Posted September 22, 2023
By Zach Scheidt
Fed Update: Key Takeaways From This Week's Meeting
This week all eyes were on the Fed as Jay Powell once again took center stage with the most recent Fed policy meeting.
Although they didn't actually change their policy, we did see a more hawkish tone than the markets were expecting. And this certainly stirred up fear in the minds of investors.
I discussed this in more detail yesterday on my regular live Zoom call that I hold for my Income Alliance subscribers.
You can check out a portion of this call by clicking on the video below.
As you guys probably know, and I'll fill you in if you don't, the Fed meeting was yesterday, and this is the meeting that the Fed holds every six weeks or so for their policy decision on interest rates. At yesterday's meeting, not just the press release, but also the press conference where Chairman Powell answered questions, it came across to investors as more hawkish than expected. Hawkish just simply means that the Fed is more likely to keep interest rates high, so they're continuing to put the brakes on the economy in an effort to fight against inflation. And this really does make sense. On our last call, we talked about how inflation was likely to be higher than what many had expected, simply because we're seeing prices in the energy market pick up, and specifically we're seeing crude oil, the prices are moving higher, and at the same time we're seeing gasoline, diesel, jet fuel, all of the refined fuels that we make from crude oil, those prices have been picking up as well.
So that naturally leads to inflation just because it costs us more to pay for the important fuel. As you know, a lot of times the Fed and other market prognosticators look at core inflation, which strips out food and energy. And the reason for this is because energy prices swing a little bit more wildly than other prices. So if you take those out and then you look at the core, it gives you a little bit more of a steady data set that you can kind of see some trends in how they're evolving. But the thing is that with higher energy costs for inflation is still likely to come up even if you cut out the energy, the specific energy cost, because energy has a way of flowing through to everything else that we buy. And we talked about this a little bit. I don't want to beat a dead horse here, but just so it's important for, we've got a lot of new members here at the Income Alliance, and welcome, by the way, we love having you guys as part of our community, but as energy prices move higher, it raises prices for other things too because remember, all the fresh produce that we're going to buy at the grocery store, that has to be shipped in to the grocery stores and it costs more to ship them in.
Same thing for if you're going to run a factory, it costs more just to keep the lights on and to keep all of your machinery and equipment running if energy prices are higher. And that's true in many, many areas of the overall economy. So even if you strip out the specific energy cost as it relates to the price of oil and the price of a gallon of gasoline, your other costs will go higher as well, just because energy is such an important part of the overall economy. At the same time, we're seeing other areas of inflation that continue to be very stubborn. Wages are relatively high, and the more we see issues like we've got the United Auto Workers on Strike demanding more pay, as well as other benefits that they're looking for. We've got the writer strike going on in Hollywood. We've got the actor strike going on in Hollywood.
And all of this will require higher wages from some really key important industries, which as wages move higher, it means that people have more money to spend, which means that they can pay more for the things that we want. And anytime you have more money to spend, it means that more consumers are literally competing against each other to buy things. And so the only way that they're able to win that competition is for prices to move higher until some people say, okay, well I don't really want to pay that much for X, Y, or Z. So higher wages also helps to fuel inflation. And then we're seeing the stock market has been moving higher. Now, obviously it's lower today, but over this year we've seen a new bull market. We've seen the overall market trend higher, which helps the more affluent fluent investors, but also affluent consumers have more money to spend and also just more have more confidence.
So even if you never pull money out of your brokerage account, if you know that your brokerage account is up 10% or 15% or 20% from where it started the year, you'll be more likely to spend the money that's in your checking account because you know have that safety buffer. And the same thing is true for home prices. Home prices have been moving higher. So again, the affluent consumers are the ones that are more likely to have a home and to see that home equity increase, and even without pulling cash out of your home, even if you don't take an extra mortgage, just the fact that you know your home is worth more and you have more equity in your home, gives you more confidence to spend that money that's in your checking account. And so all of that is working together to drive more consumer spending, which again pushes prices higher.
So it's really no surprise that inflation has been hotter than we may have expected two or three or four months ago. And it's no surprise that the Fed is taking this more seriously and likely to keep interest rates higher for longer. That's the phrase that you're going to continue to hear probably through the end of this year and into next year. Now, the Fed didn't actually raise interest rates at the last meeting, but they did leave the door open to possibly raising interest rates by another quarter point in their November meeting. And there are some who say that we could even see two or three more interest rate hikes before the Fed is done. So the idea that they call it the terminal rate, that's kind of the economic term for it, but the highest rate that the Fed target interest rate will be has now moved higher just because people are expecting the potential for higher interest rates rate hikes over the next few months. And that is really what is pressuring markets today.
One of the things that we have to think about with investing is basically why are stock prices moving lower if investors are expecting interest rates to move higher? It has a lot to do with the dynamic between stocks, bonds, and the different alternatives that we have as investors for what we want to invest in. It also has to do with a really important model that most professional investors at least pay homage to when they're making decisions on whether they should buy or sell a stock. And that's called the discounted cash cashflow method. There are several other names, the Efficient Market Hypothesis and some others. But basically the idea behind this whole theory is that you look at all of your future expected profits if you were going to invest in a stock. So if you're invested in Spotify, you look at how much is Spotify going to earn per share over the life of the time that I expect to hold this stock? Or how much is Coca-Cola going to earn over the life of the time that I own KO and so forth. And then you determine if I'm going to get this much in profit over years and years and years to come, how much are those future profits worth today?
