Stock Market Volatility

Inflation and rising interest rates are putting downward pressure on stocks and bonds. It is too early to tell if this is the start of a larger inflation and interest rate cycle, or just a correction from the pandemic-induced extremes. Either way, stock prices will likely continue to be bumpy.

2022 has ushered in a new period for the stock market. S&P 500 has dropped more than 10% for the first time since the plunge in early 2020, which was triggered by the onset of Covid-19.  At the same time, day-to-day volatility is way up. It seems the Dow being up or down 500 points in a day is becoming somewhat common. But what’s driving this volatility and where is the marketing heading? 

A little history…

Following the pandemic-induced market collapse in 2020, the federal government and the Federal Reserve moved aggressively to stabilize the economy. Specifically, interest rates were lowered, the Fed added liquidity to the market through their open-market operations, and government spending shot higher.

But as it turns out, the tools used by policymakers to stabilize the economy are the same tools that benefit the financial markets. 

Almost like magic, policymakers’ actions revived the collapsing financial markets… and money began flowing back in. Emboldened by the government’s response and the easy-money environment, investors continued to bid up the prices of stocks, bonds, real estate and other risk assets like cryptocurrencies. This all in the backdrop of a surging pandemic.

Ironically, during these frightening times, the assets that seem to appreciate the most also seemed to be the riskiest: tech stocks, “meme” stocks (e.g. Gamestop and AMC) and crypto. While this may seem odd, it’s really not, nor is it the result of working-from-home employees becoming Robinhood day-traders and wreaking havoc in the markets. Something bigger is at work here.

Investment values are largely driven by four factors: growth, inflation, risk premium, and discount rates. Without getting into the weeds, the government’s actions had reduced the cost of owning risky investments by spurring growth, lowering the discount (interest) rate, and providing liquidity which lowered the risk premium. And this all happened in an environment where inflation was still low. 

In other words, the government’s actions to save the economy from the pandemic had the unintended consequence of making risk assets “cheaper” to own. As a result, tech stocks and other risky investments shot higher during the pandemic.

The Painful Unwind

It appears now that the government’s actions may have gone too far. Policymakers intended to support the economy while it struggled through the pandemic. And, the government largely succeeded. U.S. GDP growth surged in the second half of 2020 and stayed very strong through 2021. However, this strength caused inflation to surge. And policymakers are now being forced to reverse course to combat inflation.

The Fed is now raising interest rates to combat inflation, while also cutting back on open market operations, which reduces liquidity.

At the same time, interest rates have surged. The 10-year Treasury bond yielded 1.5% at the beginning of the year. In four months, this yield has almost doubled to nearly 3%. 

And finally, economic growth has stalled. First quarter 2022 GDP was negative. This is the first negative quarter since the pandemic started. Furthermore, consumer sentiment is dour with stubbornly high gasoline prices, falling 401k balances, and rising mortgage rates making an already unaffordable housing market even more so.

All these factors and conditions have led to a re-pricing of stocks and other investment assets. The investments that have been hurt the most are largely the same investments that surged following the pandemic. And the reasons are largely the same, but in reverse. The cost of owning risky investments is now more expensive due to higher inflation, higher interest rates, and slower growth.

This point is borne out by a quick look at the markets. Year-to-date, the Dow Industrials are lower by roughly 9%, the S&P 500 is down 13%, and the Nasdaq is off by more than 20%.

At the same time, value and dividend stocks have fared much better. For example, two funds that are widely owned by SilverPeak Wealth clients are the Vanguard Value ETF (symbol: VTV) and the Schwab US Dividend ETF (symbol: SCHD). These ETFs  are down by only 3% and 5% respectively year-to-date.

Outlook

Much of the downward pressure on stocks has come from rising yields in the bond market. Should inflation persist and drive bond yields even higher, riskier investments like stocks will continue to suffer.

However, this is not a foregone conclusion. In fact, the bond market, which is generally pretty accurate, is predicting that inflation will moderate. Indeed, the optimistic outlook is that inflation, interest rates and the Fed will all normalize in the coming months and the market volatility will smooth. But it is simply too early to tell when these pieces will fall into place. Until then, stock market volatility is likely to persist.

Action

I penned a piece a number of months back titled: Portfolio Strategy for the Long Haul. It has aged well and I think it provides a good framework for thinking about portfolio strategy in this volatile environment.

 

THIS POST IS GENERAL IN NATURE AND MEANT FOR INFORMATIONAL PURPOSES. IT SHOULD NOT BE CONSTRUED AS INVESTMENT ADVICE. ALL INVESTMENT STRATEGIES AND INVESTMENTS INVOLVE RISK OF LOSS. ANY REFERENCE TO PAST OR POTENTIAL PERFORMANCE IS NOT A RECOMMENDATION OR GUARANTEE OF ANY SPECIFIC OUTCOME OR FUTURE RESULTS.


Sign Up for the SilverPeak Wealth Newsletter!

» Market analysis and commentary from Hank Nicholson, CFP
» Actionable updates on important issues
» Actually receive valuable information in your inbox

SilverPeak Wealth values your privacy & adheres to a strict NO SPAM policy. Your information will never be sold, shared or used for any purpose other than SilverPeak Wealth.

SUBSCRIBE HERE