Over the last few weeks, following the financial markets has felt a bit like watching the prom scene from Carrie—the party’s over, there’s blood all over the floor, and flames appear to be eating the building while the whole crowd runs screaming for the exits.
Am I being hyperbolic here? Maybe a little? The point is that, despite a rally on Friday, everybody’s portfolio has been getting killed. After a bubbly two-year run that gave us meme stonks, Matt Damon shilling crypto, $2 million monkey JPEGs, woozy tech valuations, and so much more as retail investing once again became a national pastime, stock prices finally seem to have popped while Bitcoin and other digital currencies are now in a total freefall. We’ve entered the era of crash memes.
There are interesting, sometimes complicated stories about why individual stocks and various blockchain schemes have gone sideways. But the main explanation for why your 401(k) has started to look like the aftermath of a Brian De Palma film is pretty straightforward: The Federal Reserve did it. The U.S.’s central bank is raising interest rates in order to fight inflation and has in the process sent tremors all throughout the markets. That’s partly because rising rates have a direct impact on how stocks and other assets are valued, but also because many investors are worried the Fed might tighten credit so much that it triggers a recession. In other words, stocks are falling thanks to both math and fear.
Here’s our guide to what’s going on.
So, exactly how bad is the market right now? I can swear I hear Jim Cramer shrieking somewhere in distance…
It’s not great! Despite its little bump at the end of the week, the S&P 500 index, which tracks the largest U.S. companies, is now down about 16 percent since it topped out on Jan. 3. The Nasdaq tech index has fallen about 25 percent for the year.
That’s not quite on par with the great stock-market crashes of yore. The S&P 500 declined by more than half in 2008, for instance, while the Nasdaq tumbled 78 percent in the dotcom bust of the early 2000s. It’s also important to keep in mind that the stock market dips all the time. There have been several cases where the S&P dropped 15 percent or more before mostly recovering, or even finishing higher for the year.
Still, we’re in the midst a serious fall: Investors traditionally say it’s a “bear market” once stocks tumble 20 percent from their last peak. The S&P 500 is getting close to there, and the Nasdaq is well past it.
Then there’s crypto. Bitcoin’s price has fallen by more than half since last fall, from about $67,000 in November to $47,000 in March to around $30,000 as when this story was published. The total value of all digital currencies has similarly plummeted. The cryptoland rollercoaster hath crashed.
And this is all the Fed’s fault?
Fault is a slightly loaded word. But yes, the Federal Reserve is the key factor here—which I guess in my overextended movie metaphor would make Chair Jerome Powell a teenager with supernatural powers burning down the party. (Everybody pause to manifest that disturbing image in their heads … OK, onward!)
The Fed is aggressively raising interest rates to curb inflation, which is running at 40-year highs. This month, it hiked by half a percentage point, its biggest single increase in 22 years. At the same time, the central bank is allowing its giant stash of government bonds to shrink (you might have heard this described as “running down its balance sheet”), a move that should also push up long-term interest rates and tighten credit.
All of this is quite bad for stocks and other assets that involve some risk (like Bitcoin). If you look at corporate earnings reports and forecasts, big companies are actually doing pretty well. There have been some high-profile disappointments such as Netflix. But overall, more companies are exceeding their estimates than last year. They’re getting pummeled for things beyond their control.
OK, but why exactly are higher interest rates bad for stocks?
Well, like I said, some of it is just a product of the math that investors use to value companies.
Care to elaborate?
Of course. When interest rates go up, so do the returns on low-risk assets like government bonds. That makes higher-risk assets like stocks less attractive in comparison, so their prices tend to drop. That’s the simple version.
(A sidenote: Sometimes you’ll hear people say things like: “When rates rise, people sell stocks and buy bonds,” but that’s an oversimplification and not really what’s happening now; bonds have been selling off too.)
