Financial markets have been on a tear recently. Most everyone you talk to, even people who weren’t investors prior to the pandemic, seems to have a story about how they’re making money hand over fist right now. The stock market, housing, cryptocurrency… pretty much anywhere that you can deploy your money did incredibly well last year. Other than poor old boring bonds — a total bond fund like Vanguard’s BND offering dropped 5% last year. But investors who took more risk than a savings account or bonds were rewarded very handsomely.
Of course, high returns in the past correspond with high asset prices today. And everything certainly feels expensive. More than that though, it feels like a bubble. There’s an irrational exuberance among investors, especially novice investors. I’m far from a seasoned investor myself, going on a little under seven years that I’ve actually been able to put serious money into the markets. But some of the things I’ve been hearing on the street are just so unrealistic, and the number of people saying these things growing so fast as to be concerning.
For some historical perspective, take a few seconds to recall one of the most notorious fraudsters in Wall Street history, Bernie Madoff. As many now know, Madoff ran what is currently the largest Ponzi scheme in history. Thousands of investors in his fund were ultimately ripped off to the tune of tens of billions of dollars spanning over two decades. The bait for his unsustainable scam? A claimed annual return of just under 11%, delivered steadily and with little volatility.
Feeling bubbly
Today, we live in interesting times. 31% of U.S. adults (including 46% of millennials and 59% of Gen Z) believe that they will become millionaires off of their cryptocurrency investments, according to a survey by Big Village. That’s over half of adults age 40 and under.
In the real estate world, Redfin reports that a record 18.2% of U.S. homes sold during the 3rd quarter of 2021 were purchased by investors. This during a period where capitalization rates are at record lows after a decade during which home prices grew 1.92 times faster than rents, according to home price and rent index data that I analyzed from the St. Louis Fed. In my area, rents on a single family home don’t even seem to cover the landlord’s total monthly costs if they put 20% down. Many of these investors are clearly banking on continued price appreciation as they jump in after the housing market posted double digit price gains in 2020 and 2021.
And stocks, what a fabulous year it was, including for my own portfolio. The S&P 500 increased 26.89% in 2021, according to Macrotrends. In context, this really isn’t that remarkable, as that’s well within the standard deviation of returns that the index usually throws off which has averaged out to about 10% over the long-term. Of course, how could we forget the meme stock frenzy earlier in 2021, during which over a quarter of American adults reported buying shares in viral, overhyped companies like GameStop and AMC after being driven by a social media frenzy.
There’s debate among economists about whether “bubbles” even exist. One group is exemplified by Nobel Prize winner Eugene Fama, who claims that the term bubble is meaningless, that they’re unpredictable, and can only be defined with 20/20 hindsight. Another Nobel Prize winning economist, Robert Shiller, took a crack at defining the term bubble back in 2005, in the midst of the housing bubble run-up:
“A situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”
Robert J. Shiller, “Irrational Exuberance” (2005)
The Fed holds a golden pin
High valuations compared to historical norms can at least partially be explained by low interest rates. Borrowing money becomes cheaper for consumers and businesses. As rates fall, bonds become a worse proposition, so investors seeking yield are pushed into tilting towards riskier assets to achieve their desired expected return. On Wall Street, this phenomenon is known as TINA — There Is No Alternative — to describe how investors are piling money into stocks primarily because every other option is far worse.
Real estate likewise soars in a low interest rate environment for a couple reasons. Buyers are mainly “buying the monthly payment,” not the total price of the house, which causes home prices to have an inverse relationship with interest rates. Each 1% decrease in mortgage rates is about a 12% decrease in monthly payments, so on paper buyers can afford more even though they end up just paying a higher sticker price for the same home. Additionally, investors are willing to accept lower capitalization rates as they compare their risk premium with bonds, causing price:rent ratios to rise.
As inflation continues to rage with today’s Consumer Price Index data release revealing a 7% inflation rate over the past 12 months, this low interest rate environment we’ve experienced for over a decade may be coming to an end. Federal Reserve Chair Jerome Powell has recently pivoted sharply on inflation. No longer is he claiming it is transitory, and now it’s clear that The Fed will be breaking out their toolbox to fight inflation and prevent it from becoming “entrenched.” Which will include tapering of bond and Mortgage Backed Security (MBS) purchases, balance sheet run-off, and three or four interest rate hikes this year.
Look what has happened to mortgage rates over the past two weeks just as a result of The Fed publicly changing their stance on inflation, combined with purchasing less MBS over the past few months. They haven’t even touched the Federal Funds Rate yet!
We’re seeing a remarkable shift in monetary policy. The inverse relationship between interest rates and risk assets is a widely known correlation. The big unknown going forward is whether The Fed can tame inflation without deflating, or even crashing these inflated asset prices.
What is an investor to do in this environment?
Are bubbles real, and how should we respond to them? Between the noted economists Fama and Shiller, who is correct?
I believe the correct answer is somewhere in the middle, maybe leaning ever so slightly towards Shiller. That bubbles exist and are driven by human psychology. But to Fama’s credit, I don’t believe that they can be timed predictably or accurately.
One big counterpoint to hysterically selling all of your investments in the face of this Federal Reserve pivot is that this information is freely available to market participants. If markets are even partially efficient, three or four rate hikes this year should already be priced in to the stock market. The market hasn’t tanked and is sitting near all-time-highs, so maybe investors overall see this as fairly neutral.
On the other hand, maybe TINA has fully taken hold and irrational investors have just decided to collectively run off the cliff at the last second when the rate hikes actually become reality. Seriously, what are you going to do, sell out of risk assets and sit in cash in this 7% annualized inflation environment?
Given all of this information, the optimal decision is to… do precisely nothing! Continue investing in low cost, passively managed index funds to grow long-term wealth. I’ve written about this in the past — statistically (and somewhat paradoxically) buy and hold index fund investors undeniably achieve above average returns when compared to market participants in aggregate. This is the optimal strategy, and temporary distortions in market valuations or changes in Federal Reserve policy do not change the math.
I have a couple coworkers who tried to time the market in 2020 at the start of the pandemic. They sold out of stocks in their retirement funds in early March when prices started dropping, convinced COVID was going to tank the world economy and markets were going to go down with it. They were patting themselves on the back as markets continued to drop 20% beyond where they sold out… then the whipsaw recovery came along with government intervention, and they were left in the dust.
Last I talked to both of them a few months ago, they were still sitting on the sidelines waiting for a crash. Only now they need the market to crash 30–40% just to get back to the point where they sold out, let alone buying back in lower than that. They’ve both lost a lot of potential growth in their retirement funds, probably permanently.
So just ignore the noise, and continue piling your money into total US and international stock market funds like Vanguard’s VTSAX and VTIAX offerings. Or go with a total world equity fund like VTWAX for an even simpler portfolio. Pay attention to financial news only if it’s something that interests you, not because you’re looking for actionable portfolio advice.
Don’t try to time the stock market. Don’t speculate on individual stocks. Don’t buy an investment property with a poorly thought out plan like counting on price appreciation to carry you to prosperity. And please, don’t put a penny more than you’d be willing to lose at the casino into cryptocurrency.