Why Is The Stock Market Falling? Ask The Fed

Investors are struggling to reposition themselves for a rising interest rate environment as Federal Reserve Chairman Jerome Powell sharpens his talons.

There’s little question that the Fed’s hawkish pivot to tighter monetary policy is bleeding the stock market. That comes after a year and a half when an unprecedented amount of money gushed into stocks from monetary and fiscal policies designed to halt the Covid-19 recession and prop up the economy.

Those balmy days of unstoppable gains are done and gone. American workers are quitting in droves in search of better pay while inflation is surging at levels not seen since Olivia Newton-John’s “Physical” ruled the airwaves. Now the Fed is rushing to catch up and keep those rising prices from getting entrenched in the economy—and in people’s expectations.

Investors, on the other hand, are worried about the Fed. With quantitative easing (QE) bond purchases all but finished, markets have become fixated on when the central bank will follow up with Act II: Reducing the massive size of the bond holdings it’s built up, in a process dubbed quantitative tightening (QT). Then there’s the thrill of betting how many rate increases could be in store in 2022.

“The biggest challenge in the environment we’re in now is that investors want a forecast that tells them we’re heading to a single point,” said Patrick Kaser, portfolio manager at Brandywine Global. “The best defense right now is acknowledging there’s a range of possible outcomes.”

The Lessons of January

The first trading day of 2022 saw the S&P 500 top out at an all-time high just shy of 4,800, but it’s been all downhill since then. The benchmark index lost 5.3% in January—and there were six separate sessions where it fell by 1% or more, marking the dramatic return of volatility to markets.

The big moves last month could be a sign of things to come. There have been eight times since 1945 when the stock market enjoyed a so-called Santa Claus rally—big gains in the last week of the year—followed by a sell-off in the first five trading days of the new year plus an overall decline for the month of January, according to CFRA chief investment strategist Sam Stovall. In those instances, the S&P 500 ended up lower for the full year by an average of 9.6%.

The market pessimism began after the release of the December FOMC meeting minutes. The minutes showed that Fed officials were not only considering rate hikes and ending QE quicker than expected but that they would also consider shrinking the Fed’s balance sheet by selling off some of the horde of assets it has built up.

If QE is defined (in part) as the Fed buying bonds, then the Fed selling off those bonds must be called quantitative tightening, market participants reasoned.

The FOMC minutes were released in the afternoon of Jan. 5. The S&P 500 declined nearly 2% that day. By Jan. 24, the S&P 500 had entered correction territory. It didn’t stay there, but it certainly did freak everybody out.

“I think that if the Fed follows through with hawkishness, it will move us in a recessionary direction,” said David Frederick, director of client success and advice at First Bank. “The unemployment rate might start to rise, and businesses and consumers will have a harder time getting funding from banks.”

The Fed’s Conflicting Mandates

The Fed has two jobs—the so-called dual mandate—assigned by Congress: Keep prices stable and maximize employment. While it may be entirely appropriate for the Fed to end bond purchases and raise rates to tame inflation, some market participants hope the central bank doesn’t go overboard and sacrifice economic growth and jobs.

“The consensus among bond traders is that after a relatively small number of rate hikes the economy will slow meaningfully, at least enough that inflation will cool and the Fed will stop hiking,” said Tom Graff, head of fixed income at Brown Advisory.

That’s why the yield on 10-year Treasuries remain so muted despite sky-high inflation. While growth may have been strong when money was being pumped into the system, the economy will revert to pre-pandemic low-to-moderate growth thanks to long-standing themes, such as an aging workforce, globalization and technological advances.

The Fed thinks it can turn toward a hawkish policy because the employment situation has improved so much since the initial pandemic fallout. The unemployment rate, for instance, is down to 3.9% and wages are surging—although not as much as inflation.

At the same time, other metrics show that more work needs to be done. Roughly 3.5 million fewer people are employed now compared to February 2020, and there’s almost 11 million open jobs. While many Americans are rethinking their priorities as part of the Great Resignation or are afraid to go to work because of health issues, the labor market isn’t exactly where it was before.

That disconnect may be why the Fed doesn’t end up acting as aggressively as many assume. In one sense, the Fed is caught in the middle with its dual mandate: Tighten too much, and you’re not going to be able to maximize employment, after all.

Looking forward, the Fed’s commitment to a more normal monetary policy will be tested should inflation fall and the jobs data worsen.

How Should You Position Your Portfolio?

Regular investors need to bake into their expectations that 2022 will be different from the Covid-19 boom.

“This is a restart, not a typical recovery,” according to a recent BlackRock market commentary. “Inflation is driven by supply constraints following a huge shift in demand during the pandemic, not an overheating economy, so the traditional policy playbook does not apply. We think the Fed will eventually back off but are prepared for a bumpy ride in markets.”

Here are a few words of wisdom as you prepare for the new market environment:

Stay the Course

Even if the Fed tightens aggressively, it doesn’t necessarily mean stocks will fall.

According to Datatrek, in the three years when the Fed increased interest rates five times or more (some analysts see five hikes this year) investors hardly lost their shirts. The worst year was in 1994, when the S&P 500 delivered a total return of 1.3%—not great, but also no cataclysm. The other two years—2004 and 2005—saw total returns of 10.4% and 4.8%, respectively.

Trouble is, there seems to be a dearth of good options. With inflation surging, bonds will likely lose money on a real basis, as they did in 2021. Meanwhile, cash will lose out to rising costs. Growth stocks and small-caps are in big trouble (more on that below).

Setting all this aside, the larger lesson is that one shouldn’t change one’s risk profile based on short-term concerns.

This Is Not the Moment to Buy the Dip

At the same time, you don’t want to buy stocks just because they’re falling.

Big growth companies have dominated the headlines in recent years (honk, honk, Tesla), but they’ll probably struggle. That’s because companies with high multiples—stock prices that trade well beyond their future profits—should see less demand as interest rates rise and liquidity dries up. So far this year, Tesla is down 11%.

“Longer duration, low margin and high valuation growth investment vehicles have been under the most pressure, as they’ve been reliant on near-zero interest rates these past few years,” said John Lynch, chief investment officer at Comerica Wealth Management. “As they led the market up during this time, they’re currently leading the market down in recent weeks.”

Investors could also shun risk should a new variant cause cases to peak and consumers to retreat back into their homes or if the Russia/Ukraine situation boils over into international conflict involving the U.S.

Check out the Value Stock Comeback

After a decade-plus of growth stocks dominating the market, thanks to all that easy money, it may finally be time for underappreciated value stocks to shine.

“Investors are more eager to reconsider the value sectors of energy, industrials, materials and financials and increase their exposure to them,” said Nigel Green, CEO and founder of deVere Group. “Some of the tech and growth stocks’ valuations are simply too high and it doesn’t make sense to be over-exposed.”

Check out health care stocks, especially pharma and biotech companies, where you can find companies that are trading at a relatively cheap price, said Kaser. But even this environment requires conviction—that means buy and hold though the volatility to come. That’s not as flashy as betting on the new, new thing.

“Being a value investor requires a lot of patience,” said Kaser. “You’re that person alone in the corner at parties.”

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