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“Don’t fight the tape, don’t fight the Fed” - Martin Zweig

Today’s post is inspired by Real Money Bret Jensen’s “That 70s Market” on March 4. Jensen discusses inflation at 40-year highs and the risk of a return to slowing growth and stubborn inflation, or stagflation, in part, because of inflationary pressures associated with Russia’s invasion of Ukraine and resulting Western sanctions.

  • A hawkish Federal Reserve suggests the business cycle is maturing.
  • A shift in sector leadership because of changes in monetary policy is likely.

As a young sell-side analyst, one of the most important lessons my mentor taught me was “don’t fight the Fed,” a mantra coined by famous investor Martin Zweig.

The Federal Reserve has the mandate to tame inflation and maximize employment. It does this by setting a target rate that influences bank lending rates, and its actions are called monetary policy.

It accelerates economic growth by making loans cheaper when it cuts interest rates. However, when the Fed hikes rates, it slows economic growth by making loans more expensive.

In response to rapid, slowing economic growth in 2020 caused by the COVID era shutdowns, the Federal Reserve cut rates to 0%, and then it bought Treasury bonds to boost money supply and tap down rates on longer-term bonds.

At the same time, Washington, D.C., passed legislation providing stimulus payments to Americans to keep spending flowing.

These monetary (Fed) and fiscal (government) interventions were unprecedented.

And they worked.

In Q2, 2020, U.S. gross domestic product, or GDP, a measure of the country’s economic output, was negative 31%, the worst since official GDP calculations began in 1947.

But GDP rebounded 33.8% in Q3 2020, and it climbed by an average of 5.36% each quarter since.

Sidebar: In case you’re curious, real output dropped 30% in the Great Depression between 1929 and 1933, according to the Federal Reserve Bank of San Francisco.

Undeniably, low rates, bond buying, and stimulus checks sparked a ferocious recovery, and stocks responded as expected. The SPDR S&P 500 ETF Trust (SPY) gained 18.3% in 2020 and another 28.6% in 2021, and many high-growth stocks delivered triple-digit returns.

In short, stocks tracked the early stage of the business cycle perfectly.

High growth stocks in sectors like information technology and consumer discretionary significantly outperformed defensive stocks that do better in the later stages of the expansion/contraction seesaw.

That was then, but this is now

The market is a discounting mechanism. It’s more interested in what’s coming at it on the freeway than what’s in the rearview mirror.

Some growth is good, but too much growth is harmful if it means the cost of goods and services soar because demand outstrips supply, and that’s what’s happening.

The rapid uptick in economic growth means market forces are attempting to balance supply and demand via higher prices, and now, it appears we’ve hit an inflation tipping point, requiring the Fed to step in and make borrowing expensive again.

What’s it mean for investors?

The Fed isn’t your friend (for now).

The Fed’s notorious for overshooting on rates, and if interest rate hikes happen too fast or go on too long, we could find slowing GDP thrusts into recession.

This worry has led to investors swapping high-growth stocks reliant on cheap credit and economic expansion for stocks that do better in the later stages of the business cycle, such as commodities, healthcare, utilities, and consumer staples.

Unshockingly, the late-cycle baskets have generally been top performers this year, and that’s been particularly true this week during the first few days of March.

GRAPHIC-Leading-Defensive-Stocks-0307-2

I suspect this trend in sector performance continues until the Federal Reserve shifts guidance away from its hawkish tilt to higher interest rates. If I’m right, investors ought to make sure they own some stocks within the defensive sectors that tend to perform best at this stage of the business cycle, including the most defensive groups that perform best in recession if the Fed overshoots including healthcare.

The smart play:

  • Diversify your portfolio to include late-cycle stocks.
  • Review your existing holdings to make sure your thesis for owning high-growth stocks is unchanged, and if the reason you owned the stock no longer exists, sell.
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