I wanted to provide a little update on investing in what I like to call the "age of repression." In this blog, we will delve into some key economic indicators and discuss the implications for asset allocation.
First and foremost, the rapid rise in interest rates, driven primarily by inflation and the Federal Reserve's response, is the key factor underpinning all investment decisions. We have seen one of the quickest increases in interest rates in history. While rates have been higher, they’ve never gone up as quickly in percentage terms. When rates go up, asset values go down. I believe we are in what is just the early stage of a much larger devaluation.
I have been closely following a model developed by Piper Sandler, which explains how the economy responds to interest rates. Milton Friedman famously said, "Monetary policy has long and variable lags," meaning it takes time for the effects of monetary policy to be felt across the economy.
Piper Sandler's "HOPE" model outlines their view on how those variable lags show themselves in the economy. The slowdown starts with housing, moves to orders, then to profits, and only in the last stage does it impact employment or unemployment. The entire process takes about 24 months.
As of now, we are just over a year into this cycle, and we have observed some interesting trends. The housing market saw a significant rise in prices during and immediately after the pandemic, but prices seem to be leveling off having peaked in April 2022. While prices have declined moderately, the end result seems to be that the market has locked up, with prices neither collapsing nor skyrocketing.
Long term we expect housing prices to align with rent increases closely. The chart below shows that housing prices escalated before the great financial crisis and then quickly collapsed to the long-term rent increase trend. Post-pandemic we have only seen a modest convergence even as rent growth has accelerated.
We see a similar dynamic with stocks. In the chart below of the S&P 500, we did have a sharp downturn after a peak in early 2022. Since then, the market has been flat trading up and down in a narrow range. In fact, if we zoom out, stocks are essentially in the same place they were 2 years ago. Again we see modest decreases but it feels the market hasn’t fully come to terms with rising interest rates. We can see similar trends in orders and profits. They have peaked and come down slightly.
I’m watching one final indicator to know when things are breaking called the high yield spread. This is the spread between the base SOFR rate and what riskier companies need to pay to borrow. Traditionally when the spread goes above about 8-10% or so, stocks are going to nose dive and we are in a recession. It isn’t perfect. Stocks are usually already losing ground as it starts rising but it gave pretty good indications before massive drawdowns. Right now the spread is below 5 so nothing looks imminent.
Welcome to the Grind
Eventually, we will have a recession and that will help to deflate asset values but I don’t think the HOPE model or the high yield spread shows that it has arrived. My conclusion is that we are likely stuck in a sideways market for most asset classes for the next 6-12 months. If rates and inflation stay high as I expect them to that means asset values will erode against inflation. That can be a long and grinding process.
Remember, I am not an investment advisor so do your own research but I’m sticking to short-term treasuries for any new capital and keeping stock risk to a minimum. I’m not out of the market entirely but my equity allocation is down by 1/3-1/2. I’m also staying away from real estate investments for now.
Unfortunately, I believe that the longer this sideways market goes, the longer the Fed has to keep interest rates elevated and the longer the Fed has to keep interest rates elevated, the greater the chances of a more severe recession when it comes.
In summary, investing in the age of repression is mostly about sitting around and waiting, with lots of volatility but little actual change. That’s a grind. Keep an eye on the indicators and prepare for the potential impacts of a recession. I'll be sure to keep you updated on any developments and implications for investment strategies in the future. Stay tuned!
Note: I fed three older blogs into ChatGPT and told it to analyze them and then imitate my writing style. I then cut and pasted the transcript from the video into that prompt chain and ask ChatGPT to turn it into a blog. I did edit the result but ChatGPT gave me a 75% solution. Oh, brave new world that has such technologies in’t. What do you think?