Well, the way to figure that out, there's a calculation and you figure it out by saying, if I were to invest today in something safe like treasury bonds, what would that give me over a long period of time? And then you back into the fact of, okay, so if I'm going to invest in something that has more risk, what should I be willing to pay? Because I'm probably going to get more in return in profits from this. But there's also the risk that some business could change, that the economy could go into a recession, whatever, and those profits may not be as much as I expected before. So in today's market, we're starting to see A, there's more risk, and B, there's more competition on the bond side because I can actually lie a bond that I know with certainty will be paid back that gives me a higher rate of return.
So why would I take risk and buy this more risky stock when the bond itself is paying me a decent return? So the higher interest rates go, the more competition there is for investors capital, and the more money comes out of these risky, and it doesn't mean that there's something wrong with the company, but you just know that there's always risk with stocks, whereas there's not risks with a treasury bond. And so the money is naturally going to come out of growth stocks and into treasury bonds. And that is a big part of the reason that we're seeing money move out of the stock market right now.
So growth stocks at this point are more risky and they don't offer that much potential return compared to what they might have just before we saw interest rates move higher. So the way that we have to think about this then is how do we play this type of market? What is the best way to invest, to trade and to generate profits in this type of market? So on the bullish side, I really like companies that generate reliable profits. So this would be the companies that are more stable, that have been around for a long, long time that have plenty of cash on their balance sheet. And the reason why those stocks make more sense than some of the growth stocks is because a lot of investors are going to be looking for safety. And so even institutional investors that are required to stay invested, they may pull money out of their growth stocks and put 'em into something safe.
And so the price for those safe stocks could go higher just because there's more market demand for safe investments. I also like companies that benefit from inflation. And for that, just think about commodity producers. If inflation drives the price of lumber higher, if inflation drives the price of oil higher, if inflation drives the price of crops higher and so forth, then you want to own stocks that actually benefit from those commodities, oil producers, gold producers, and so forth. I also like stocks that benefit from volatility. So volatility in the market, we're seeing stock swing back and forth while some of the trading companies, whether it be exchanges that actually offer the ability to trade for investors or some of the large investment banks that actually make money trading their own capital, trading their investors' capital, and in markets where they help stacks come public like the Instacart or the Arm IPO that just came out over the last few weeks, those companies should do very well.
And then finally, companies with solid financial positioning. So they have cash to cover their interest payments, they have assets. And ironically, it's really interesting, but a stable company that has plenty a lot of debt right now actually is not a terrible thing in an inflationary environment because if you have a company that owns assets, but they also have some debt, well as inflation drives the price of those assets higher, that helps that side of the company's balance sheet, right? Their assets become worth more and more as inflation rises. But the liability side of their balance sheet, the debt still stays the same. So as long as they don't have to refinance and pay higher interest on that debt, the debt stays the same, the value of the assets moves higher. And so to a reasonable extent, a company that has leverage because they have debt on their balance sheet, as long as they have plenty of cash to pay the interest on that debt, and as long as they have assets to offset that debt, that can actually be a real benefit in today's market.
Now, on the bearish side, I like the idea of trading foot contracts which grow in value as a stock trades lower. And I like the concept of buying puts on growth stocks right now that have large expected future profits. Remember, if those future profits are what investors are looking at, the future profits are worth less and less and less today if interest rates are higher. So those stocks are under pressure as interest rates rise. Also, I'm looking at stocks that are very popular with retail investors right now because retail investors don't take offense to this. I'm a retail investor too, according to the technical terms, although I have been a professional investor plenty of times in my life. But retail investors are just individual investors like you and me. And retail investors tend to panic more easily than professionals. It's not always true, but it often is true.
And so if you own or if you're buying, put contracts on a stock like Tesla that lots and lots of investors love on a stock like Nvidia that lots of investors love, and these investors start to panic because the market is trading lower because interest rates are higher because they start to see their brokerage accounts declining in value. If those investors panic, it's the more popular stocks that will get hit first and that will get hit the hardest as these investors hit that red switch and pull out of their investments. And then finally, I like to buy, put contracts on expensive stocks that are very, the stock price is expensive compared to the earnings per share that these companies are making. There's a time when these expensive stocks are great to bet on because investors become more and more excited. And the greater fool theory, I may be a fool for buying this, but I can find a greater fool to sell it to for a higher price that works during bull markets when animal spirits are high, when investor enthusiasm is high. But at a point like we've got right now where we're starting to see more fear creep into the market, those are the stocks that can drop very quickly. So those are just some of my thoughts on the overall market, how we can position ourselves to profit in what is turning out to be a pretty unsettling little bit unstable market following the Fed's last interest rate decision.