A great way to make
A hard situation worse:
Fix it till it breaks

In the movie “Forgetting Sarah Marshall,” lovelorn Peter (Jason Segel) receives his first surfing lesson from Kunu (Paul Rudd). In the scene, Kunu imparts upon Peter a lesson that would equally impress either a wise Zen master or a sun-bleached stoner with too much salt water on the brain:

“Don’t try to surf. Don’t do it. The less you do, the more you do.”

After watching his new pupil practice popping up on his board, Kunu critiques the performance:

“That’s not it at all. Do less.”

And so the lesson goes. Peter keeps trying to stand up on the board, and Kunu keeps telling him to “do less,” until Peter gives up and just does nothing at all, laying prone on the board.

Kunu and his new pupil eventually paddle out to catch waves. Of course, there are none to catch, so they paddle back in and get some drinks. All that instruction for nothing.

And this is like the United States economy right now.

As of this writing, the Fed’s Jerome Powell announced the latest interest rate hike of 0.25%. This is the 10th consecutive rate hike by the Fed, and the third hike since the start of 2023, which was only 4 full months ago.

To the extent that the profoundly complex economy of the United States, with its practically infinite number of inputs, outputs, and feedback loops, can be understood by anyone, the current situation can be encapsulated through two charts.

The first chart is a history of the Federal Funds rate – the rate set by the Fed. You can see this on the St. Louis Fed’s website, but here’s a screengrab:

What should become immediately apparent is how recent and historically abnormal a 0% interest rate is.

The other chart that can help us understand matters is a chart showing the history of the price of the S&P 500, which tracks the weighted average stock price of the roughly 500 largest companies in the United States. You can see that data on this link, but again, here’s a screengrab of the past 23 years:

The early 2000s saw the tech bubble burst, followed by the September 11th attacks, followed by the launching of two wars. This corresponded with a three year drop in the price of the S&P 500.

Then, a recovery started. The recovery may have been at least partially stimulated by relaxed regulations around underwriting standards for mortgages to help encourage home ownership for previously marginalized demographic populations. What could go wrong? Well, from October 2007 to June 2009, the world was thrown into the worst financial crisis since the Great Depression.

What followed was a series of “loose” money policies by the Federal Reserve and the Federal Government. The government bailed out huge financial institutions and The Fed relaxed access to capital. How does the Fed maximize access to money? By dropping the cost of borrowing money to 0%.

Similar to the way oxycontin can assuage the agony of post-surgical trauma, it worked. But, also like oxycontin, a short term problem was solved at the expense of creating another problem.

At some point during the historic bull run of June 2009 to March 2020, the Fed could have sooner started gradually restoring interest rates to something resembling a “sweet spot.” Experts differ on this, but perusing various economic articles online you can find that a rate between 2-3% seems to strike a balance between keeping inflation under control while keeping access to debt-based capital affordable enough to encourage private sector job creation.

(Quick aside: the reason having unemployment figures above 0% is important is because a certain amount of unemployment means there are jobs being created that haven’t been filled yet. Too much unemployment means too few jobs, too little unemployment means big companies aren’t growing, and small companies aren’t being created, which means no economic growth. The “sweet spot” for unemployment percent, seems to be somewhere around 4%, depending on what you read).

The Fed didn’t start raising interest rates until December 2015, about the time the S&P 500 had re-attained its January 2000 price. The Fed did so gradually, only to drop rates again in early 2019, then down to near zero again as a result of the pandemic.

Two years after the start of mild Fed Funds Rate increases, the Federal Government installed the Tax Cuts and Jobs Act of 2017, which put between $1-2 trillion of Federal tax revenue back in the wallets of taxpayers. Why? To counter the tightening monetary policy from the Fed, which threatened to slow the unprecedented run of 0% rate-fueled growth. The Federal Government loosened fiscal policy (fancy speak for increasing cash in the economy by lowering taxes).

Similar to 2008, the combination of a loose fiscal policy - Federal bailouts of huge financial institutions in 2008, big tax cuts in 2017, huge stimulus packages in 2020 - and loose monetary policy – The Fed lowering the Federal Funds rate to next to nothing - boosted economic growth. 2021 was a banner year for the economy, with the S&P gaining 28.75%.

