If you’re one of my long-time readers, you know I’m one of the most bullish guys in the newsletter business.
Since 2015, I’ve been telling anyone within earshot that we’re in a long-term secular bull market that would last a decade or more.
(I also said short-term bear markets would punctuate that long-term bull market like we’re experiencing now.)
So what I’m going to tell you today will be shocking…
If you think we experienced a lot of pain in the stock market last year, I’m sorry to tell you 2023 could be even worse.
The last 12 months were fairly mild compared to what a real bear market looks like…
Just ask investors who were around for the 2008–2009, 2000–2002, and 1987 crashes. Those were real bear markets.
What we saw in 2021 was more like a love pat than an all-out mauling…
(At least for stock investors. Bond investors got crushed.)
Last year, the S&P 500 and Nasdaq dropped as much as 25% and 35%, respectively.
Again, that’s a pinprick compared to the dotcom crash of 2001–02, when the S&P 500 and Nasdaq crashed 49% and 78%, respectively, from their peaks…
Or the 2008–09 Great Financial Crisis, when the two indexes plunged 57% and 56%, respectively, from their peaks.
History suggests that under certain conditions, stocks could have a lot more room to fall – especially growth stocks.
And it all comes down to one key metric: The risk-free rate of return.
The Key Financial Metric Everyone Should Be Watching
Every institution has rules that govern how and when they’ll allocate capital to equities.
They use financial models that change the allocation based on prevailing interest rates.
The 10-year U.S. Treasury rate – the “risk-free” rate – is typically what they choose.
If that rate of return is higher, they’ll move away from what they see as high-risk investments – things like bitcoin and high-growth tech stocks.
Instead, they’ll move into safe blue-chips with earnings, predictable cash flows, dividends, and inflation protection.
That’s what we saw happen in 2022. The Federal Reserve hiked rates from 0% to 4.25% over nine months. It was the fastest pace of rate hikes in over 40 years.
Here’s the thing…
The Fed has said it isn’t done hiking rates yet. But the market does not believe the Fed. The market forecasts that the Fed will stop hiking rates and begin lowering them in 2023.
Given the tough talk coming out of the Fed, the only thing I can see getting the Fed off its anti-inflation stance is either a collapse of a systemically important company or a sudden surge in unemployment that overshoots their internal targets.
As of this time, neither of these outcomes appears imminent. That suggests equity prices are still quite high compared to the current risk-free rate of return.
If the Fed raises rates to 5%, which the Federal Reserve is telling us it will do, then my research suggests the S&P 500 is overvalued by at least 20–25%. That means the S&P 500 could drop to 3,000.
That would be about a 37% drop from the peak and be well in line for a more typical bear market move.
Under this scenario, growth stocks would see another leg lower. Even if you’re already down 90% on certain risk-on assets… You could see them go down another 50%.
That’s why I’ve been cautious about recommending stocks over the past year – except for safe blue-chips with earnings, predictable cash flows, dividends, and inflation protection.
But there’s another way to earn safe income right now – and potentially pocket double-digit appreciation along the way.
The Best Low-Risk Investment Today
It bears repeating it’s not an ideal time to buy growth stocks.
The earnings yield right now in the S&P 500 is 4.78%.
That means if you owned the entire S&P 500 companies outright, your yield (from the S&P 500’s collective earnings) would be 4.78% annually.
But the risk-free rate of return is 4.6%. So it doesn’t make much sense to gamble on equities when you can lock in similar guaranteed returns on U.S. government debt.
Even better, you can buy investment-grade bonds from some of the world’s best companies, paying 6–7% yields to maturity.
That’s an incredible return when you understand just how little risk there is in owning investment-grade bonds. According to S&P Global, the highest default rate on an investment-grade bond was just 1.02%.
Back in December, I was nibbling on some 7% yield to maturity investment grade bonds… and in hindsight, I wish I had bought more.
I made 20% on them in just eight weeks. That’s an insane return for investment-grade bonds bought with zero leverage.
