One of the hottest topics on investors' minds in the past couple years has been inflation. Rising prices across the economy, which came to the forefront about two years ago in a surprising fashion, have hurt consumers in a wide range of shopping categories.
But besides the real-world impact, inflation has prompted the Federal Reserve to aggressively hike interest rates since March of last year to pressure demand and get stubbornly high prices under control. In fact, the central bank has never increased rates at a faster clip than it did in 2022. To be fair, inflation has cooled in recent months.
From an investment perspective, it's a good idea to think about ways to shape our portfolio strategies around what will happen with interest rates. After all, we can't control interest rates. However, we do have full control over what we can do to prepare for their unpredictability.
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It's all about the Fed
Besides keeping unemployment levels low, one of the primary tasks of the Federal Reserve is to keep inflation close to its 2% target. And, one of the most powerful tools it has at its disposal is to adjust the fed funds rate, which is the rate that banks charge each other for overnight loans.
When the economy is struggling and in need of a boost, the Fed will lower rates to spur demand for borrowing, which can drive growth. On the other hand, when the economy and inflation are running hot, like what we saw following the worst of the pandemic, the central bank hikes rates. To summarize, the Fed tries to affect changes to the real economy.
However, it's kind of shocking to realize how much of an impact the Federal Reserve has had on stock prices. Loose monetary policy and historically low rates led to the longest bull market in history during the 2010s. And on the flip side, the quick rise of rates in 2022 resulted in a 19% decline for the S&P 500 and a 33% plunge in the Nasdaq Composite.
Investors now have become obsessed with what Fed Chair Jerome Powell will say next, dissecting his specific words to guess what policy shifts are on the horizon, all in order to figure out ways to position their portfolios. It's best to avoid this entirely, something that's a lot easier for long-term investors to do.
Valuation always matters
Warren Buffett, arguably the greatest investor ever, says that it's worthwhile to only focus on what's knowable and within once "circle of competence" when analyzing stocks. Buffett considers interest rates to be in the category of "macro stuff". While interest rates do affect stock prices, what truly matters is understanding the fundamentals of the business in question and its current valuation.
There's little doubt interest rates might be important in the next six- to 12-month period at the macro level, especially if they are not very stable. However, they certainly don't play a role in a company's long-term value creation. Put differently, management teams (apart from those of banks) don't plan their long-term strategies around interest rates. Moreover, predicting changes in interest rates longer into the future is a fool's game.
If there's one thing the past couple of years taught me, it's that valuation always matters. Higher interest rates generally pressure stock valuations. The simple explanation is that fixed-income securities, such as bonds, become more attractive to investors versus stocks. And the so-called growth stocks, in particular, whose profits are expected further out in the future, are hurt the hardest.
Investors might have been able to ignore valuations for most of the past decade because of declining interest rates. But in the future, it's anyone's guess what happens with rates.
So what's within an investor's control? Buying shares of outstanding businesses when they sell at attractive prices is the best course of action, no matter what the economic situation is. This means seeking out stocks trading at below-average price-to-earnings or price-to-sales multiples. This helps ensure you aren't overpaying for businesses.
