Wall Street’s slow crash probably isn’t over yet

After falling for six straight days, U.S. financial markets rebounded on Friday, with all major equity indices posting gains, and the Nasdaq enjoying its biggest percentage rise of 3.8% since November 2020. Some assets in Cryptocurrency beats have also surged and the appearance of green on trading screens has brought much-needed relief to investors. However, all of this must be put into perspective.

Even after Friday’s rebound, the Dow Jones, S.&P. 500 and Nasdaq all closed at least 2% on the week. The Dow has fallen for seven straight weeks, its longest losing streak since 1980, according to Reuters. If you look further back, the picture is even darker. Over the past six months, the Nasdaq Composite has fallen twenty-six percent, the S. & P. ​​500 fourteen percent and the Dow eleven percent. Many individual stocks fell further: Netflix and Peloton are both down around 70%.

Cryptocurrency assets have seen some of the biggest declines. Since last November, the value of Bitcoin has halved and Coinbase, a crypto exchange, has fallen nearly eighty percent. Earlier in the week, TerraUSD, a stablecoin backed by assets including other cryptocurrencies believed to maintain a value of one dollar, fell to fourteen cents, and Luna, a cryptocurrency associated with Terra, has lost almost all of its value. .

Speculating in crypto has always been a pursuit for the intrepid or nave. But, as tens of millions of American households see the value of their 401(k) and other more conservatively invested retirement accounts decline 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.

At the end of November, Jerome Powell, the chairman of the Fed, signaled that the central bank was preparing to reduce inflation, which had reached a high of 6.2% in thirty-one years. In March, after the Department of Labor announced that inflation had reached a 40-year high of 7.9%, the Fed raised the federal funds rate by a quarter of a percentage point and indicated that it could introduce up to six additional interest rates. hikes before the end of the year. Noting the mood at the Fed’s March meeting that raised the rate, Powell told reporters, as I looked around the table at today’s meeting, I saw a committee perfectly 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 concerns arithmetic. In theory, the value of a stock is determined by a formula that has future dividend payments (or cash flows) in the numerator and an interest rate in the denominator. When the denominator increases, the stock value decreases. And what goes for individual stocks also goes for the market as a whole.

The second reason is more practical. By increasing the cost of borrowing to buy homes, cars and everything else, higher interest rates slow the economy and, in extreme cases, push it into a recession. A period of interest rate hikes by the Fed 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 consequence of the coronavirus shutdowns.) When investors saw the Fed embark on an unlimited series of interest rate hikes, they had good reason to fret. alarm.

Another reason for the market crash is psychological, and perhaps the most important of all: investors have lost their safety blanket. Despite the historical association between interest rate hikes and recessions, many professional investors had come to believe that the Fed would always be supported if the stock market ran into serious trouble, the central bank would step in and support things. This reassuring belief has acquired a name: the Fed put. (A put option is a financial contract that grants an investor the right to sell a stock at a given price on a certain date in the future, thereby limiting the downside.)

This faith in the Fed was not based on wishful thinking. In 1998, Long-Term Capital Management, a giant hedge fund, got into trouble and the markets crashed. Under Alan Greenspan, aka the Maestro, the Fed orchestrated a Wall Street bailout of LTCM, and the dotcom bubble inflated for another year and a half. During the global financial crisis, the Fed, with Ben Bernanke at its helm, cut interest rates to near zero and enacted quantitative easing creating trillions of dollars to buy financial assets, primarily treasury bills. In March 2020, when the onset of the pandemic caused another wave of panic on Wall Street, the Fed quickly released its Great Recession playbook. Between March 1, 2020 and December 1, 2021, the Nasdaq doubled, meme stocks burst into the sky like fireworks, and the value of Bitcoin increased sixfold.

Many investors fear that the Fed’s put option has now been withdrawn. As Powell and his colleagues reverse course on interest rates and quantitative easing next month, the Fed will start selling some of the stocks it has bought in recent years. Their language has also changed dramatically. Lately, Powell has repeatedly stated that he would welcome tighter monetary policy; this statement can be roughly translated into higher lending rates and a lower stock market. Last week, he told a press conference, we have to look around and carry on if we don’t see that financial conditions have tightened enough; this could be interpreted to mean that the Fed thinks the market needs to go down further.

How much further? Many ways if stock price valuations return to historical norms. Take the price-to-earnings ratio, a commonly used valuation measure. For the S. & P. ​​500, the average price-to-earnings ratio, or P/E, dating back to 1880 is around sixteen. Even after recent market declines, the P/E ratio currently sits at around twenty. This discrepancy suggests that stocks could fall another twenty percent. However, history also tells us that markets often overshoot on the downside as they do on the upside, suggesting that an even bigger drop could be in store.

Of course, no one can be sure what will happen, and hope is eternal. The Fridays rally reflected a buy-down mentality that has taken root. But, as long as the Fed is on the offensive against inflation, ordinary investors should be cautious. In any period of rising interest rates and market volatility, there is a risk that something will break and trigger a rapid crash. The gyrations of TerraUSD, as well as the collapse of Luna, provided an illustration of this. In all likelihood, the sums lost in this particular debacle were not enough to threaten the entire financial system. But it was a timely reminder of what an old-school fast crash looks like.