Frank Thoughts: Fed Funds and The Impact of Valuation
Frank Boland
June 16, 2021

My dinner guest had just come into the restaurant, with three attractive young women. As he headed towards me, I thought to myself, “Is this a scene from Charlie’s Angels?” It was late 1987 and we were in an upscale Italian restaurant in downtown Boston. People there probably assumed he was a rock star or professional athlete. He wasn’t. But he had done something no one else had been able to do that year. He was a mutual fund manager who was “sitting” almost entirely in cash during the market crash of October 1987. The financial press had made him a cultural hero. A market wizard.

He came over to the table where I was sitting and introduced me to his “assistants.” We ordered wine. Lots of it. Sometime after dinner, over glasses of Grand Marnier, he told me what had been his “secret.” While Fed funds were down sharply from the 20% high five years earlier, he thought yields were “still attractive on a risk adjusted basis” versus an historical stock market average of nine/ten percent. “Why take any risk?” he asked. After the crash, he was incredulous people were sending him millions of dollars a day … “to have me buy something they could buy for free and not pay me 1%.”

Today Fed funds are essentially 0%.  So, this issue of risk versus reward – 34 years later – has been totally flipped. It’s demonstrative of the power of a secular bull market in fixed income and why this concomitant bull market in stocks is unlike anything anyone has ever experienced. There are stocks selling at huge multiples of sales, not earnings. Many have billions in revenue, billions in market value, and have never made a dollar. Some have not made money for 10-12 years! At 0% interest rates, it is also startling how much “hidden” money has surfaced into previously unheralded “coin” markets.

To fully understand this current equity bull market, one must realize 75% of trading is done by nontaxable accounts. They owe their genesis to giant sovereign wealth and public sector funds. Historically, these accounts would hire fiduciary managers who would create balanced accounts with 60% in equities and 40% in fixed income. With historic long-term bond yields of 5.18% (3% real 2% inflation) they could assume expected returns of 5-8% a year enabling them to meet future pension obligations. But with 0% interest rates, caused by two crises in 12 years, that has disappeared. 

Additionally, government largess has caused the money supply – M2 – to expand 25% in the last 12 months. This has increased valuation in unprofitable companies in the market and flowed into tangible assets ranging from lumber and housing prices to coconut oil, copper and platinum.  When too much money chases too few goods, by definition, you have inflation. This has shown up at the supermarket or buying gas. The Fed has remained steadfast in holding interest rates at 0% creating a large schism in the stock market. One that has investors worshiping at the altar of Pareto’s law.

Pareto was a 19th century Italian economist who developed the 80/20 rule. It states a lot comes from a small percentage. It’s a concept, not an absolute. Today it’s known by the name “INNOVATION.” The group’s performance and valuation is unlike anything before. In the 1960s, the “Nifty Fifty” had an average valuation of 42x times’ earnings vs. a multiple of 20x for the market. “INNOVATION” today sells for 20x to 40x sales … without profits! That night in 1987, no one could have imagined Fed funds would again have such a dramatic impact on market valuations. From a high of 20% 39 years ago to a current low of 0%. At 0 it will only move higher as will active management performance once again.  

Francis Patrick Boland

 

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