Some interesting longer-term financial perspective

October 14, 2022

Today I want to give you some context. Market whiplash continues. So let's step back and try to look at the longer picture.

Unless you've been in a cave-based sleep experiment, you know that interest rates are going up. Here is the Federal Funds Rate over 62 years:

Source: Macrotrends 10/14/22

Two things to note. First, the slope of the current line up is steep. That's like "Front four at Stowe" steep. Because of the slope, the chance of an interest-rate hike overshoot is real; it takes businesses and consumers months to react to these changes, and by then, new changes in rates are afoot. Setting interest rates is like steering a supertanker.

Second, the market currently expects that rates will top out at 4.6% or so. They may well go higher, and predictions are often, if not generally, wrong here. But let's go with 4.6% for now. Where does that put us? Oh, about average since 1950. It's probably a good thing to get back to normal. Having to pay money for capital is not the worst idea in the world. It mutes euphoria and it wipes out lots of bad business ideas, like selling couches online or having drivers deliver Chapstick from the grocery store.

So rates are going up. How is the market responding? If you are a buyer of securities and anticipating the future, really well from your point of view - it's been dropping and allowing you to buy a lot more product on sale, and that product is creating higher cash flows in 2022. While that view affects many people, it's not the classic view, because almost everyone "drives while looking through the rear view mirror." The rear-view mirror view is also the correct view for someone who is divesting securities in retirement for cash to live.

If we look at the classic 60% stocks / 40% bonds portfolio (note that the graph below is *not* a One Day In July strategy), how is performance this year relative to the past century? Well, we're in the running for bottom three. So invert that three-person champions podium you see at track meets, and crawl under it, and we're there. Next, you have to knock out 1931, as the economy was in a deflationary spiral then and we're in an inflationary spiral now, so the real returns now are lower than those of that second full year of the Great Depression. That puts us pretty much tied for the worst year in a century, or more than three standard deviations from average.

This is not your weatherman speaking, with the "storm of the century" occurring every few months. This is actually the storm of the century:

Source: WSJ 10/7/22

Well I hope that brightened your day. The good news is that if you survived 2022 without going to cash or annuities, you'll probably make it as an investor long-term. And, if you look at the bad years on the graph, historically the follow years have been quite pleasing.

Okay. Okay! It's Friday and you want some more positive. Let's look at the price/earnings ratios of small-cap stocks. This is a forward P/E ratio, so it predicts earnings over the next year, which could change:

Click here and look at the bottom graph on the 3rd page (named Page 1)

Note that the ratio is now at quarter-century lows, matched only by the depths of the 2008-2009 financial crisis. Should the earnings hold up, this implies buyers are getting value. The "margin of safety" in buying in this asset class has improved. Looking forward this is good news.

Have a nice fall weekend,

Dan Cunningham