Markets During Rate Cuts vs Rate Hikes

Market sentiment and activity can change during times of rate hikes and cuts. How do those events differ? What does that mean for investors trying to adapt their trading strategy? Adam Johnson, Portfolio Manager of the Bullseye American Ingenuity Fund joins Cassidy Clement to discuss.

Summary – Cents of Security Podcasts Ep. 76

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement:

Welcome back to the Cents of Security Podcast. I’m Cassidy Clement, Senior Manager of SEO and Content and Interactive Brokers and today I’m your host for the podcast. Our guest is Adam Johnson, Portfolio Manager of the Bullseye American Ingenuity Fund. And also you may know him as the author of Bullseye Brief.

Market sentiment and activity can change during the times of rate hikes and rate cuts, but how do those events differ? And what does that mean for investors when they’re trying to adapt their strategy? In this episode, we want to explore all of that and more. Welcome to the program, Adam.

Adam Johnson:

 Oh Cassidy, thanks for having me. Very happy to be with you.

Cassidy Clement:

Of course. So I’m familiar with you because I know Bullseye Brief. We’ve published you on, IBKR campus and I’ve seen your items in your articles all about the financial news world. But for those of our listeners who are not familiar with you, you know, what’s your background in the industry? How’d you get started?

Adam Johnson:

Well, Cassidy, I launched Bullseye Brief back in 2016 and I envisioned it as a way to just sort of explore American ingenuity. I didn’t realize at the time it would grow into a money management business, but, the vision was I wanted to try to identify the people, companies and technologies driving our world forward. So each week I would write up a new stock pick, and as I started adding all these stock picks together it became the portfolio that has grown into the American Ingenuity portfolio. And from that has grown the money management business, and I stay pretty true to that original vision. You know, it’s gone through several permutations, but, what I’m trying to do is identify exciting companies that are growing earnings because they have unique differentiated products that are changing the way we all interact and operate. And if I can identify a company with a great story, data that supports the thesis and some sort of fundamental catalyst or newsy hook, then I’ll write it up in Bullseye and ideally put it in the portfolio, especially if I can identify cash flow growth that justifies a doubling or tripling of the stock over the next several years. I’m a long term investor, so, buy and hold is my strategy and American ingenuity is my North Star.

Cassidy Clement:

So because of all that, that’s kind of the reason why I reached out to you, because you’ve seen the market and the securities react to all different types of landscape changes, especially when it comes to rates. So, really, most people will think that rates will impact much more than just from a fiscal perspective. It may impact usually a lot of expectations on market sentiment. So when rates rise or they fall, why exactly does it have such a large impact on the economy and then the securities associated?

Adam Johnson:

Well, starting with the economy, you know, you think about it, it’s kind of like gasoline, right? I mean, it affects everybody, the price of oil. In the same way interest rates affect everybody from people who are looking to buy a first home and what’s the cost of the mortgage, or borrow money against their home, what’s the cost of a home equity loan? You’re buying a car, and you want to finance it, what’s the interest rate? That affects, you know, the type of car you’re going to buy. Well, just now imagine that at the corporate level where you’re a CFO, and you’re trying to figure out what’s the most efficient way for us to raise capital. Do we do it with stock? Do we do it with bonds? We want to reinvest more money into the company, CapEx, right?

Are we going to finance that? And what are the interest rates? And the higher the interest rates, obviously the more expensive our cost of capital, but also the higher return, we’re going to have to try to get on investing that money, right? So there’s so many different, ways that interest rates percolate through not only individuals, but through companies. And then there’s the whole investment side of it. You know, Cassidy, I’m not sure that the average investor necessarily appreciates the notion of a discount rate, but I’ll tell you it’s really important. And just to touch on it briefly, because it’s so important to stock prices when you buy a stock or when an analyst like me is looking at a company and trying to figure out what the future cash flows are worth, I then have to discount those future cash flows back to the present.

