Navigating a Foggy Cycle with Value

Greenspan suspected there was a significant chance a deflationary bust had begun, just as it had after the speculative mania in 1929. These fears deepened when the year-over-year change of the Consumer Price Index (CPI) fell to 1.14% in February 2002, then sank further to just 1.07% in June. These were the lowest inflation readings in four decades, and they were reminiscent of the early hints of deflation in 1930.

For Greenspan, even the smallest risk of a deflationary spiral warranted easy monetary policy to counter the threat, as idly standing by while deflation took root in the early 1930s had been the Federal Reserve’s greatest Great Mistake.

It was not until three years after the 2001 recession ended, when the risk of a deflationary spiral appeared to have faded, that the Fed felt inclined to begin increasing interest rates. In June of 2004, the Fed hesitantly lifted the Fed Funds rate by a quarter point, from 1.00% to 1.25%. When the economy did not fall apart in response, the Fed proceeded to slowly and steadily increase interest rates through the end of the year.

Six months after the Fed started hiking rates, however, signs emerged that the modest rise in interest rates was not producing a normal cyclical response. Instead of rising with the rising Fed Funds rate, as is typical during an early expansion phase of an economic cycle, long-term Treasury yields remained stubbornly low through the first months of 2005.

In an another usual sign, after a full year had passed since the Federal Reserve had started raising interest rates, the yield on the 10-year Treasury note was lower than it had been at the start of the rate hike campaign. In June 2005, with the Fed Funds rate having risen from 1% to 3%, the 10-year Treasury had sunk from 4.6% to 3.9%.

For Greenspan, this was a conundrum – it was not how long-term Treasury yields typically responded to a rate-hiking campaign. And given what the Fed was trying to do at the time, it was not appreciated.

Although Greenspan had feared a deflationary bust was possible in 2002 and 2003, inflation readings had moved strongly higher since then. In 2004, the inflation rate had risen above 3% from its low in 2002. And by the summer of 2005, the inflation rate had jumped above 4%. Amidst rising inflation, the Fed wanted monetary policy to tighten, not loosen.

Yet with the Fed Funds rate and the 10-year Treasury yield both below 4%, monetary policy was still, four years after the recession had ended, stimulating the economy with negative real rates. It had become increasingly uncomfortable for monetary policy to be so behind the curve.

Thus, in late 2005, set between a rock and a hard place, the Federal Reserve had little choice but to keep tightening monetary policy to get interest rates above the rate of inflation. The Fed Funds rate was raised at a slow and steady pace throughout the rest of 2005, until it reached 5.25% in July 2006.

At that fateful moment, the Federal Reserve suddenly stopped in its tracks, and three events occurred which would have far-reaching and long-lasting consequences.

First, after steadily rising from the time Greenspan worried about deflation to above 4% in June 2006, the inflation rate suddenly fell after July 2006, reaching 1.4% in October. This collapse in headline inflation caused real, inflation-adjusted interest rates to spike higher. With the Fed Funds rate at 5.25%, real interest rates had risen from 0.8% to 3.8% in just four months, which was the sharpest rise in real rates since the early 1980s.

Second, after remaining subdued and continuing to drift closer to short-term interest rates in 2004 and 2005, long-term Treasury yields suddenly plunged below the Fed Funds rate in August 2006. This pivot lower in long-term yields inverted the Treasury yield curve.

Lastly, but certainly not least: the housing bubble began to burst.

It was no coincidence that these three key events occurred around the same time. Having inflated while the Federal Reserve maintained negative real interest rates, the sudden spike in real interest rates in the summer of 2006 proved to be the pin that pricked the bubble. The pop started a chain reaction which largely remained hidden from view, until it breached the market’s surface the following summer, when two hedge funds that had been leveraged to mortgage securities suddenly collapsed. From there, the chain reaction continued to gather speed and force until it precipitated the worst global credit crisis since the Great Depression in the fall of 2008.

Throughout history, negative real interest rates have fueled bubbles in nearly every asset class, from real estate, to commodities, to railroads, and stocks. The era of negative real interest rates between 2002 and 2006 proved to be no exception.

Yet in the two years after that fateful moment in the summer of 2006, while the worst financial crisis in several generations was brewing beneath the surface, the S&P 500 gave few hints of the turmoil ahead. Driven ahead by the Four Horseman, the most popular technology companies at the time, the market moved firmly higher in 2007.

When the Federal Reserve began lowering interest rates in the wake of the hedge fund failures in the summer of 2007, traders and investors took that as a signal to pour into the Four Horseman and nearly everything else that would presumably benefit from lower rates, and the stock market sprinted higher. China’s equity market rose 50% in just two months. Oil began a parabolic rise that would see its price double from $75 to $147. Even as home prices flashed warning signs by recording the first nationwide decline in postwar history, market strategists talked of economic “decoupling” and the resilience of the U.S. consumer. Fed Chair Ben Bernanke, who had replaced Greenspan in 2006, assured Congress and the public in early 2008 that the difficulties in the housing market would remain “contained.”

Lost amid the cacophony of equity market euphoria and theories of decoupling and containment was the simple, reliable signal the bond market sent in the fall of 2007.

