dubbed the Powell Pivot? In a word, inflation. Because higher rates make it more expensive for people to finance big purchases, they’re the government’s most effective tool in fighting inflation. Higher rates are intended to slow the economy. At the extreme, rate increases can even put the economy into recession. Result: Higher rates are generally bad for share prices.
How did the stock market react to Wednesday’s news? Contrary to intuition, all of the major market indices immediately moved higher. Why? One possible explanation is that investors were relieved to see the Fed finally taking action. For months, Fed Chair Jerome Powell had been maintaining that the current bout of inflation was “transitory.” But with mounting evidence to the contrary, investors had become skeptical and worried that the Fed was out of touch with reality. While higher rates aren’t great for stocks, taking action to raise rates was nonetheless received positively. That’s because it was a sign that the Fed was taking action to contain runaway inflation, which would have been far worse for stocks.
As a kid, I remember people joking about the notion of double reverse psychology. But in many ways, that seems to be the stock market’s specialty. Intuition might lead you to expect one result. But things often turn out differently. While it might seem maddening that the market often shifts in unexpected ways, it’s an important dynamic to understand. Indeed, there are other situations where the market can deliver results that run contrary to intuition.
For instance, with all of the talk about inflation, there’s been increased interest in Treasury Inflation-Protected Securities (TIPS). With both an inflation-protection guarantee and government backing, they seem like the ideal investment right now. If you looked at recent performance, it would appear to confirm that hypothesis. Over the past year, short-term TIPS have risen more than 5%—far more than comparable non-inflation-protected Treasury bonds, which have actually lost a fractional amount.
But here’s the problem: Past performance doesn’t guarantee future results. In this case, TIPS prices today already reflect an assumed inflation rate that’s much higher than it was a year ago. To gauge this assumption, investors consult a metric known as the breakeven rate. That’s the rate of inflation that’s implicitly priced into TIPS bonds.
At this time last year, that rate stood at 1.9%. Today, it’s 2.7%. This breakeven rate means that investors purchasing TIPS today are counting on inflation being 2.7% or higher. If it’s any lower than that, TIPS investors stand to lose money relative to conventional Treasury bonds. In other words, TIPS bonds were, in hindsight, a good deal a year ago, when no one was worried about inflation. But now that nearly everyone is worried about inflation, the most obvious defense against inflation is offering a much less effective defense.
The TIPS phenomenon is similar in many ways to the challenging nature of growth stocks. Consider Zoom Video Communications. When the pandemic first hit in February 2020, Zoom shares took off. Between March and October of last year, the stock rose 400%. But investors who bought in after that runup have seen the shares lose well over half of their value. While Zoom shares are still up more than 70% from March of last year, that isn’t much better than the S&P 500, which has gained 54% over the same period, but with far less volatility. And Zoom isn’t alone. Shares of Peloton Interactive, for example, have followed a nearly identical trajectory. Just like with TIPS, the problem is that a good investment can turn into a bad—or, at least, less good—investment once everyone starts paying attention to it.
The risk posed by growth stocks is well understood. Anyone who lived through the 1990s or similar crazes knows how these things usually turn out. But sometimes the trap is more subtle. Between 2005 and 2010, emerging markets stocks looked like a great investment. The BRICs—short for Brazil, Russia, India and China—were a favorite topic of conversation. Investors marveled at economic growth that was double or triple that of the U.S. With younger, faster-growing populations and export-oriented economies, they looked like a no-lose proposition.
But things didn’t turn out quite that way. Just like TIPS and Zoom and Peloton, these countries’ stocks were, as the saying goes, priced for perfection. That is, the share prices already reflected an assumption of continued strong economic growth. But to invoke another investment cliché, trees don’t grow to the sky. Growth in those countries slowed—and emerging markets stocks have vastly underperformed U.S. stocks over the past 10 years.
Another situation that can whipsaw investors: when the “smart money” appears to have spoken. I recall a situation several years ago in which a startup company was developing a medical therapy. The list of angel investors read like a Who’s Who of prominent physicians in that particular specialty. To laypeople, it looked like an ideal investment endorsed by a long list of experts. But things didn’t go as planned when the company tried to bring its product to market. The company is now close to shutting down.
It’s one thing when experts speak. It’s another thing entirely when experts in positions of power speak. That presents an even more treacherous trap for investors. Let’s come back to the Powell Pivot. Careful observers may notice that this week’s policy shift was hardly Powell’s first.
Back in 2015, the Fed had started a series of incremental rate increases. In its usual careful fashion, those increases continued steadily through 2019. Because the economy was strong and unemployment was low, those increases were expected to continue. The Fed had communicated that there was no apparent need to cut rates. And yet it happened. Whether it was due to political pressure or other reasons, Powell abruptly reversed course and began lowering rates. That was well before the pandemic, and few expected it.
An often-used expression in the investment world is that things are never as good or as bad as they seem. These examples, I think, help explain why that’s the case. Whether it’s TIPS or growth stocks or interest rates, investment markets are often like a hall of mirrors. Math, intuition and the opinions of experts and even policymakers often fail in their predictive abilities. And not only do they fail, but they often point in the opposite direction. The lesson: This is another reason I believe the best approach for investors is to combine two simple ingredients when building a portfolio: a large amount of diversification—and a minimal amount of fiddling.