Why be cautious when making our investment

Stock investment prices have risen sharply over the past three weeks, and it's not hard to spot why. The business results The second quarter ended better than analysts expected, while investors are increasingly confident that inflation has peaked. But if you are wondering if it is time to start preparing for the arrival of a new bull market, perhaps you should wait. We explain why…

The Fed is unlikely to change course soon累​

The Federal Reserve has two objectives, to keep employment near its maximum level and to keep prices stable around 2%. With unemployment in good shape, at a pre-pandemic low of 3,5%, the main problem is curbing the country's inflation. As the central bank has stressed on several occasions lately, it is willing to do whatever it takes to achieve this.

The point is that inflation fell a little in July, but it is unlikely to fall unless demand for goods and services collapses. That's why the Federal Reserve is raising interest rates so aggressively. With these actions it aims to curb demand by stifling economic growth with higher interest rates. It's the kind of situation where good news can lead to bad news. If growth prospects improve (normally we would say good news), then inflation will likely rise again (bad news), which in turn would force the Fed to raise rates even further, even faster ( very bad news), until growth stagnates enough to curb inflation.

Nobody says it will be easy to lower price pressures. Core inflation (excluding more volatile food and energy prices) will likely remain stable for some time, preventing inflation from falling to a level where the Fed can comfortably stop raising rates.

This landing is likely to be anything but smooth​

Regardless of what the Federal Reserve does, we have no guarantees that we can achieve the so-called “soft landing«that is, moderate growth enough to reduce inflation, but not so much as to drive stock investing into a deep recession. After all, the Fed has only managed that kind of landing once. And there's a good reason for that, since a soft landing requires a perfectly timed slowdown, and monetary policy (the only tool the Fed has) is not a precision instrument. It is a tool that may well provide us with the wrong amount of stimulus at the wrong time. To make things even more difficult for the Fed, the effects of changes in interest rates are usually felt with a delay of several months. It's like steering a raft on a river with only one paddle facing backwards.

This is important to understand because, although high inflation and a red-hot labor market suggest that the Fed has not raised rates enough, it could be that the effects of those rate hikes have not yet manifested themselves. As we explain here, rising interest rates affect different areas of the economy at different times.

They have much more to lose than to gain​

For investing in stocks to offer good returns now, company profits would have to at least meet expectations. And those expectations are already quite optimistic, given that investors see profits growing between 7 and 10% over the next two years. They also expect profit margins to widen from their highest levels and inflation to fall as quickly as it has soared. And even in the unlikely event that all of this happens, the stock investment will not earn as much as we might expect, because these high expectations are already partially priced into current stock investment prices.

On the other hand, if things don't look as good as investors hope, stock investment prices will likely fall quite a bit to reflect the new reality. Let's remember that losses have a greater impact on our portfolios than profits. After all, we need a 100% profit to offset a 50% loss, which means it could take a while to recover those losses. For example, investors who bought during the June 2001 bear market rally had to wait until April 2006 to get back to square one.

How can we take advantage of this equity investment opportunity?

If you feel like replenishing your stock investment, waiting for a little more clarity on where growth and inflation are headed may be the smartest thing we can do. Of course, it's possible that we're wrong and the Fed gets a perfect soft landing, with corporate earnings meeting the market's high expectations and stock investment prices continuing to rise. If that is the case, and you have been left out of the market, you will only miss out on some initial benefits. But if we are right and things turn sour, we would not only avoid the pain of real losses, but we would also be in a much better position to replenish our investment in stocks at discounted prices.

As we have said many times, there are times to be aggressive and times to wait for better opportunities. With such an uncertain macroeconomic environment and such optimistic investor expectations, we could say that the most appropriate thing to do is to continue analyzing the development of the news.