Maybe the single most important saying in the financial market is this: Don’t fight the Fed.
The U.S. Federal Reserve is the master of the financial universe. The beliefs of its voting members are enacted into monetary policy – the most important of which is the prevailing interest rate – and that policy determines everything in the world’s largest economy, from which stocks perform on Wall Street, to how much your mortgage payment is…
So, investing veterans have developed the phrase “don’t fight the Fed” to encapsulate the spirit that the Fed rules all, and if you want to succeed on Wall Street, you need to go with it.
What is the Fed doing right now?
They’re sitting on the sidelines.
They threw the kitchen sink at the U.S. economy back in March 2020 when the Covid-19 pandemic shut down the world. They literally did everything in their power to prop up economic activity – primarily, they cut interest rates to zero, and pumped a ton of money into financial markets via bond purchases.
Even as the U.S. economy has improved substantially since then and is currently in the midst of the fastest and most robust economic recovery in modern history, the Fed has stayed the path with this accommodative monetary policy.
Where the Fed Is Headed
Just two days ago, the Fed issued a statement after a two-day meeting in which they said they’re going to keep buying bonds and will hold rates steady at zero.
A lot of folks are scratching their heads at this lack of action. After all, it seems that every data report that comes in these days shows record economic expansion, red-hot inflation, and improving labor market conditions. Those are characteristics which, historically, have led to the Fed tightening monetary policy to prevent the economy from overheating.
But the Fed firmly believes that the current red-hot economic recovery will inevitably mature in the back half of 2021, and that all those big inflation and growth numbers we’re seeing today will cool down.
We believe the Fed will be proven right.
We see economic expansion slowing dramatically in the back half of 2021 as pent-up consumer demand is exhausted, all those dollars that households saved during the pandemic get spent, and enterprises more permanently adopt automation technologies – like QR code ordering – that rose in popularity during the pandemic, thereby challenging the labor market recovery.
As economic growth slows over the next 12 months – and as inflation pressures subside and the labor market recovery stalls out – the Fed will do what this Fed has always done: They’ll stay accommodative, by keeping interest rates at zero and providing a wall of liquidity that will prop up the stock market to new highs.
You see… an accommodative Fed is a friendly Fed… because with the Fed providing essentially infinite liquidity, all those dollars must go somewhere… and with interest rates stuck at zero and U.S. Treasuries yielding only 1.27% (below the inflation rate), a lot of those dollars will inevitably make their way into the stock market (the only liquid market where you can get real returns these days).
This is the liquidity tailwind. It’s a major tailwind. In fact, it’s arguably the most important and powerful tailwind in financial markets. So long as there’s a ton of liquidity, the stock market should continue to head higher – barring some “black swan” event.
So, I say stay long the U.S. stock market.
More importantly, go overweight growth stocks.
Getting Into Growth Stocks
That’s because low rates are really helpful for growth stocks. The theoretical value of a company is the net present value of its future cash flows – calculated by taking a company’s future cash flows and discounting them back by a discount rate – plus whatever its balance sheet says the company is worth today based on current assets and liabilities.
Naturally, growth stocks derive most of their value from the “future cash flows” portion, since all their value is tied up in how much they’re going to grow. Value stocks, meanwhile, derive a lot of their value from the “current balance sheet” portion.
So… when rates are low… the “future cash flows” portion of the valuation equation goes up in value… and because that portion is a bigger part of the equation for growth stocks… it means that growth stocks are disproportionately large beneficiaries of low rates.
It’s simple math.
And the simple math is telling you, without bias, to buy growth stocks, because they’re going to surge over the next 12 months as the recovery loses steam and the Fed stays on the sidelines.
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On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article.
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