How Far Could Stocks Fall?
The stock market was down again today, the exchanges beginning where they left off last week. But it’s the larger trend that’s really disconcerting.
Investors don’t need to be told about the stock market collapse in recent months. The Dow Jones Industrial Average is down over 20% since January. The S&P 500 is down 23% since January. And the Nasdaq Composite is down 32% since its all-time high last November.
Those falls are not as bad as the crashes in March 2020 during the pandemic or late 2008 during the global financial crisis, but those comparisons offer little comfort since they were among the worst in history.
The real problem for stock investors today is not that the crash is bad so far, but that it might just be getting started.
We may be looking at losses that more closely resemble the over-80% collapse of the Dow Jones from 1929–1932 or the 80% collapse of the Nasdaq in 2000–2001 in the wake of the dot-com bubble.
Different Causes, Same Outcome
The culprit this time will not be reckless mortgage lending, Chinese viruses or sock puppet spokespersons. The danger is the much higher interest rates needed to squash global inflation.
Rates have been going up since last spring, but inflation continues at very high levels. The question for analysts and investors is how high will rates have to go before inflation falls to levels deemed acceptable by central bankers.
Most observers have connected the interest rate hikes with the fight against inflation, but relatively few have realized the full implications. The real key to fighting inflation is to do so by increasing unemployment.
Fed Chair Jay Powell had a lot to say at a press conference following last Wednesday’s decision to raise interest rates another 75 basis points (the Fed’s third consecutive 75-basis-point increase).
Powell began by emphasizing that stopping inflation was Job One. He said, “Without price stability the economy does not work for anyone.” He noted that “Growth in consumer spending has slowed.”
His key phrase was “The labor market has remained extremely tight… Job openings are incredibly high… They need… to come down.” That’s Powell’s way of saying higher unemployment is the key to lower inflation.
Powell also said, “We think that we’ll need to bring our funds rate to a restrictive level and to keep it there for some time.” Restrictive level means a level that will cause inflation to drop toward the desired target over time.
When asked when restrictive policy levels will be reached, Powell said “There’s a ways to go.” To emphasize the point, Powell also said, “We’re committed to getting to a restrictive level… and getting there pretty quickly.”
What is the Fed’s target exactly?
Powell said the target was “to bring inflation down to 2%,” the Fed’s desired rate. When asked about the 2% inflation target, Powell said “We can’t fail to do that.” He went on to say, “We have got to get inflation behind us. I wish there were a painless way to do that but there isn’t.”
You get the point.
Rates will have to go to 4.75% (from the current level of 3.0%) in the hope that inflation (as measured by core PCE year over year, the Fed’s favorite gauge) drops from 4.6% to 3.5%.
At that point, real rates will be over 1.0% and the Fed will wait as long as a year for inflation to drop from 3.5% to the Fed’s target of 2.0%.
The real takeaway here is that Powell is dead serious about hitting a 2% inflation target. It seems he’ll raise rates as long as it takes to get there. He’s in a hurry to do so. And he was completely candid about the fact that there would be economic pain in the process.
Unfortunately, the cost will be a severe recession and a rise of unemployment to 5% or higher with millions of job losses, massive business failures, billions of dollars in bad debts and a continued crash in stock prices.
Will Powell Back Down?
This suggests some critically important questions for markets. Will Powell actually have the stomach to force rates up to 4.75%, about where they need to go to slow inflation?
Based on his remarks, the answer is yes. But we’ll have to wait and see.
The Fed was raising rates and reducing its balance sheet when on Dec. 24, 2018, the stock market tanked and proceeded to fall 20% in 2½ months. Powell panicked and pivoted again to monetary easing. Maybe he’ll do it again.
But there’s an important difference between then and now. There was no inflation to speak of in 2018. The Fed could therefore afford to pivot to easing without any real concern about inflation.
That’s obviously not the case in late 2022. Inflation is the Fed’s biggest concern right now, and Powell is making it clear that he’s serious about getting control of it, even if it results in a lot of economic and financial pain.
All Pain, No Gain
The problem, which I’ve addressed many times, is that the Fed has misdiagnosed the nature of today’s inflation.
The Fed is trying to crush inflation by reducing demand in the economy. They’re focusing on “demand pull” inflation where consumers are buying in anticipation of even higher inflation to come.
But the inflation we’re seeing is called “cost push” inflation. This comes from the supply side, not the demand side. It comes from global supply chain disruptions and the war in Ukraine.
Since the Fed has misdiagnosed the disease, they are applying the wrong medicine. Tight money won’t solve a supply shock. Higher prices will continue. But tight money will hurt consumers, increase savings and raise mortgage interest rates, which hurts housing among other things.
So the question is how much damage will Powell’s quest do to the economy and markets? That’s the biggest issue for investors. The answer is that Powell will do far more damage than he expects.
History shows that the Fed will overshoot. There won’t be any “soft landing.”
That damage may help Powell get to his inflation target. But it will increase unemployment and destroy stock markets along the way.
That’s if all goes according to plan. The actual scenario could be worse. Market investors are not ready for this.
But you should be.