Now, to get a little more in the weeds…
Let’s say you were a stock market analyst at a bank, and your boss told you to go figure out how valuable Google really is. If you were feeling very proper and traditional, you might break out what’s called a discounted cash flow model, which calculates how much a company’s future profits are worth to investors today.
Step one would be to guess how much money Google might make in the future (probably a lot).
In step two, you’d have to account for the fact that time really is worth money to investors. Profits that lay way out in the future are worth less to a company’s shareholders than profits that are earned today, because collecting them requires locking up capital and skipping other investment opportunities.
To account for that, you’d subtract out what’s known as a “discount rate,” which reflects how much your clients could make if they just parked their money somewhere safe, like Treasury bonds, instead of gambling on the long-term viability of targeted search engine ads and YouTube spots. You’d then throw in a few more steps, run the numbers, and get a reasonable stock price.
The important thing to remember is that when interest rates go up, so do the returns on safe assets like government debt. As a result, discount rates go up too, and stocks start look like a worse deal in the eyes of equities analysts and investors yielding excel spreadsheets. Ergo, their prices drop.
Now, obviously this is not how the market always works in the real world. Because the real world is insane. Retail investors trying to overcome their pandemic boredom by trading options on Robinhood and scrounging for stock tips on Reddit were not doing careful net-present-value calculations while piling into GameStop or posting diamond-hands memes while AMC seesawed. For that matter, the hedge funds and other pros aren’t always breaking out a DCF model when they want to assess. Surveys suggest that more often, they’re using measures like price-to-earnings ratios to figure out what’s a good deal. Or, maybe they’re a hedge funders trading on momentum or by algorithm or something. There are lots of strategies out there.
Aside from all that, predicting future profits can be a very subjective exercise, especially if the company in question is a money-losing tech firm like Uber with a great narrative but murky path to profitability.
But professionals very frequently do some version of this math when picking stocks to make sure a company’s share price makes at least a little bit of sense. So while higher rates don’t always cause stocks to drop—there are a lot of factors that determine where the market ends up—they do weigh on prices. They’re especially problematic for risky stocks where investors are betting on lots of future growth, since their profits are further away and more affected by discount math.
Are there any simpler reasons higher interest rates might be bad for stocks that you’ve glossed over?
If borrowing money gets more expensive, it might cut into companies’ profits down the line. But that honestly doesn’t seem to be the major issue right now.
So now that we’ve taken this, uh, delightful trip through corporate finance, how else is the Fed messing up my portfolio?
Sure. One of the key reasons stock prices went nuts over the past few years is that there was just a ton of cash sloshing around. Or, as investors like to say, there was a lot of “liquidity” in the market. Just imagine a big, winding river of dollars, looking for places to flow. Such was finance in 2020 and 2021.
For that, we can thank the easy-money policies the Fed pursued in response to the coronavirus crisis, which led it to slash short-term rates to zero and buy massive amounts of bonds in order push down longer-term rates—the tactic known as quantitative easing, or QE.
Since interest rates were so low and investors couldn’t make much money by parking their cash in safe stuff like government debt or high-grade corporate debt , they started turning to much more speculative assets that offered the hope of a jackpot, or at least decent returns. Hence, they poured their capital into stocks and laid down some bets on crypto, among other novelties.
Now the Fed is throwing all of that into reverse. Instead of quantitative easing, it has turned to quantitative tightening by letting its big hoard of bonds shrink. As a result, there’s less money, or liquidity, to go around, and some of those crazy stock prices are finally deflating a bit. The river of money is drying up.
Another way to think about things, though, is that the stock market is just kind of going back to normal after an unusual run. The S&P 500 has averaged a 9.4 percent annual return over the past 50 years; in comparison, it averaged a 24 percent annual return over the last three years. We were probably bound for some mean reversion once the Fed tightened credit, and by some measures, stock valuations are still pretty high compared to historic norms.
Aside from all that, everybody’s worried that the Fed is going raise rates so high that it will start a recession, which would be bad for stocks (among other things).
