Can Your Portfolio Outsmart the Three Fed Bears?

Once upon a time, Goldilocks saw inflation at 6.8% and knew the Federal Reserve would have to act. Worried about the value of her home and stock portfolio, she visited the Fed house. First, she saw Papa Fed Bear who was big and scary. “We’re in a bubble. I’m going to cause asset prices to crash, especially stock and real estate prices. Interest rates and the cost of capital will soar, leading to bankruptcies and major recession. Only after a major purge can healthy economic growth resume.”

Next Goldilocks met Baby Fed Bear, who was small and cute. “I won’t hurt your portfolio Goldilocks. I’ll just do a little cosmetic tightening and pull back at any sign of market unease or complaints from elected officials. The main thing is not to disrupt the economic healing from the pandemic.” But Goldilocks knew that was as scary as Papa Fed Bear. A timid, politicized Fed in the 1970s managed to drag down the economy without taming inflation, leading to stagflation and perverse government policies like wage and price controls.

Finally, Goldilocks found Mama Fed Bear. She promised firm tightening to deflate bubbles, clear out economic deadwood and limit inflation to 2%, while keeping real economic growth at least positive for the next year and setting the stage for years of robust growth afterward. “Let the politicians yell and scream, let the markets beg for mercy, I will hold a steady, independent course based on good data, firm theory and battle-tested models.”

I don’t know which of the three Fed Bears will show up in 2022, but all three are plausible enough that investors should diversify so none can cause fatal financial damage. Just as important, decisions should not be made on fairy tales but by sober consideration of the probabilities and likely magnitudes of the three scenarios.

The median forecast for 2022 seems to be that the Fed ends asset purchases early in 2022, and raises its target for the federal funds rate three times, or by 0.75 percentage point. Since 1954, the real total return on the S&P 500 Index -- including dividends but after inflation -- has been 3% in years when the fed funds target rate rises by 0.75 percentage point or more, versus 10% in other years. The chance of a 10% real decline is 21% in those years and a Papa Fed Bear 20% decline happens 8% of the time. Those are twice the 11% and 4% probabilities in years when the Fed does not raise the fed funds rate by 0.75 percentage point or more.