Looking Ahead at the Fed

Photographer: Ron Bennett, HUD

When markets collapse, I find it pretty easy to write another email to you.  The bad news of the day poses a problem which interferes temporarily with the growth of our economy, and I usually have little difficulty explaining it away as a temporary aberration and giving you reassurance that conditions will improve in the future.  I like doing that because the market recovers every time.  I feel smart.  Fears of a big crash almost always greatly exceed reality.  It's an easy call to make.

When markets appreciate, I write less often.  For one thing, it's not really news.  The system is supposed to work this way.  We expect earnings to grow in perpetuity, and for the stock market to appreciate roughly in unison.  For another thing, markets react to bad news, but they often move up prematurely, in anticipation of good news.  I find the good news difficult to guess in advance.  I know that you're not bothered to see your portfolios rise in value, so I often skip these emails, thinking you will not miss them, rather than make things up.

But today, and against my own better judgment, I'll try.  The first rule of guessing the direction of the market is: "Don't fight the Fed."  If the Fed raises rates or keeps them high for a prolonged period of time, then we may expect the growth of corporate earnings to slow down, even to decline, and the stock market to slow down with it.  When the Fed moves to ease, then markets usually rally.

I think that the market has gone up in expectation of lower rates in the future, and that we are on the cusp of such an easing by the Fed.  Right now, we have some of the highest real rates since 2008.  Inflation has moderated but rates haven't really budged.  Investors expect the Fed to ease, perhaps as early as September, certainly by next May, when Jerome Powell's term as Fed Chairman expires.  The stock market is getting a head start on that.

If I'm correct about this, then real estate will go up too, and for the same reason.  Buy your next home now.  High rates act as a significant barrier to home ownership, and they slow investment in property.  In the regions which I follow, real estate has appreciated slowly or not at all for several years.  Low rates will pour gas on this fire.

Neither stocks nor real estate look especially cheap right now.  The P/E ratio on the S&P 500 has been higher than  it is right now for just a few periods in history, and real estate, even if it hasn't gone up much in the last few years, hasn't gone down either, at least not on the coasts.  Neither asset class looks especially cheap.  I'm aware of these counter indicators.  They suggest the danger of a crash or other significant decline, perhaps in October, the market's favorite month to crash, if I'm wrong about the Fed easing rates.

But the last rule of guessing the direction of the market is also: "Don't fight the Fed."  Lower interest rates have a magical effect of boosting optimism, which I find conspicuously lacking right now, and stimulating growth.  Everything else, concerning valuations, or tariffs, or budgets, or midterm elections, or what Trump had for breakfast, pale in comparison to rates.  To be honest, on current evidence, I don't think that the Fed has much choice but to ease, which is why I feel emboldened to give you this analysis and make this prediction.