The slow crash on Wall Street is likely not over yet

After dropping for six consecutive days, US financial markets rebounded on Friday, with all major stock indexes posting gains, and Nasdaq posting its biggest percentage gain – 3.8 percent – since November 2020. Some crypto-assets also rose sharply, providing The appearance of green on the trading screens is a relief that investors desperately need. However, all this must be taken into account.

Even after Friday’s bounce, the Dow, S.&P. 500 and Nasdaq all closed down at least 2 percent for 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 more bleak. In the past six months, the Nasdaq Composite is down 26 percent, the S&P 500 is down 14 percent, and the Dow is down 11 percent. Lots of individual stocks plunged further: Netflix and Peloton both fell about 70 percent.

Crypto assets have experienced some of the biggest drops. Since last November, the value of Bitcoin has halved, and Coinbase, a crypto exchange, is down nearly eighty percent. Earlier in the week, TerraUSD, a “stable currency” — a cryptocurrency backed by assets, including other cryptocurrencies — that is supposed to maintain the value of one dollar, fell to fourteen cents, and Luna, a crypto-linked currency, fell to fourteen cents. With Terra, it has lost almost all of its value.

Cryptocurrency speculation has always been a quest for boldness or gullibility. But as tens of millions of American families watch the values ​​of their most invested 401(k) and other retirement accounts drop month by month, many of them wonder why and when this slow crash will end. The second question is more difficult to answer. The first question can be answered in three words: the Federal Reserve.

At the end of November, Jerome Powell, Federal Reserve Chairman, indicated that the central bank was preparing to tackle inflation, which had risen to a 31-year high of 6.2 percent. In March, after the Labor Department announced that inflation had reached a forty-year high of 7.9 percent, the Federal Reserve raised the federal funds rate by a quarter of a percentage point and indicated that it could offer up to six Additional interest rates rise significantly before the end of the year. Referring to 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 that is acutely aware of the need to return to price stability and is determined to use our tools to do just that.” .

There are at least two reasons why stocks tend to fall when interest rates go up. The first is about 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 rises, the value of the stock decreases. What applies to individual stocks also applies to the entire market.

The second reason is more practical. By increasing the cost of borrowing money to buy homes, cars, and anything else, higher interest rates slow the economy and, in extreme cases, push it into a recession. Four of the last five recessions were preceded by the Fed’s rate hikes: in 1981-1982, 1990-1991, 2001 and 2007-2009. (The exception is the recession in 2021, which was a result of the coronavirus shutdown.) When investors saw the Federal Reserve committing to an open series of interest rate increases, they had good reason to worry.

Another reason for the market stagnation is psychological, and it may be the most important of all: investors have lost their security blanket. Despite the historical association between high interest rates and recession, many professional investors have come to believe that the Fed will always be on their side — if the stock market ever gets into serious trouble, the central bank will step in and prop things up. This reassuring belief has earned a name: “the status of the Federal Reserve.” (A sale is a financial contract that gives an investor the right to sell a stock at a certain price at some date in the future, thus limiting the downside.)

This confidence in the Fed was not built on wishful thinking. In 1998, Long-Term Capital Management, a giant hedge fund, got into trouble, and the markets collapsed. Under the leadership of Alan Greenspan, aka the Maestro, the Fed organized a Wall Street bailout for LTCM, and the dot-com bubble inflated for another year and a half. During the global financial crisis, the Fed, led by Ben Bernanke, cut interest rates to near zero and enacted quantitative easing – creating trillions of dollars to buy financial assets, primarily Treasuries. In March 2020, when the onset of the pandemic triggered another bout of panic selling on Wall Street, the Federal Reserve quickly pulled its playbook out of the Great Recession. Between March 1, 2020 and December 1, 2021, the Nasdaq doubled, meme stocks shot up into the sky like fireworks, and the value of Bitcoin surged sixfold.

Many investors are concerned that the Fed’s position 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 securities it has bought in recent years — their language has changed dramatically, too. Recently, Powell has repeatedly said he would welcome “a tighter monetary policy”. This statement can roughly translate to mean higher loan rates and a lower stock market. “We need to look around and keep going if we don’t see financial conditions tighten enough,” he said at a press conference last week; This can be interpreted to mean that the Fed believes that the market needs to fall further.

What is the dimension? It is quite a way if stock price valuations are to go back to historical norms. Take the price-earnings ratio, a commonly used valuation metric. For the S. & P. ​​500 Index, the average price-to-earnings, or P/E, going back to 1880 is about sixteen. Even after the recent dips in the market, the P/E ratio is currently around twenty. This discrepancy suggests that stocks could fall by another twenty percent. However, history also tells us that markets often skip the way down as well as the way up, indicating the potential for a bigger drop.

Of course, no one can be sure what will happen, and hope springs eternal. Friday’s bounce reflects the “buy on dip” mentality that has become ingrained. But as long as the Federal Reserve is on the offensive against inflation, ordinary investors should exercise caution. In any period of high interest rates and volatile markets, there is a risk of something going wrong and causing a rapid crash. TerraUSD’s volatility, along with the Luna crash, provided an example. In all likelihood, the sums lost in this particular disaster were not enough to threaten the broader financial system. But it was a timely reminder of what the old rapid meltdown looked like.

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