Capitalization-Weighted Indexes are About to Have a Moment

Part II of Volume II, Issue VII

The aggressive monetary tightening launched by the Federal Reserve last year has brought an end to a “Golden age of investing’ that will force Wall Street traders to rethink how they allocate their portfolios, says Ralph Schlosstein, chairman emeritus at Evercore ISI.

“The last 40 years have kind of been the golden age of investing. I don’t think we are going to have that for the next 10 or 20 years,” Schlosstein said on Bloomberg TV Wednesday. “If you step back a little bit, we went through a 40-year period of time where rates were generally declining, longer rates, and they got extraordinarily low. I think that period of time has passed.”

~ Bloomberg, August 23, 2023

The US bond market hasn’t flashed recession warnings so consistently for so long in at least six decades.

On Wall Street and in Washington, optimism may be building that the Federal Reserve is poised to steer the economy toward a soft landing. But for 212 straight trading days, no matter what the indicators have said, the Treasury market has delivered what is widely understood as a starkly different message: The economy is veering toward a contraction, since 10-year yields have held below 3-month ones. Such an inversion telegraphed the last eight recessions. And on Thursday, the market surpassed the 1980 record to hold that way for the longest consecutive daily stretch since Bloomberg’s records begin in 1962.

The apparent disconnect between the market’s warning and the surprisingly resilient economy shows how much uncertainty has persisted since the Fed started its aggressive rate hikes in March 2022.

~ Bloomberg, September 14, 2023

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Editor’s Note: This is Part II of Volume II, Issue VII of The Macro Value Monitor. Part I, The Initial Education from a Secular Pivot, can be found here.

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Joseph Schumpeter

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The return of inflation has altered the investing landscape in a way last seen more than half a century ago.  The last time inflation and bond yields pivoted higher, as they have over the past several years, Lyndon Johnson was president, McChesney Martin was chairman of the Federal Reserve, and the U.S. dollar was still officially tethered to gold. 

In those years before the Great Inflation, the Federal Reserve considered inflation in the 1%-2% range to be the achievement of price stability.  In the decades since McChesney Martin departed the Fed, however, consumer prices have risen at a 3.95% annualized rate, and inflation in the 1%-2% range has come to be considered a borderline policy failure. In the decade after the financial crisis, inflation in the 1%-2% range caused much consternation in the Fed, and provoked the largest monetary expansion since the Great Depression in an effort to get prices rising at a consistently higher rate.  After years of trying, those efforts finally succeeded in 2021.

Investing in a more inflationary market environment is an exercise in knowing which parts of investing dogma and lore to hold onto, and which parts to let go in favor of a more informed approach.  The initial education from the secular pivot in 2022 was deeply felt by the traditional 60/40 portfolio of stocks and bonds; at its lowest a year ago, a diversified portfolio of stocks and bonds had lost a quarter of its value in just nine months, with both stocks and bonds declining in tandem.  Such coincident losses had not happened in more than fifty years, and it demonstrated how vulnerable a portfolio can be to a secular lift-off of interest rates and yields.