After falling for six days in a row, U.S. financial markets recovered on Friday, with all major stock indices posting gains, and the Nasdaq experienced the largest percentage gain — 3.8 percent — since November 2020. assets also rose strongly and the appearance of green on trading screens provided much-needed relief for investors. However, all of this needs to be put in perspective.
Even after Friday’s rebound, the Dow, the S.&P. 500 and the Nasdaq all closed at least two percent in the week. The Dow has fallen for seven weeks in a row, according to Reuters, the longest losing streak since 1980. Looking further back, the picture is even more grim. In the past six months, the Nasdaq Composite is down twenty-six percent, the S.&P. 500 is down 14 percent, and the Dow is down 11 percent. Many individual stocks have fallen further: Netflix and Peloton are both down about seventy percent.
Cryptocurrency assets have seen some of the biggest declines. Since last November, Bitcoin has halved in value and Coinbase, a crypto exchange, has fallen by almost eighty percent. Earlier this week, TerraUSD, a “stablecoin” – a cryptocurrency backed by assets, including other cryptocurrencies – that should maintain a value of one dollar, fell to fourteen cents, and Luna, a cryptocurrency associated with Terra, virtually lost all its value.
Speculation in crypto has always been a pursuit for intrepid or naive people. But as tens of millions of American households see the value of their more conservatively invested 401(k)s and other retirement accounts plummet month after month, many of them are wondering what is causing this slow crash and when it will end. The second question is more difficult to answer; the first can be answered in three words: the Federal Reserve.
In late November, Fed chairman Jerome Powell signaled that the central bank was preparing to push inflation back to its 31-year high of 6.2 percent. In March, after the Labor Department announced inflation had hit a 40-year high of 7.9 percent, the Fed raised the Federal Funds rate by a quarter of a percentage point and indicated it could introduce six additional interest rates. walks before the end of the year. Noting the mood at the March Fed meeting that raised rates, Powell told reporters: “When I looked around today’s meeting, I saw a committee that is well aware of the need to return to price stability and determined to use our tools to do just that.”
There are at least two reasons why stocks tend to fall when interest rates rise. The first is math. In theory, the value of a stock is determined by a formula with future dividend payments (or cash flows) in the numerator and an interest rate in the denominator. If the denominator rises, the value of the stock falls. And what applies to individual stocks also applies to the entire market.
The second reason is a more practical one. By raising the cost of borrowing money to buy houses, cars and everything else, higher interest rates slow the economy and, in extreme cases, into a recession. Four of the last five recessions preceded four of the last five recessions: in 1981-82, 1990-91, 2001 and 2007-2009. (The exception is the 2021 recession, which was a result of the coronavirus shutdowns.) When investors saw the Fed committing to a series of open-ended rate hikes, they had good reason to be alarmed.
Another reason for the market collapse is psychological, and perhaps the most important: investors have lost their safety blanket. Despite the historical link between rate hikes and recessions, many professional investors had come to believe that the Fed would always be behind them — if the stock market ever got into serious trouble, the central bank would step in and keep things on track. This comforting belief was given a name: the ‘Fed pit’. (A put is a financial contract that gives an investor the right to sell a stock at a specified price at some point in the future, mitigating the downside.)
This confidence in the Fed was not based on wishful thinking. In 1998, Long-Term Capital Management, a giant hedge fund, ran into trouble and the markets collapsed. Under Alan Greenspan, aka the Maestro, the Fed orchestrated a Wall Street bailout for LTCM, and the dotcom bubble remained inflated for another year and a half. During the global financial crisis, with Ben Bernanke at the helm, the Fed cut interest rates to near zero and introduced quantitative easing, creating trillions of dollars to buy financial assets, primarily government bonds. In March 2020, as the onset of the pandemic sparked another panic attack on Wall Street, the Fed quickly pulled its script out of the Great Recession. Between March 1, 2020 and December 1, 2021, the Nasdaq doubled, meme stocks flashed like fireworks and Bitcoin’s value increased sixfold.
Many investors are concerned that the Fed put has now been withdrawn. Now that Powell and his colleagues have reversed course of interest rates and quantitative easing — next month the Fed will begin selling some of the securities it has bought in recent years — their language has also changed dramatically. Of late, Powell has repeatedly said he would welcome “tighter monetary policy”; this statement roughly translates to higher borrowing rates and a lower stock market. Last week he said at a press conference: “We need to look around and move on if we don’t see financial conditions tightened enough”; this could be interpreted as meaning that the Fed believes the market should fall further.
How much further? That would be quite a way if stock market valuations returned to historical norms. Take the price-earnings ratio, a widely used valuation metric. For the S. & P. 500, the average price-to-earnings ratio, or P/E, dating back to 1880 is about sixteen. Even after the recent dips in the market, the P/E ratio currently stands at around twenty. That discrepancy suggests that stocks could fall another twenty percent. However, history also tells us that markets often overshoot on their way down, just as they do on their way up, suggesting an even bigger drop could be ahead.
Of course, no one can be sure of what will happen, and hope comes forth forever. Friday’s rebound reflected an ingrained “buy the dip” mentality. But as long as the Fed remains on the offensive against inflation, ordinary investors should be cautious. In any period of rising interest rates and volatile markets, there is a danger that something could break and cause a rapid crash. The upheavals of TerraUSD, along with the collapse of Luna, provided an illustration. In all likelihood, the amounts lost in this particular debacle were not enough to threaten the wider financial system. But it was a timely reminder of what an old-fashioned fast crash looks like.