Why is the stock market down so much now? 

The short answer is inflation, but more accurately, the Federal Reserve is fighting inflation by sharply increasing short-term interest rates.  Higher interest rates will slow the economy, slow the housing market, reduce employment growth and eventually reduce inflation.  The sharp increases in short-term interest rates have decreased stock valuations across both domestic and international markets. 

Over much of the past 20+ years, when the economy stumbled, since the inflation rates were historically low, the Federal Reserve was willing and able to reduce short-term interest rates to stimulate the economy.  Since the Federal Reserve did not have to worry about controlling inflation, they could focus their energy on their second mandate of “full employment”.  During the Covid-19 crisis, short-term interest rates set by the Fed were reduced to 0.25%.; nearly zero.  Interest paid on savings was practically zero, pushing more investors into stock investments, which helped to drive stock prices up.  The Fed’s focus on lower short-term interest rates also drove mortgage rates lower; combined with a persistent housing shortage, home prices around the country hit new records, especially in areas where office working “Covid nomads”, could work anywhere there was a decent internet connection. 

The war in Ukraine, and the resulting energy crisis is driving foreign stock and bonds markets down as well.  The foreign markets, especially Europe, are seeing much more volatility and will likely have a significant recession and potentially a winter with insufficient energy reserves to keep both factories operating and homes warm.  Recent lockdowns in China are still impacting supply chains around the world.  Both factors have negative impacts on foreign stock prices.   

Major moves in the market are usually concurrent with major shifts in investor sentiment, which is decidedly negative at this point.  It appears that the Federal Reserve will have to continue to increase interest rates for the next 6 months at least and possibly longer to get the current inflation rate under control.  Last year the academics within the Federal Reserve and many market commentators opined that the elevated inflation that was evident, was “transitory” and was primarily related to supply chain issues resulting from the Covid shutdowns.  Over the past 6 – 9 months the Federal Reserve has recognized that inflation was not subsiding as they had hoped and projected, but inflation was gaining momentum.  Once inflation becomes deeply imbedded in the minds and future expectations for consumers, employers and corporations, it becomes very difficult to interrupt.  It can become its own “self-fulfilling prophecy.” We have seen this before in the late 1970’s and early 1980’s where the Fed chairman at the time, Paul Volker, eventually contained inflation after raising the short-term interest rate to 21% in 1981.  We certainly do not expect to see a repeat of those historically high interest rates, but Chairman Powell’s highest priority is getting inflation under control as soon as possible, with less concern about the impact to the economy or stock market. 

This graph below shows the Federal Funds rates since 1996 and the shaded areas represent recessions.   

Notice how short the 2020 Covid recession in comparison to 2002 or 2008 (very narrow vertical band).  Note the very steep increase in the Federal Funds rate in 2022 in the bottom right of the chart.  We are witnessing the fastest increase in short-term interest rates in recent history. 

Figure 1:

*Figure 1: Historical Fed Funds Rate from 1995 to present 

It is our hope and expectation that the recent, sharp interest rate increases will begin to slow the rate of inflation, but several components of the inflation equation, like housing costs (measured by rental rates), are still rising, and it can take several quarters or more until we see the full impact of the prior rate increases. 

Why are my bond funds also down?  I thought bonds typically did better when stocks were down. 

Yes, that is typically what we have seen in most down stock markets of the past 50 years, but the unusually fast interest rate increases we are seeing have sent a shock wave through the bond markets.  We have had falling interest rates for most of the past 40 years, but we are in a new pattern now, where bond yields are rising quickly, which causes bond prices to fall quickly.  We do not use long-term treasury bond investments due their risk, but those bond funds holding 20-year U.S. government bonds are down -20% this year.  We have seen some excellent bond funds we have used for years, fall in value by more than 10% so far this year.  This is extremely unusual. 

The chart below shows the total return of a sample portfolio with 60% stocks and 40% bonds, for the first three quarters of each year, going back to 1926.  We normally use charts showing full year returns, but this chart enables us to compare 2022 year-to-date with other times of extraordinary financial stress, like the first three quarters of 1931 and 1974.   As the chart shows, the returns of the first three quarters of 2022 are nearly as bad as they have ever been since 1926.   

Figure 2: 

*Figure 2: Historic return of 60/40 Portfolios over the first three quarters of a year.   

 

What are the best steps to take now? 

There are many variables that move markets, but there is an old adage that says, “You can’t fight the Fed.”  When the Federal Reserve (The Fed) is driving up interest rates, their #1 priority is to tame inflation, so the Fed will not be coming to rescue the stock market with low interest rates this time.  Chairman Powell has referenced “there is more pain to come,” as interest rates continue to rise.  We must wait for the rate increases to percolate through the economy and eventually slow demand for goods and services, which will result in lower inflation levels.  When markets are down sharply, we try to focus on the following: 

1.  Maintaining our disciplined asset allocation.  We want to take advantage of tax losses where possible, but we will maintain the asset allocation and we will have market exposure to benefit when the stock and bond markets once again rewards investors.  We will make minor portfolio adjustments as needed depending on client needs.  Just last week, the broad market jumped 5% in just two days. 

 

2. Taking advantage of higher cash and bond interest rates.  We can now get much better returns on cash than any time in the past 10+ years using short-term government and corporate bonds.  We are using shorter duration bonds to avoid negative impacts related to the rising interest rates.  We are also moving client funds to higher earning “traded” money markets to capture better yields. 

 

3. Continuing to use alternative assets where possible to give us a source of returns that is not correlated to the stock and bonds markets.  Over the past year, our private real estate interval funds and private debt funds have performed much better than the broad stock and bond indices. 

 

4. Being patient, disciplined investors who stay the course have historically reaped the benefits of maintaining market exposure through downturns.  We know how hard it is to be patient during down markets, but we know that trying to exit and re-enter the markets usually leads to a worse outcome. 

 

The chart below shows the returns of a hypothetical investment of $100 invested in 1926 with the green bars representing past recessions.  With the possible exception of the Great Depression, investors have done well by maintaining their asset allocations over longer periods of time.  We continue to believe disciplined investors will continue to be rewarded going forward once our current market recovers. 

Figure 3: 

 

*Figure 3: Return of $100 invested. Green bars represent recessionary periods 

Times like this are never fun, but if we want to earn better returns than government bonds over longer periods of time, stocks must be in the picture.  As always, we are closely monitoring the market conditions and we are happy to address your individual questions and concerns.  Email is the best way to reach the office.  Please let us know if you have any questions and we will be happy to schedule time to call or meet with you. 

 

Best regards, 

Pete and the BrightPath Team