How Deeply Will Fed Policy Lags Impact the Economy in 2024?
Bloomberg recently penned a great piece on the “Law of Unintended Consequences.” To wit:
While the article focuses mainly on the rise in bond yields, it applies to several current market events. As is always the case, individuals are always looking for why Not surprisingly, as discussed last week, the consequences of such thinking consistently lead to underperformance. To wit:
Reasons for Underperformance
Behavioral biases lead to poor investment decision-making. Dalbar defined nine of the irrational investment behavior biases specifically:
The biggest problems for individuals are the and
These two behaviors tend to function together, compounding investor mistakes over time. As markets rise, individuals believe the current price trend will continue to last for an indefinite period. The longer the rising trend lasts, the more ingrained the belief becomes until the last of finally as the financial markets evolve into a
As the markets decline, there is a slow realization that is something more than a opportunity. As losses mount, the anxiety of loss begins to climb until individuals seek to by selling.
Unsurprisingly, the consequences of emotional biases are the most negative at market peaks and troughs.
High Valuations, Rates & Low Volatility
In 2023, the big story is the surge in interest rates. Higher borrowing costs impede economic growth, which ultimately reduces corporate earnings. Interestingly, investors are choosing to believe it’s different this time. Such is evident by higher asset prices and suppressed volatility.
VIX vs S&P 500
At the same time, despite the consequences of higher interest rates, investors are willing to pay higher multiples for corporate earnings despite slowing economic growth rates. Historically, the consequences of overpaying for valuations in a rising rate environment have not been positive. However, in the short term, investors are often lulled into a sense of complacency, again believing this time is different.
Rising Rates vs Valuation Reversals
An interesting point was made on Twitter last week when I posted the following Valuation (P/E) to Volatility (VIX) ratio chart. The chart shows that when the ratio is elevated, such has often coincided with either more significant corrections or bear markets.
S&P 500 Valuations To VIX Ratio
Unsurprisingly, I received the following comment.
Tweet On Vix PE Ratio
Thomas seemed to forget the 20% decline in late 2018. However, suggesting that the indicator is over two historical instances is certainly hoping on the scenario.
At some point in the not-too-distant future, investors will likely discover the unintended consequences of overpaying for assets and ignoring risk in a high interest-rate environment.
As is always the case,
The Consequences Of Hope
It is an exciting period that we live in currently. On one hand, a large contingent of investors hopes that stocks will continue higher indefinitely. Such is seen in the sharp rise in options trading over the last few years. Options and futures are some of the most speculative forms of assets as they have an expiration date.
Options Trading vs Futures Volume
On the other hand, there is a significant chorus betting on a continued bear market in bonds.
10-Year Treasury Net Short Positioning
While each camp is betting on it is unlikely that both will be right. The consequences of higher rates and tighter monetary policy are a drag on economic growth. As such, and unsurprisingly, such policies have always preceded economic recessions and financial events.
Financial Conditions Index vs Crisis
However, for those hoping for a scenario, one must believe the Government or the Federal Reserve can control outcomes to limit financial crisis events, bear markets, or recessions. In (, 1936), Robert K. Merton proposed five possible reasons why the best-laid schemes of politicians and planners so often go awry:
While this time may seem different in the short term, the unintended consequences of monetary policies have always manifested themselves in the long term.
This time is no different.