If you’re itching to wade into the bond market right now, I will caution you to be patient.
Recently, bond prices have rallied strongly as we’ve seen the 10-year yield drop from a high of 4.2% to a recent low of 3.4%.
This drop in yields has corresponded with a big rally in bond prices, and that’s why I took profits on my bond position.
I don’t think the current bond rally is sustainable… So I’m holding a lot of short-term (30- to 90-day) government bonds. They’re yielding 3–4% with zero risk.
I’m waiting for rates to spike again… and when they do, I plan to redeploy my short-term funds into longer-term investment-grade bonds yielding over 6%. That’s because I don’t believe the Fed can keep rates high for an extended period.
Like Wall Street, I also believe the Fed will eventually have to pivot.
I just don’t think it’ll happen as quickly as the Street believes it will. So in my eyes, the lowest-risk way to make money right now is to sit back in short-term government bonds and wait and see if rates jump again.
If they do, load up on investment-grade corporate bonds and ride the rally in bond prices as rates start their trip back down when the Fed finally pivots.
But we’re not there yet…
What If I’m Wrong
For most people, bonds are boring. They prefer to chase the upside on growth assets like cryptos and tech stocks.
Me too. But not during a bear market’s mid to late stage of a bear market, and certainly not with big money.
By all means, if it’s right for you, nibble away on your favorite ideas and continue to dollar-cost average into bitcoin, equity indexes, and your favorite stocks… But making a big directional bet right now looks very risky to me.
I’d rather give up the first 10–15% of market upside and wait for an ACTUAL Fed pivot than lose another 30–50% trying to time it.
The other thing to consider is this: Most investors already have massive exposure to growth.
So if I’m dead wrong about bonds, and the market recovers faster than I expect, it’ll mean the growth side of your portfolio will recover… and you’ll make a tremendous amount of money on your stock and crypto positions.
But trying to time the bottom in equities is a fool’s errand.
So instead of catching a falling knife, you can make over 4% per year risk-free on government bonds and over 6% in investment-grade debt.
Best case: Yields fall. You’ll make 15–30% capital gains on your bonds when the Fed pivots and begins to cut rates again.
(Bond prices move inversely to yields. As yields go down, prices go up, and vice versa.)
Worst case: Yields stay flat or rise. You’ll still make income on your bonds and recoup your capital at maturity while keeping capital free to take advantage of much cheaper stock prices.
But Isn’t The S&P 500 Cheap?
Right now, many investors are making a big mistake. They believe the S&P 500 is cheap at current levels. But it’s still horrendously overpriced – by at least 20%.
The only way that corrects is if we have explosive earnings growth or a dramatic drop in interest rates.
The most recent ISM Manufacturing Index reading of 48.4 tells us the U.S. economy is slowing… So I don’t know where the earnings bump will come from.
(The ISM Manufacturing Index measures the level of economic activity in the U.S. manufacturing sector. A reading above 50 indicates an expansion of manufacturing, while a reading below 50 indicates a contraction.)
When we look at the most recent inflation number, yes, it was down… but it was still up 6.5% year-over-year.
That’s way off the Fed’s 2% target, suggesting that rates are not coming down anytime soon.
Where will the upside for stocks come from if earnings don’t boom higher and rates don’t come down?
(That’s a serious question. Help me see the other side of this. You can send a comment to us here.)
Friends, relative to prevailing interest rates, the current market valuations measured by the S&P 500 don’t make sense…
But the good news is short-term government bonds (90 days or less) are paying over 4%.
I’m quite happy making 4% and only losing 4% to inflation while I wait for truly great prices to emerge… or the much discussed (yet still missing) Fed pivot.
Let the Game Come to You!
P.S. While we wait for bargains in the bond and stock market, a different asset class has outperformed all my traditional investments combined over the last two years… and I don’t expect that to change any time soon.
To learn more about this inflation-proof, volatility-resistant asset and how you can get started for as little as $50… click here.