The problem was no one could do anything about the supply line shocks caused by China’s Zero COVID policies and the largest land war in Europe in 70 years. In 2023, the economy of every nation on earth functions within an interconnected global system, and domestic policy can only do so much to impact the downstream impacts of geopolitical turmoil.

Supply line shocks coupled with loose fiscal and monetary policy predictably caused rampant inflation. Too much money was trying to buy too few goods. Fueled by fears of stagflation, the Fed began its run of interest rate hikes. Unable to put more goods on shelves due to international pandemic policies, the Fed tried to take money out of the financial system by making loans more expensive.

This increased short term rates to where they stand now, at over 5.2% for the safest money in the world, the 3 month Treasury Bill.

Now, if you’re a private business, or a multi-millionaire, are you going to be satisfied with getting 3%-ish from a bank account protected up to $250,000 by the FDIC? Or, are you going to buy a 5.2% annualized rate on Federal Government debt that doesn’t require FDIC insurance to be considered safe?

This conundrum turned the US Treasury into a competitor for banks. Huge depositors pulled money from banks and moved it into Money Market funds and Treasuries. The subsequent loss of deposits inspired investors to sell their shares in the troubled banks, whose stock prices proceeded to crater. Falling bank stock prices further inspired fearful depositors to withdraw their money from the banks.

After Silicon Valley Bank and Signature Bank collapsed from bank runs, the Fed instituted its new lending system practically overnight. This lending system allows banks to take out loans secured against their long-term, low-interest debt.

Why do banks have so much long term, low-interest debt? Because of the 0% Fed Funds rate that had persisted for about a decade. That low interest rate meant that banks could only generate safe yield by buying longer-term debt issues, which are worth very little if sold in a high interest rate environment. The Fed’s new lending system allows banks access to funds without selling these “marked to market” bonds at a loss.

But infusing money into the economy in any way represents loose money policy, the very policy that helped fuel inflation to begin with.

So, what happened? The core inflation rate – which excludes volatile prices of goods like groceries and gas - showed an increase by the time the Fed had its last meeting. It’s possible the Fed contributed to this latest inflation spike by giving banks what effectively amounts to a stimulus payment. Stimulus means new money is circulating in the economy.

When the Fed began rapidly increasing interest rates last year, some of our firm’s portfolio managers, who are employed by the second largest research firm on Wall Street, were exasperated that the Fed wasn’t waiting to see what downstream impacts a given rate hike might have before instituting more rate hikes. As we near the 18 month point since the S&P 500’s previous high, that concern appears prescient.

If lovable Kunu from “Forgetting Sarah Marshall” taught the Fed how to implement monetary policy, his lesson would probably be “do less.”

What can an average American take away from all of this?

Avoid rushing into major changes. If they are absolutely necessary, make one change and then wait to see what the impact of that change is before making another one. Like a swimmer exhausting herself flailing in a strong current, quickly compounding changes on top of each other can do more harm than good.

In short, don’t be like The Fed. Do less.

Now is an excellent time to adhere to best practices.

Pay close attention to your risk tolerance – your emotional tolerance for loss – and risk capacity – the amount of loss your portfolio can withstand without long term damage. Use this information to allocate your portfolio between risky growth investments and instruments with some guarantees of principal protection. Once you decide on an allocation, stick with it for at least several months to see how it works and how you feel about it.

If you need income from a portfolio, explore allocations to interest and dividend-paying instruments that allow you to preserve principal instead of withdrawing it.

If a portion of your portfolio is showing a loss, see if you can realize a tax benefit from that loss while staying invested. If no tax benefit exists – such as within IRA or 401k accounts – consider making no changes at all. No one knows when a market recovery will happen. Using fear and greed to guide investment decisions – the two impulses behind market timing – is a recipe for long term underperformance.

If you aren’t sure how to apply best practices to your portfolio, and need help implementing a durable, flexible plan that can weather this and future storms, we’d love to speak with you.