The Federal Open Market Committee of the Federal Reserve (Fed) met last week and while they did nothing, they said plenty. Fed Chairman Jerome Powell told us that the Fed now expects economic growth in 2021 of 6.5 percent, and that the Fed will still not raise rates even if inflation creeps up beyond their 2 percent target.
This rosy outlook on growth is partly due to the fact that Congress just promised to spend another $1.9 trillion dollars on top of what was already a rapidly recovering economy. The market has sold off; how could that be?
In a word, inflation. Right now there is a tug of war going on between people who believe that all this stimulus and the Fed keeping rates low will lead to wonderful economic growth, and those who believe that all this spending on top of easy money will lead to simultaneous high unemployment, high interest rates, and high inflation. Grow out your sideburns, flare out those pant legs and someone find us a disco ball, 1970’s here we come! Would “Billy Beer” be considered a micro-brew? (Now I’ve dated myself.)
Thus far the inflation worriers are winning. The short-term data is certainly helping them. The last reading for the Consumer Price Index came in at 1.7 percent, and the last reading for the Producer Price Index (or wholesale prices) came in at 2.8 percent. In the meantime, the Fed can keep the overnight borrowing rate low, but markets control other rates and the 10-year Treasury is yielding 1.74 percent as I write this article. That is up from 1.44 percent at the beginning of this month, or 0.93 percent at the beginning of this year. This does not bode well for the economy, and it comes as expectations are extremely high.
What does this mean for the market? That is a good question. It is times like this when prudent selection of individual investments really matters. When things get uncertain and the market is not sure where to go, bottom-up investors tend to do best. This flies in the face of the modern groupthink that index investing is the way to go.
Recently we took a look at our own institutional business, where we help retirement plan sponsors decide which money managers (through mutual funds or other institutional products) to include in their plans. Over the decade that ended December 31, 2020, we have 28 managers that we have held in client plans for that entire decade. Of these 28, 23 are outperforming their market benchmarks and five are not. That equates to 82.1 percent outperforming. The average amount of outperformance is 1.90 percent annualized over that decade, and the average amount of underperformance is 0.38 percent.
Keep in mind that one cannot actually invest in an index; one can only invest in a product that seeks to mimic the index, and by definition all of these products will underperform the index due to the real-world fees and expenses. These investors insist that outperforming is impossible. They proudly save a few basis point in fees and end up sacrificing, in this specific case, almost 2 percent in net return per year.
In fairness, there is the possibility of survivor bias, meaning we would have fired underperforming managers. There were four managers fired and replaced 9 years ago, all of the four new managers are outperforming, but we did not include them because we did not own them 10 years ago. The last replacement we made was three years ago, and we replaced two managers six years ago. The fact is, we have consistently done what the popular press says cannot be done: picked managers who outperform over the long haul after we pick them.
This is not an advertisement in any way. Perhaps it would be if I believed that what we do is unique, but I do not. I truly believe that there are many firms that can do what we have done. This is strictly for educational purposes. Intelligent managers who make prudent bottom-up investment decisions add significant value over time.
This is very important information when we are collectively heading for a very uncertain future. We will continue to discuss specific economic policies and their real-world results on our Perspective blog, but the big picture is that we seem to be heading for what Jimmy Carter called a malaise. We shall see, but if Jerome Powell’s 6.5 percent is an over/under bet, I will take the under, and still sleep well knowing that my investments have been selected prudently.
Chuck Osborne, CFA