In other words, what do I think those profits tomorrow are worth in terms of the stock price today? And when interest rates are high, that discount rate is higher, which means the value of those future earnings goes down. By contrast, when interest rates are low, I can afford to pay more for those future earnings, and that causes stock valuations to go up. So over the past few years, we’ve all gotten an education in discount rates. Courtesy of inflation and then the Federal Reserve responding to that by raising rates. And that’s why stocks went down just fast and furious in 2022 and, you know, just week after week, month after month, you just were beating your head against the wall. This is a great company, one day it’s going to make so much money and nobody cared because the value of those future earnings was going down every time the Fed raised rates. Thankfully, now the Fed is pivoting to a series of rate cuts. We could argue about how many they’re going to be, but, that is why stocks have rebounded. Those future earnings are worth more now that the Fed is talking about lower rates and because inflation has come down.

Cassidy Clement:

So you had mentioned something where you’re thinking about it to yourself going, wait a second, this company should be winning. What’s the problem here? What’s happening? So when you’re looking at something that we’ll say should be on the upward path and it’s coming into an area of the landscape where the market rates are cut or they increase. What is the normal market sentiment around that? Is there always an expectation that, hey, rates are up so the company might stagnate a little or rates are down, so the company may start to invest more and grow at a larger rate? What’s the, general idea there? Does that have any inclination to another or any type of a relationship?

Adam Johnson:

Yeah absolutely. I think you’re getting a perception and how that plays into it. And one of the things I’ve learned, you know, having been in the markets since I got my economics degree out of Princeton a few decades ago, which is hard to believe, but, perception really matters, and pendulums, tend to swing based upon perception, and pendulums always swing too far. So, you know, you can look back at, just recent history, like the past five years, anytime we’ve gotten our heads, all wrapped up and worked up, about recession, markets go down. And the fact is, we really haven’t had any recessions in the past several years. I mean, you know, 2018, the market was so certain about recession and it never happened. Okay, Covid came along, but that’s like an off balance sheet item. We did go into a recession, because of COVID and lockdowns, but that was not just a normal economy.

That’s a, you know, a one in a hundred years kind of event. And then you look at the past several years and think of all the times we’ve had, people tell us that recession was inevitable or you’d hear, well, Goldman Sachs has just raised its recession odds to 50% from 30%. And you say, oh my gosh, that’s terrible and, you know, bonds respond and stocks sell off. Perception really matters. And one of the things that I try to do for my readers and for my investors is to cut through that. You know, to pick a point on the horizon and say, that’s where we’re steering. And, and I think the market’s gotten obsessed with, or, has gone way overboard with a certain notion, whether that’s inflation, whether that’s recession, stagflation, all the sort of fear mongering stuff that we rack our heads with, but ultimately, you know, tends to work out.

Like, for example, you remember only about a month ago, we thought that, oh my gosh, no one’s going to be able to get any Christmas presents because all the dock workers are going on strike. And three days later it worked out. So, you know, you have to always be aware of perception and recognize that we tend to, I think as human beings, just get ourselves worked up more so than we need to. Fortunately, rational thinking generally wins out in the long term.

Cassidy Clement:

So, obviously the human mind will impact our markets, but when these increases or decreases happen within the rate system, do certain securities see more of a demand? Maybe if something goes up, people are looking for maybe more of a long term conservative investment versus down when they’re like, oh, it’s a little bit cheaper now. Maybe I go that route. You know, how exactly does that show itself or does it show itself at all in market activity?

Adam Johnson:

Well, you know, sort of the knee jerk obvious trade. Not that I’m a trader, but you know, I think you’re getting at flows. When rates are going up, you sell banks. Bottom line. And, and by contrast, you buy utilities because utilities are an income instrument and they pay dividends. And so when, rates are going down, all of a sudden the value of a dividend paying stock goes up. So again, when rates go up, banks go down, utilities go up. And then, you know, vice versa when rates are going down. There’s some of those kind of reflex trades that you just learn over time. Or you know, another obvious one, if rates are going up, home builders are probably going down because obviously mortgages are going up, and if mortgages are going up, housing demand goes down, therefore the profitability of homebuilders goes down. So, you know, all that’s probably pretty intuitive and makes sense. The one that may not make as much sense is small caps, but it’s that discount rate thing that we were talking about.