A recession? No bueno.
I mean, nobody really knows if or when a recession is coming, and I’m not going to play economic forecaster. But the bottom line is that, at least since the 1950s, the Federal Reserve has never managed to bring down inflation as high as it is today without plunging the economy into a downturn. There have been times where it raised rates pre-emptively to head off inflation and didn’t cause a recession, but it hasn’t ever accomplished what it’s trying to do today.
And Powell, who was just confirmed for his second term as Fed chair, has signaled that he might be willing to push the economy toward recession if that’s what it takes. In an interview with Marketplace this week, he admitted that the Fed might not be able to achieve a “soft landing”—i.e., quell inflation without bringing down the economy—for reasons it can’t control. But he’s determined to get consumer prices under control regardless.
“Our goal, of course, is to get inflation back down to 2% without having the economy go into recession, or, to put it this way, with the labor market remaining fairly strong,” Powell said. “That’s what we’re trying to achieve. I think the one thing we really cannot do is to fail to restore price stability, though. Nothing in the economy works, the economy doesn’t work for anybody without price stability.”
Well, that’s nerve-racking!
It is. It’s kind of a finance cliche to say that investors are fretting about uncertainty—but that’s part of what seems to be going on. It’s a big event every time new inflation numbers come out, because if they’re high, it means the Fed may have to hike rates faster and higher, which would be worse for stocks and the economy. But if inflation falls a bit in the coming months, then the Fed won’t have to be as aggressive.
What’s a little odd about this situation is that, at the moment, the economy still seems pretty OK (other than 8.3 percent inflation ticking everyone off). Employment is high, and even if job growth has slowed a bit in the last couple months, it’s still going relatively strong. Gross domestic product unexpectedly shrank in the first quarter, but that was mostly because things like business inventories and imports; the core of the economy, consumer spending, kept rising, and most economists seem to think we’ll grow overall this year. But with the Fed tightening, people are jittery.
So should I be angry at the Fed?
Eh. Powell & Co. have a hard job. They kept rates low at the height of the pandemic because the economy was fragile, which was almost certainly the right move; but one side effect was that it may have allowed some crazy bubbles to form. They’ve also had to deal with absurd curveballs, like a war in Ukraine that’s sent energy costs soaring. One fair criticism is that it should have maybe started tightening monetary policy earlier, to start taming inflation sooner; if they had, they might not be considering drastic action now. But it’s had to say for sure.
What about Biden? Did he screw up?
Honestly, I just don’t have the heart to talk about the White House right now.
OK, but now tell me why tech stocks and crytpo are getting hammered worst.
Think about this way: As we discussed, higher interest rates and tight credit are worst for risky companies with profits that are way out in the future. That describes … a lot of tech firms. Uber loses money right now. Shopify loses money. Zillow loses money. Investors are willing to tolerate that and content themselves imagining a bright future of fat margins when cash is cheap, but not so much when money suddenly costs money. It doesn’t help that some of these companies’ big ideas also just aren’t panning out—Zillow had a big plan to automate home flipping that turned into an expensive flop.
(A more boring issue is that a lot of the top tech companies make large amounts of money overseas; right now the dollar is getting more expensive, thanks in part to higher interest rates, which reduces the value of foreign profits.)
As for crypto: The thing to realize about Bitcoin and its brethren is that a lot of major investors basically decided to treat them like extremely, extremely speculative stocks, a way to get in on the edge of what Silicon Valley was up to. Now that extremely speculative stocks have lost their sheen, a lot of those big money players are pulling out to reduce their exposure to risk.
Also, crypto, Gamestop, and other Internetty obsessions a big boost from retail investors who decided to use their stimulus checks on day trading. Obviously, there haven’t been any stimmies in a while.
All right, but the market had a good day Friday. Does that mean the carnage might be over?
Eh, you know how horror movies work. You think the villain’s dead, then a bloody hand shoots out of the grave.