After More Than A Decade Of Monetary Excess Wall Street's Hangover Is Finally Kicking In
The Fed is now raising interest rates into the teeth of multi-decades high inflation. Brace yourself: The stock market just switched difficulty mode from Animal Crossing to Elden Ring.
Hello again! It’s been a hot minute since I last published anything. I decided at the start of this newsletter not to force a post for the sake of it. I only ever want to write when I have something to say.
Almost exactly one year ago in May 2021 I published a newsletter on this very Substack titled “This Stock Market Bears Some Resemblance To The Dot-Com Bubble. Is The Music About To Stop?”.
In the post I drew several similarities between the then present state of markets and those of 1999 just before the bubble burst and US equities entered a devastating 2 year bear market…
From peak to trough the S&P500 effectively halved in value over an excruciatingly slow couple of soul-crushing years… That was the S&P but there was even more pain if you were heavily invested in internet stocks: Between March and November most internet stocks had declined in value by an eye-watering 75% from their highs wiping out 1.75 trillion in value.
The common refrain is that history doesn’t repeat itself but it often rhymes. Let’s take a look at today’s stock market environment and compare it to the situation we just examined in 1999…
Low rates environment? Check.
Increased retail investor participation? Check.
Companies going public having never made a profit? Big check.
Growth as priority? Check.
Overnight paper millionaires? Check.
These signals on their own wouldn’t necessarily be cause for concern because even if we are in a bubble these things can inflate for years before topping out. What has me concerned are the noises the market has been making over the last month. Inflation is rearing its ugly head for the first time in decades and may force the Fed to raise interest rates to stop the US economy from overheating. Sound familiar?
Well, here we are 12 months on from that post and the annual inflation rate in the US has doubled to 8.5% in March of 2022, the highest since December of 1981… Woof.
Inflation is caused by too much demand chasing too little supply. Inflation can therefore be combatted by either lowering demand or increasing supply. Unfortunately central banks aren’t able to magically boost the supply of goods, which leaves them only one option: Lowering demand.
The way central banks destroy demand is one of capitalism’s multitude ugly sides. The Fed (or any central bank) must deliberately raise interest rates (the cost of borrowing money) until it damages the economy. Imagine a set of cascading dominoes to understand how this one simple act impacts the lives of so many regular people on the ground…
The Fed raises interest rates until…
businesses and individuals can no longer afford to finance debts or secure funding on favourable terms…
In response, businesses slow their expansion or lay off workers to reduce costs and fortify balance sheets. Consumers reduce their spending also hitting businesses.
This leads to layoffs increasing unemployment and lower wages
Thus consumer’s have less money to spend…
Et voilà: Less demand.
At the time of publishing this, the Fed is only just now beginning to raise interest rates. Mohammed El-Erian the Chief Economic Advisor at Allianz has been ringing the alarm for months warning anyone who’ll listen that the Fed has been too slow and that we’re now entering a new paradigm…
The bottom line: The Fed has been too slow to react to inflation and is now having to hit the breaks too hard and too fast. The stock market has been hooked like a drug addict on zero interest rate policy (ZIRP) since the Great Financial Crisis and that is now ending. We are about to find out what happens to the body when the drugs are suddenly taken away.
With interest rates barely off the runway we’re already seeing markets price in the impending damage and this is compounding week by week. In 2022 so far the S&P500 is down 13% and the tech heavy Nasdaq is down over 21%, officially entering a bear market. Big name tech companies are leading the way down and are getting absolutely crushed, particularly the high profile consumer facing names that emerged as big winners during the height of the pandemic in 2020-21. Consider…
Netflix down 68% since the start of the year
Shopify also down 68%
Paypal down 54%
Facebook/Meta down 40%
Spotify down 58%
Teladoc down 64%
Adobe down 29%
The list goes on and on. That is a LOT of pain for investors to absorb in four short months and is exactly the pattern I worried about in my post of May last year…
If (and it’s a big if) we are living through the same set-up that we saw going into the millenium, we will see the non-profitable tech stocks continue to plunge as investors slowly flee loss-making highly leveraged companies. If that happens the risk-off approach could spill into other sectors triggering a wider flight to safety. “Could” being the keyword here. Nobody knows what will happen next, but we must all be aware that the music could stop at any moment.
I believe the music stopped last week and that we are now seeing that risk-off approach spill into the broader markets. How long this lasts or how much damage gets delivered to the broader indexes I have absolutely no idea and anybody who claims to know is speculating at best.
A question I can answer is “How concerned should you be?”. This depends almost entirely on your age and whether you have savings or cash to put to work. I write this Substack for a specific generation so I’m going to assume you’re under 50 years old and hopefully you have cash to invest. For you this is all quite wonderful news if you can look past the short term pain any of your existing portfolios are no doubt experiencing: Its possible (though not probable) that we’re about to get a once in a decade opportunity (potentially once in a generation if things get really gnarly) to buy equities at dramatically reduced valuations. Wouldn’t you have loved to hop into the DeLorean to go back in time to 2009 to buy stocks at the bottom of the great financial crisis? This could turn into one of those opportunities.
In terms of action points, I recommend building a shopping list of index funds and high quality businesses to keep an eye on. A few names at the top of my list include Airbnb, Shopify, Microsoft, Match, Starbucks and Google, though at least 50% of my investable cash will go into index funds. Timing the buy of equities is almost impossible so I suggest making small and frequent purchases (dollar cost averaging) of stocks once inflation starts to show signs of retreating. Remember, if your investing horizon can be measured in decades, your relative youth is your edge. Buy stocks in quality businesses. Fight the urge to sell. Be patient then be patient some more. Hold on tight and enjoy the journey.
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