So, you know, small caps, smaller companies need to borrow money more than larger cap companies because they’re still growing and they may not also have strong earnings streams yet. We hope they will in the future but again, we talked about the discount rate if it’s a small cap company that needs to borrow and it’s not yet producing a lot of earnings and rates are going up we have to discount those future theoretical earnings that we’re hoping for. We have to discount those at a higher rate which means the stock price goes down and, small caps get hit a lot harder than large caps for that reason. Large caps already have profits and they probably don’t need to borrow as much money. So it’s really a double whammy for small caps and in fact, if you look at the Russell 2000 Index, or the IWM, which is the ETF some of our viewers and listeners might already be familiar with. That has still not gone to new highs. So we have the S& P 500, the NASDAQ, and the Dow making new highs week after week, sometimes day after day and yet small caps are still lagging. And it’s because rates have come down, but not by that much. So, rates really do matter. And that’s, certainly the lesson of the past several years. Perception matters, and rates matter.

Cassidy Clement:

So you had talked about when we were referencing some perception and some research, there’s so much noise out there for researchers or our listeners or anybody looking to make an investment to cut through. We’ve had episodes on here where we’ve talked about cutting through the noise within financial news especially in today’s day and age, you know, it’s like a consistent amount of information flow. It’s not necessarily like you wait for the newspaper to come out the next day. It’s essentially whenever you have a cell signal something has happened somewhere around the world that probably will pertain to your portfolio.

So when we have these elements of rate changes or there’s rate change upon us in a general sense, if there is, what are some things for investors to keep in mind? if they’re looking to adapt their strategy or add or remove anything from the portfolio. I mean, myself with my research basically it’s like, hey, listen, you got to pay attention to fixed income and inflation in addition to these rates. Is there anything else that, you know, are some items or crucial questions to ask yourself if you’re looking to adapt your strategy during a time that sounds like it’s going to have some changes in it?

Adam Johnson:

Yeah. Well, I think, what you’re getting at is sort of the checklist. And if you ask me what my checklist is, it’s actually pretty straightforward. And, I think it ought to be everybody’s, checklist. The economy, right? Start big, start up here. The economy. Is GDP growing or is it contracting? Earnings. Are they growing? Are they shrinking? What’s employment doing, you know, do people have jobs? Are they making money? Are they spending money? Credit. If they’re spending money, are they doing it on borrowed money? And what’s the credit quality? Are non performing loans going up at the banks or is, you know, credit quality pretty good? These are all the big picture things that I think everyone, should really be aware of. And, and I sort of say, and people probably say, yeah, well, I’m not an economics major, I’m not an economist. No, but we all read the newspaper. We all talk to one another and we, you know, can all form opinions about that.

As far as, how I interpret all that stuff right now, here’s what I would tell you. We have an economy that is growing about three percent. That’s pretty good. It’s a little below the long term average, which is more sort of three and a half, but three percent, that’s decent. Certainly no recession anytime happening. We have very high employment, right, 4.1% or 4%, somewhere there. I mean, that’s really strong. We have a lot of people working, so unemployment’s low. And when we have a lot of people working, they, have money to spend and because they are spending money, they are generating earnings growth at companies. In addition, we have inflation that has come down to somewhere between 2.5% and 3%. Actually, we recently learned the GDP Price Index is down to 1.8%. That’s below the Fed’s target of, 2%. So, inflation’s going the right way, which means we also now have, interest rate cuts at the Fed.

