Do This To Stay On The Fed’s Good Side

“Don’t fight the Fed.”

Famed fund manager Marty Zweig came up with that one in 1970 and repeated it religiously until he passed away in 2013.

The Federal Reserve has been raising rates since March of 2022, and Fed funds rates have gone from 0.25% to more than 5%. Three-month Treasury yields have risen from 0.03% in December of 2021 to 5.21% today—“only” a mere 173 times higher.

There is an excellent reason not to fight the tape: interest rates can change valuations dramatically.

Let us take an example using the basic evaluation model that they teach at investment banker summer camp: if I value Microsoft using Wall Street’s current growth estimates and the 5% rate from a year ago, the fair value is about $419. This is above the current price, implying that Microsoft is a bargain stock.

Warren Buffet, the king of discounted cash flows, has suggested in several recent interviews that 10% is a better discount rate to identify potential bargains. With a 10% discount rate, Microsoft is now worth about $257, well below the current stock price of around $330.

That’s just one stock – the same applies to almost the entire market right now. So here’s what you need to do…

Growth rates also matter, and despite the committee members that set monetary policy in the United States telling you we will have a recession, Wall Street refuses to make meaningful adjustments to earnings forecasts, and if history is a guide, it will only do so once the recession has arrived, and most analysts are parking their Teslas at a friend’s place in New Jersey so it does not get repossessed.

If we take Wall Street’s aggressive 10-year earnings forecast of 16% growth, trim it to 10%, and discount that at 10%, we get a fair value of $176 for Microsoft. That is way below the current price of the stock.

We could do this for hundreds of stocks and get similar results.

If we take the market, use the $220 estimate that is the current consensus for the S&P 500 and a 10% discount rate along with an 8% annualized earnings growth rate for the next decade, the fair value of the S&P 500 is $3,369—slightly above the $3,000–$3,200 I have been telling subscribers to expect for a long time.

If we take JP Morgan’s (JPM) $202 estimate, which is probably a lot closer to reality given the likelihood of a recession and uses a more realistic 10-year growth rate of 5%, we get a value of $2,575, well below the current price of the S&P 500.

I repeat: do not fight the Fed.

Earnings are the ultimate detriment of stock prices. If rates are going higher and earnings are going lower, stocks will eventually move lower to reflect the new reality.

That is a good thing for patient-aggressive investors.

Right now, you can buy bank stocks that have high levels of capital and management with a solid history of not making stupid mistakes. Real estate investment trusts are also nearing what should be a generational buying opportunity. Fixed income is poised for extraordinary returns over the next several years, and real estate-related debt and preferred stock returns should move the needle from extraordinary to spectacular.

Keeping some money in cash at 5% until equity prices reflect reality and can be had for a bargain makes enormous sense. A market sell-off will give us a chance to buy high-quality smaller companies well below liquidation value and absurd levels of free cash flows.

There are signs that the market is beginning to run out of steam after a fantastic run to start 2023.

Artificial intelligence stocks are reaching the absurd valuations we saw in internet stocks in 2000. Trading them here is playing a financial game of pass the burning match—everyone thinks they will pass it off in time and not get burned.

But almost all of them will get burned.

Chasing stocks right now, hoping to squeeze out gains, is a lot like going to the track with the name of a guaranteed winner at long odds in the last race. Instead of waiting patiently, you bet on overpriced favorites all day and have very little, if any, money to place on the big payoff race.

Be smart: put a little on some real estate bonds—I’ll have a couple to share with you next week. Buy some banks with a lot of capital and bankers with solid records of avoiding stupidity. Keep an eye on REITs. One last wave lower, and it will be time to buy with abandon.

Hold high-yielding cash and wait for the big payoff opportunity.

This post originally appeared at Investors Alley.

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