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The Resonant Review: Easy money pullback on horizon?

December 3rd, 2021

Rodney danger

The 1986 comedy classic "Back To School" contains a scene (link) where the age-inappropriate lead character played by Rodney Dangerfield throws what's described as “the greatest party of all time.” In a scene where an exuberant attendee gets sick in the dormitory yard, the police arrive. They are there, presumably, to shut down the revelry, but instead they deliver more beer to keep the party going. Most of the movie was filmed on the UW-Madison campus, as seen in the photo of Dangerfield at the top of Bascom Hill at left.

Our office full of UW graduates and Madison residents recall this movie well, and the scene noted above has come to mind recently. Domestic and international fiscal and monetary authorities responsible for "end(ing) the party" have fueled it further with accommodative policies that are having a variety of effects. These interventions feel good today but will likely generate sickness this evening and a hangover tomorrow.

In our quarterly letter we referred to this low interest rate, high-valuation environment as “the everything bubble,” reflecting excess speculation across many asset classes fueled by cheap credit and cash stimulus. As a result, year-over-year inflation has surged to 6%, well above the Fed’s stated long-term target of 2%.

But perhaps change is now coming. This past week, Federal Reserve Chairman Jerome Powell, newly re-nominated and so relatively immune to political pressure, made news on two fronts. First, in prepared remarks he noted the Fed’s discussion of the possibility it will accelerate the pace of reduction in its asset-purchase program. Second, he suggested that it may be time to retire the word “transitory” when describing inflationary pressures. The latter comment was quickly and relatively strongly reinforced by Treasury Secretary Janet Yellen and markets have struggled to digest the change in tone if not actual policy from their “police officers”.

In addition to the shift from the Fed and Treasury, investors are also dealing with the emergence of a new COVID variant, Omicron, which was identified in late November in South Africa. Markets turned volatile on this news, coupled with the Fed's revelations, selling off this week as resulting supply chain disruptions and fears of additional shutdowns could increase inflation pressures as well. Scientific data on the new variant is not yet well-understood, though if it behaves as it appears to (more transmissible but less virulent), it would be following historical tracks of prior virus-driven pandemics that become endemic.

Despite near-term volatility due, we feel that a balanced approach remains sensible. Until the Fed withdraws its accommodative policies and we "learn to live with the virus" we are likely to continue to see market fluctuations. We continue to favor stocks over bonds, and see value in small and mid-cap companies relative to their larger brethren. Companies that generate free cash flow and allocate it efficiently and effectively never go completely out of style, and we continue to seek out investments and management teams with those characteristics. We remain guarded on bonds in the face of potentially-rising rates and high(er) inflation. We are similarly-dubious of companies with high price-to-earnings ratios and/or no-or-low earnings, given the risk that higher interest rates could bring to their high stock prices.

When Dangerfield's character first arrives on campus to attend class with his son, he tells his Dad his first college class the next day will be economics. No good, Dangerfield says, as he has a massage scheduled at that time, so they'll need to reschedule. Our fiscal and monetary leaders likely kept the party going longer than was prudent, but they may now be showing up on time to class as they navigate through this unique period in our history.

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