In other words, you start adding all this stuff up, and there is a lot more to like than to fear. I know the elections are on everyone’s mind, and you know, no one really knows how it’ll play out. Even once we learned what the results are, no one really knows how it’ll play out until things start to happen in the new terms next year. And that takes time and so it creates anxiety in the interim. And yet, you know, you look at all that economic stuff and all the stock markets stuff, and, that’s all generally fairly positive. So from my own point of view, I am fully invested and that is because again, I think there’s a lot more to like right now than to fear.

Cassidy Clement:

Yeah. I mean, when it comes down to it, It’s important for everybody, I think, also to just take a moment and think of it a little bit from the historian’s perspective. The economy has Never been always great and just magically rewarded everyone. There’s a lot of patterns and a lot of different things that you can research.

Now, that’s not to say that patterns are indicative of everything. I mean, obviously we all were around for the market during COVID, which was unprecedented to say the least, but there’s a lot of ways that you can see the market sentiment sometimes may be based out of fear, may be based out of people being unsure of things, but there are ways to make a strategy in an environment with high rates and low rates. It’s just a matter of seeing what works for you and, you know, researching and taking the time to make sure that everything fits your financial goals and your portfolio.

Adam Johnson:

Oh, for sure. You know, I remember back in 2016, people said, you know, how did you deal with that crazy election that was contested for so long and we didn’t know? I said, well, it’s really simple. You know, from a pure markets point of view, Trump won, so we bought the banks. If Clinton had won we would have shorted the banks. And I’d say the same thing about, you know, right now. You know, a Trump win, you buy the banks. You know, a Harris win, you sell the banks, right? It just boils down to regulation. You know, you start thinking about the portfolio and how to optimize it in a democratic administration, obviously clean energy, becomes a priority. In a Trump administration oil becomes a priority, right? I mean, you know, there’s some just basic simple things you can think about, in a democratic administration healthcare, more people get coverage. That’s good for healthcare earnings. That’s a priority. By contrast in a Trump administration, fewer regulations means, in theory, biotech, gets the nod, probably so does fintech, and crypto. You know, by contrast, you look at a Harris administration and some of the tight relationships that we’ve seen over the past several years with Big Tech you probably give a benefit there. AI, I think probably wins, no matter who, gets elected. So that’s something at least you can have in there and not have to worry about. So, you know, I think as people think about how to position their portfolios over the next six months, the economy is strong.

Politics are always uncertain, but we will get more clarity and more evidence of what will happen as 2025 unfolds. And I think you can start to kind of plot out how you might want to tweak the portfolio but what I would also say, and Cassidy, this is so important. Over the long term, markets go up two days out of every three. So I, as an investor, certainly on behalf of my clients, I focus on time in the market, not timing the markets. Because when you think about it, if you time the markets, you have to be right twice. You got to time it when you sell it and you got to time it when you buy back in. And then by the way, what about three months after that or six months or maybe two years, right?

You have to constantly sell and then buy back in and then sell and then buy back in and sell. I mean, nobody’s that good and you’re going to get stuff wrong, and then it messes with your head if you’re wrong and say, oh my gosh, I sold and the markets run 12%. I don’t want to get in now because you know, it’ll probably go back down so I’ll wait for a pullback, and then the pullback doesn’t happen for another 5%. You know, it just messes with your head. So I have found that I’m much better served by focusing on high quality growth companies where I can identify a pathway to earnings growth over the next couple of years and what I think will be stock appreciation over the next couple of years and, just letting those stocks work for me and not timing the market. I know there’s some people who are, traders and they love it and they may even be good at timing the market. I am not, but I am a good stock picker and I’m comfortable sticking to my strategy.

Cassidy Clement:

Yeah, you brought up a lot of good points today, and I think the listeners will have some great ideas for putting into any of their strategies, so thanks for joining us.

Adam Johnson:

Oh gosh, Cassidy, thanks for having me.

Cassidy Clement:

Sure. So, as always, listeners can learn more about an array of financial topics for free at IBKR Campus. Follow us on your favorite podcast network, and feel free to leave us rating or review. Thanks for listening, everyone.

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