When the Fed began lowering rates, short-term interest rates fell below long-term Treasury yields, and the spread between them turned positive. While an inverted yield curve is a sign that a recession is on the horizon, the end of an inversion usually marks the moment when the recession actually begins. Shortly after the S&P 500 hit a new high in October 2007, with the Four Horseman leading the way, the recession that would come to be known as the Great Recession began in December.

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When the Federal Reserve began lowering interest rates this past September, the bond market sent investors the same signal it sent in late 2007. And in a remarkable rhyme of history, equity investors reacted to this bond market warning in late 2024 as exuberantly as they did in late 2007.

After two years of long-term Treasury yields remaining below short-term interest rates, the difference between the two reverted to positive territory in December. This reversion of the yield curve is marked by the dashed red circle in the right side of the chart below.

As you can see from the other red circles highlighting the beginning of past reversions in 2019, 2007, 2001, and in 1990, reversions of the yield curve have preceded each recession (shaded areas) and each major equity bear market of the past forty years. In other words, a yield curve reversion is a reliable signal to be prepared for a downturn in the economy and equity market. However, since this signal is usually hidden behind the news of falling interest rates, it is almost always missed by investors.

In keeping with tradition, the bond market’s warning seems to have been missed by investors this time as well. When the Federal Reserve telegraphed last summer that it would soon be time to lower interest rates, the market sprinted higher as traders and speculators poured into, not the Four Horseman this time, but the Magnificent Seven, along with nearly every sector that would conceivably benefit from lower rates. The echoes of the 2007 market peak were loud and clear.

The era of negative real interest rates which inflated the housing bubble twenty years ago lasted four years. In that relatively short span of time, monetary policy subsidized speculation, and the housing market morphed into a casino filled with leveraged speculators. When the monetary subsidy ended in the summer of 2006, it represented the ignition point of a firestorm that nearly brought down the financial system three years later. Home prices declined until leverage was eventually washed out of the market, and the casino had closed its doors.

The term financial repression has been used to describe an extended period when interest rates are below the rate of inflation. When savers lose real, inflation-adjusted value holding cash, it creates a perverse incentive to put savings into other investments, any other investments, that are not guaranteed to lose real value. By repressing the natural inclination of savers to preserve a balance of their savings in safe investments, eras of financial repression have spawned some of the most notorious financial bubbles in history – from John Law’s time until today.

It is no coincidence that the extended era of financial repression following the credit crisis, lasting not four years, but fourteen years, resulted in the first coincident overvaluation of stocks, bonds, and real estate prices in history. During the era of financial repression from 2008 to 2022, cash lost 21% of its inflation-adjusted value. This erosion of real value represented a tremendous incentive for savers to hold anything else but cash, and the overvaluation of stocks, bonds, and real estate – the Everything Bubble – was the end result.

After fourteen years of financial repression, it is also not likely a coincidence that the focal point of speculative fervor in the stock market this time, the Magnificent Seven, has now inflated beyond other episodes of mania in recent history (see below). In this case, the scale of the mania reflects the degree of financial repression that has fueled it.

Yet if history teaches us anything, it is that every episode of exuberance and its aftermath is unique. Market history rhymes, but it does not repeat in precisely the same way.

One aspect that makes the current episode unique is that it has been created not only by a long era of negative interest rates, but also a large expansion of the money supply. Unlike the housing bubble twenty years ago, which was fueled by a large expansion of private credit, the markets today are underpinned by a large expansion of the public base money supply. As a result of this difference, the risks and opportunities in the years ahead are different than they were twenty years ago. With an inflated money supply and a $36 trillion national debt, the main risks investors face in the years ahead cluster around an erosion of real asset values by inflation, rather than a deflationary collapse in asset prices.

Fortunately, history also teaches us that these real risks can be addressed with diversification and a focus on value.

Few assets have historically performed better during periods of higher inflation than gold. In the first half of the current decade, inflation averaged 4.2% per year, which is more than double the inflation rate of 1.7% seen in the decade after the financial crisis. Gold’s 14% annualized return during these last five years has been consistent with past inflationary pivots, and it is a testament to its enduring value in a diversified portfolio.

We have covered this inflationary pivot in many letters in recent years, and it has arguably been one of the most important factors impacting returns of various asset classes since 2020. Higher rates of inflation represent a long-term risk to both stocks and bonds, and it represents an especially acute risk for stocks and bonds with low underlying yields. Investors in bonds have learned this over the past four years, and it is likely equity investors will learn this in the years ahead.

Today there is a wide difference in underlying earnings yield between equities in the U.S. and equities outside the U.S., and this wide difference in yield will likely lead to a wide difference in market performance over the next decade. If the underlying earnings yields of various markets around the world return to their average over the next decade, the estimated projected real returns shown above will likely approximate the returns buy-and-hold investors realize.

You’ll notice that the U.S. equity market dominates low projected returns in the years ahead, and the sole negative expected real return is U.S. Large Cap Growth, which is dominated by the Magnificent Seven. A negative real return would be a typical outcome after a period of exuberance like we have seen. Yet with earnings yields much higher outside the Magnificent Seven, there are much better options for investors looking for higher returns in the decade ahead…

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The preceding is part of our 1st Quarter letter to clients. To request a copy of the full letter, or to schedule a consultation to review your investments, visit Getting Started.

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