The market weakness that we saw last year with growth stocks has now spread to the rest of the market. The S&P 500 entered “correction” territory in January – meaning more than a 10% drop in value. The NASDAQ was worse. So why is Mr. Market in a bad mood?
Corrections are Normal
First, let’s not forget that 10% corrections are normal. Everyone is entitled to a bad mood from time to time. On average, the S&P 500 corrects around 14% each year (and around 11% in years that end positive). Election years tend to see more corrections, while the price gains tend to happen in the back half of election years. Elections clear up uncertainty, and markets like that. It’s therefore possible that some of this unpleasantness could be with us for a while.
The Federal Reserve
The Federal Reserve has announced that they are going to begin raising interest rates soon. By itself, this is NOT a negative. In fact, it signals that they’re confident the economy is strong enough to withstand higher rates. You wouldn’t know it based on Mr. Market’s attitude in January, but stocks generally do well around these time periods. If the Fed did not act, they would risk creating greater financial instability in the economy because cheap, excess money inevitably finds its way into unproductive investments. In other words, capital is invested in dubious projects – the old “Bridge to Nowhere” – and cheap excess money can also allow price bubbles to form. This eventually leads to much bigger problems. Think housing crisis in 2008. It’s therefore a good thing the Fed is finally acting.
Many market participants are now concerned about the “pivot” the Federal Reserve has made in articulating a more “hawkish” tone on inflation. Jerome Powell’s public appearance on January 26th did not assuage those concerns. The fear is that the Fed might tighten monetary conditions too much and trigger a recession. It’s certainly possible, but this seems unlikely in an election year. The “yield curve” is flattening, so the bond market is sending a strong message to the Fed that it might be unwise to raise interest rates too much.
Inflation is coming from three distinct places: monetary policy, fiscal policy, and supply issues related to Covid.
The Federal Reserve controls monetary policy principally through short-term interest rates. They have also been buying bonds from the government to fund the federal government’s spending. The feeling is that the Fed is probably a bit late in tightening monetary policy, so now we’re hearing all this tough talk coming from the Fed. Time to start taking our medicine.
The fiscal part of inflation has its roots in the enormous amounts of money pumped into the economy by the federal government that caused the money supply to swell. The money supply is up 41% versus pre-Covid. This is big. Normally, the money supply expands about 6% per year. This money had to go somewhere, and it fueled demand for goods (services, not so much due to Covid). It most likely inflated our house prices, too. But the money supply is normalizing – we’re only up around 13% in the last year. Though there is lag in its inflationary effects, the hope is that as we continue to normalize the money supply, inflation will calm down. We can only buy so much stuff, right?
Then there is the “supply-side” inflation where supply is being crimped by supply-chain bottlenecks and a persistently poor labor force participation rate. The Fed simply cannot do anything about these problems. This is a multi-faceted problem, but it seems that management teams are navigating these issues better than anyone expected.
So What Do We Make Of This?
The monetary and fiscal aspects of inflation are still playing out along with supply-chain issues, the labor participation rate, and Covid. And throw in the Ukraine crisis for good measure. It’s an unsightly mix, so it’s not surprising that we’re seeing volatility.
Corporate earnings, however, ultimately drive stock prices, and earnings forecasts remain strong for 2022 and 2023. And don’t forget the old maxim, “The cure for high prices is high prices.” People adjust. In addition, management teams will do what they’ve always done – they go to work to solve problems. Supply and demand will ultimately converge to get things back in balance.
The economic fundamentals/backdrop remain strong, and stocks tend to do well in a rate-tightening cycle by the Fed. January reminded me of the selloff in the 4th quarter of 2018 – a near 20% drop that lasted into Christmas Eve sparked by Jerome Powell’s ill-advised statements to the press about raising interest rates (he was new on the job). Like then, there are plenty of reasons to suggest that this selloff will be seen as a mere tempest in a teapot – not the beginning of a big bear market drop.
Don’t let Mr. Market’s mood cause you to forget the opportunities caused by market turbulence. If you’ve been thinking of investing some excess cash, this is probably a good entry point for long-term money. Or if you’re considering a Roth conversion this year, now might also be a good time to have that discussion. Lastly, for taxable accounts (non-IRA accounts), it might be wise to think about booking any losses now instead of waiting for year-end.
Thank you for your continued trust and confidence. In the meantime, stay patient, stay disciplined, and stay invested.