Investment Letter – Second Quarter 2021


One of the best lessons I’ve learned during my 30-year investments career is this: DON’T FIGHT THE FED. What does this mean? It means that when Fed policies are supportive of the market (lower rates, quantitative easing), the prevailing winds will likely be favorable to stocks and other risky assets. Conversely, when Fed policies shift from supportive to restrictive (the focus goes from supporting growth to fighting inflationary threats, i.e. raising rates including quantitative tightening) then the prevailing winds will likely turn against stocks and other risky assets. Presently, we find ourselves in the midst of the most supportive policy stances in the entirety of the Fed’s illustrious history. So long as the Fed’s policies remain supportive, our position has been and continues to be that the US stock market can continue to produce positive (and perhaps even strong) results, in spite of its lofty valuations. We think we can stay in this trajectory so long as the Fed is supportive. But we are uneasy.

This position is not riskless and taking it is not easy. Things could change rapidly. In fact, never has “not-fighting-the-Fed” been so hard. Why? Put simply: because the current phase of supportive Fed policies are leading to extremes. And the extremes are, in fact, sobering.

Lets first take a look at the supportive measures of the Fed and then at the extremes these policies are leading to in the capital markets. 

Fed Support

  1. The Discount Rate. With the discount rate (the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility) set at close to zero (25 basis points), you really cannot get more accommodative than this. “Lower for longer” seems to be the Fed’s policy stance at this time. The implications are clear. The Fed is out of interest rate ammo and will need to use other measures to support economic growth.
  2. The Fed Balance Sheet. The Fed continues to buy assets in the open market. While establishing certain linkages is mathematically impossible, the relationship between a growing balance sheet and a rising stock market through inference seems obvious. Still, there is debate among professional investors about the degree to which market advances have been supported or even driven by money printing via balance sheet operations.

We do know things got rocky just prior to the COVID 19 pandemic and since that time, the balance sheet has exploded to unprecedented heights. What was going on in markets just prior to the pandemic? In the fall of 2019, there were dislocations in the overnight lending markets (rates spiked to 11.5% one night), which led to the reversal of the Fed’s quantitative tightening program. The Fed had been increasing its balance sheet in 2020 just prior to its massive response to the pandemic. The trillion-dollar question is what happens to stocks when this stops and, worse, reverses?

The Consequences of Fed Policy

  1. Roaring Markets and Lofty Valuations. The US stock market has responded resoundingly to the supportive policies, with strong returns across all classes of stocks. The massive sell off of 2020 is a distant memory replaced by the massive rally that came after it. Additionally, other speculative assets (such as crypto currencies) have experienced strong, volatile rallies. The darling stocks of the new digital era have all exploded to the upside leading to valuation levels last seen in the late 1990s. Stocks are nearing all time high valuation levels; only exceeded by the bull market of the late 1990s. Coincidentally, housing is also moving toward all time high valuation levels. This is the first time both housing and stocks are in concurrent valuation bubbles. They may go higher and they may stay here for quite a long time; whichever way they go, it probably will depend on Fed policy.
  2. Inflationary Pressures. In the recent past, we have written extensively on the threat of inflation within the economy. There are strong inflationary pressures in producer prices (commodities) but the degree to which these producer prices are carrying through to consumer prices is not yet evident. We see the risk as material, but so far the evidence has not been conclusive. The Fed and the Biden administration continue to state they believe inflationary pressures will be transitory. If these pressures prove to be more than transitory, it will very likely lead to a massive change in the Fed’s stance. This will mean restrictive policies in terms of potentially both interest rates and balance sheet operations. If this happens, the concept of not fighting the Fed will translate to reducing risk exposure by trimming/selling “risky” assets. Time and new data will determine the appropriate response.

The Way Forward

We do not believe any big moves are warranted at this time. Allowing risky assets to continue to benefit from supportive Fed policy seems reasonable.  At the same time, we are proactively taking some incremental measures to prepare for potential inflation and a shift in Fed policy. We are adding some holdings that can benefit from inflation as well as provide stock market exposure while the market works out the uncertainties.  Additionally, we are starting to implement some strategies that would behave favorably with a change in interest rate policies.  Our portfolio construction thesis is to add investment strategies that can still produce some positive returns under a supportive Fed but still perform if Fed policies shift to become more restrictive. We think that if Fed policy does change in response to inflationary threats, we need to be prepared for heightened volatility and investor nervousness in the ensuing months.


Erik Ogard, CFA®

Investment Committee Chairman