What if I told you last year that inflation was going to go down… a lot? You would have bought stocks and bonds until your head caved in.

Well, I did tell you that. And it’s not like I’m bragging—there were a lot of people in the market who were saying that inflation was peaking. So, did you buy stocks and bonds?

Nooooo.

One thing I’ve learned about investing over the years is that the simplest explanation is usually the right explanation. People on Twitter like to post all these convoluted charts and infographics, and I just shake my head. Inflation down, stocks up. So easy a caveman could do it.

It is the natural tendency of the human brain to overcomplicate things. Well, what about this? What about that? What if this happens, then that happens, then this happens? What about this small-cap underperformance? What about the poor breadth? What about the Fed—what’s it going to do? What about the low volumes? What if, what if, what if?

I see people tie themselves up in knots all the time. Inflation down, stocks up. Easy for me to say right now after inflation has fallen by more than half, but go in the 10^th Man archives and see. That is exactly what I was saying.

What Now?

Based on our experience with the ’70s, I would say that inflation is going to decline to between 2%–3% and stay there for a while before it goes back up. But that might not happen for a couple of years or longer.

Believe it or not, there is a limit as to how far the Fed will hike rates. I believe the Fed will stop hiking rates once Fed funds get to be 2% above inflation. Right now, inflation is 4%, and Fed funds are 5.25%, so we still have a little way to go. But inflation will continue to fall, and at some point, policy will be too restrictive.

Having said that, the Fed has this reflex where it continues to hike as long as stocks are going up. At the time of writing, I don’t know the outcome of this week’s Fed meeting, but a rate hike at this meeting would be a big surprise given its earlier commitment to skip and the low CPI reading on Tuesday.

Over the past 50 years, this portfolio has gone up 4,491% and is as set-it-and-forget-it as it comes. Jared Dillian's Awesome Portfolio is designed to outperform over decades, no matter what happens. If you're looking to take the stress and guesswork out of investing and sleep better at night knowing you have a proven plan for success in the markets, click here to see if the Awesome Portfolio is right for you.

If you go back in history, there were long periods when we had positive real interest rates. Positive real interest rates are a good thing! They prevent bubbles from forming. They prevent a misallocation of capital. I’ve been waiting for real interest rates to get into positive territory for a while, and they finally have. This is terrific. And given the Fed’s obsessive focus on the labor market, seemingly the only thing that would get them to cut is widespread unemployment, which doesn’t seem to be happening.

So, low inflation, low unemployment, stocks up. Sounds pretty good, right? But nobody is happy. Nobody is happy because of our experience in 2022. People are still scarred by it. Everyone is waiting for the next shoe to drop. What if there is no shoe? What if the next two years in the market are peaceful and uneventful? What if the VIX spends the next two years below 15?

Just spitballing here. People are starting to come to the realization that the bottom last October was the bottom, given that we’re less than 10% away from all-time highs at this point. I don’t know how many bears read this newsletter, but I would say that you are swiftly running out of arguments.

Where’s the Kaboom?

So, where’s the monkey wrench in this plan? I can think of a few reasons why the stock market might not realize this rosy scenario.

• War

• Fed overdoes it (by quite a bit), which causes lots of pain

• An unfavorable outcome in the 2024 elections (think: Democratic sweep)

• Some exogenous event we haven’t thought of yet (like a pandemic)

• Some other exogenous event we haven’t thought of yet

• Loss of liquidity in the bond market, leading to skyrocketing long-term rates

• Etc.

It makes no sense to invest based on what could happen or what should happen. You must invest based on what will happen.

It’s tough to see out a year. That’s why year-end predictions always go horribly wrong. But I believe it is possible to see out a few months or so. And I’m not seeing any flashing warning lights over the next few months. If the market can withstand 500 basis points of rate hikes, it can probably withstand another 100 basis points of rate hikes.

But the SPACs and crypto and meme stocks are gone forever. They are market history. So, I wouldn’t be betting on any bubbles anytime soon. Not with rates at 5%.

Remember, the simplest explanation is often the best explanation. If you ever wondered why the smartest guys on Wall Street are frequently not the best-performing, this is why.

Jared Dillian

subscribers@mauldineconomics.com