Things have changed. You feel it. Everybody feels it. Something about the economy is not as it was.
It began during the pandemic. Financial markets and real estate practically levitated. And then prices ceased making sense. I still feel unmoored ordering in a restaurant. A side of broccoli costs $20? What’s in it?
What Do Government Inflation Statistics Say?
And yet, you might be surprised to learn that not only is inflation abating, but markets expect inflation to run at 2.17% over the next ten years, close to the Federal Reserve’s long term 2% objective.
Exhibit 1: The difference between regular and inflation protected bonds equals the market’s expectation for inflation. The intermediate term ‘Break Even’ rate of inflation has remained remarkably stable over the past 20 years. Shaded areas indicate U.S. recessions. Source: FRED Economic Data
So why in late October did the interest rate on 10 year treasury bonds flirt with 5% for the first time in 16 years? And I care because it caused mortgage rates to flirt with 8%? If inflation appears to have been tamed, why are long-term interest rates so high? And is that why the stock market has pulled back in late October?
Taking a Longer Market View
Exhibit 2: The rate on a traditional 30 year fixed rate mortgage approached 8% in late October. Shaded areas indicate U.S. recessions. Source: FRED Economic Data
People love stories. We have this tendency to see patterns where none exist. In the same way that our minds transform clouds into meaningful shapes, we also regard economic events as having meaningful connections where none may exist.
I could spin you some blarney about what’s going on and I could do it confidently. I have ideas. They don’t matter. Prognostication is a dismal endeavor.
In my portfolio, I only need one story. Global markets, over time, have had a remarkable record of wealth creation. And if anyone had simply owned everything in the world in roughly the proportions that it naturally existed, they got to enjoy the ride. No special insight was required.
That is a good thing. Market insight is futile. Economic ‘truths’, like persistently low interest rates, change in ways both sudden and unpredictable. As an investor, don’t even try to anticipate them. We don’t see evidence of portfolio managers who can outperform markets consistently over the long term through trying to identify when the market is wrong. Over long periods, it is diminishingly improbable.
Where Market Insights Help (and Don’t)
That said, the current economy is different in ways that can feel disorienting. But that is often the case. In that sense, it’s always the same. Change is the only constant.
It is not to say economists shouldn’t study markets and make predictions. Their insights inform business leaders and policy makers of risks. Risk appreciation lends itself to reasoned decision making.
But as an investor, divination is as futile as it is unnecessary. Instead, own it all. Be patient.
Even better, it does not mean that investors can’t beat markets over time. What? I just said that it is futile. Well, almost. At Abacus, we deviate slightly from the ‘own everything as it exists’ approach. We believe in value and small cap investing as well as a few other wonky strategies whose premises are all identical.
The shared premise is there are areas of the market that have persistently heightened risk. For example, small companies are riskier than larger ones. That is so intrinsically easy to grasp. Ask yourself, all other things being equal, is your job more secure at a large or a small company? As an investor, in a world of infinite options, a logical actor won’t take on more risk without an expectation of getting paid a premium to do so. Small companies will always be riskier. And investors won’t ever invest without demanding extra compensation for the risk. Fortunately, over long periods, risk has reliably been rewarded.
It is not a free lunch though. My confidence in this strategy pertains only to very long periods. I’m talking about decades. I have the humility to admit that our approach will have short and intermediate-term under performance. All approaches do.
What Happens When You Switch Investment Approaches?
Switching approaches introduces an especially pernicious possibility. There are so many approaches to equity investing: large versus small, growth versus value, domestic versus global, active versus passive. Instead of sticking to a set of preferences and doing 1% to 2% better or worse than markets over time, switching between approaches introduces the possibility of flaming out. Instead of experiencing something between adequate or great, you introduce the possibility of doing quite poorly.
The usual story is that the investor grows frustrated by what hasn’t worked and shifts to alternatives. Call it FOMO. Investors move to what hasn’t worked to what has been working at just the moment fortunes reverse.
So, yes, things have changed in the economy. You are not imagining it. But it is only different in respect to the specific surprise of the moment – interest rates. Surprises are expected. It is the type, size, direction, and timing of surprises that is unexpected.
If you are curious about what Abacus’s approach to long-term investing might mean for your financial life, reach out to schedule a call with an advisor today.