The markets finally bounced on Friday afternoon after taking a terrible beating the rest of last week. On Wednesday, when the Federal Reserve (the Fed) announced another 0.75% increase in short-term interest rates to help battle inflation, this led market participants to conclude that the Fed wasn’t yet close to being done raising interest rates. And as discussed in our newsletter last week, higher interest rates typically lead to a lower stock market which eventually leads to lower prices for goods and services.
From the way the market is behaving, one might think that some of the world’s largest and most profitable companies are suddenly becoming dramatically less valuable. Are they all laying off workers, slashing prices, closing factories, and declaring imminent bankruptcy?
If all this market action and talk is sending you to anxiously scan the headlines, don’t bother; none of that is happening. Even as stock prices have fallen, and the Fed has done their best to cool the economy, earnings have grown—a fact that has been routinely ignored by the media.
Stock prices have never been a precise indicator of what companies are worth. They are a very good indicator of what people are willing to pay for their shares at any moment, and right now there seems to be an abundant supply of nervous sellers. There’s little reason to join them if you’re a long-term investor.
Why? The reasons for bear (down-trending) markets are seldom rational—which, of course, is why bear markets end and stocks return to (and always, in the past, have surpassed) their original highs.
What’s happening right now is not unlike what happens when one of our children is diagnosed with an illness, and the remedy is a daily dose of some awful-tasting medicine. The illness, in this case, is inflation, which absolutely must be cured if we are to experience a healthy economic life. Few things are worse than having the money you’ve saved up deteriorate in value at double-digit rates, which is precisely what has been happening this year and will continue to happen if it’s not dealt with.
The cure, which any child will tell you is more unpleasant than the illness itself, is the U.S. Federal Reserve raising interest rates, which is one way of reducing the amount of cash sloshing around in the economy. Rising consumer prices, just like rising stock prices, come about when there is more demand than supply. Reducing the available cash reduces the number of buyers in relation to sellers (ironically, both in the consumer marketplace and on Wall Street), and eventually slows down the inflation rate to manageable levels.
We can already see how this works in the housing market, where, just a few short months ago, multiple would-be buyers were bidding against each other to pay more than the asking prices. As mortgage rates have risen, the frenzy has completely dissipated. The process takes longer in the consumer marketplace at large, but you can bet it’s slowly working behind the scenes.
Additional evidence that inflation is cooling can be found in gasoline prices that are solidly below their summer peak levels above $5.00 a gallon, and used car prices, which are normalizing as supplies of new cars on dealer lots are increasing.
Doesn’t less spending mean less economic activity? Doesn’t that lead to a recession? The answers, of course, are yes and maybe. But at this point, a recession might not be all that bad for the economy. Recessions act like a cleansing mechanism, exposing/eliminating waste and inefficiency, ultimately creating a healthier economy when we come out the other end.
It’s impossible to know exactly which direction stock prices will go next since stock prices are inherently irrational in the short term. They may rise from here, or go down from here. We know the media’s position will always be one of doom and gloom. Tune them out.
I wish I could say that the volatility is over and that we’ve reached bottom. It’s possible, but it’s more likely that we’ll thrash around the current levels for a few more weeks as we approach the most favorable period in the markets, historically between November and April.
Meanwhile, market conditions are heavily stretched to the downside, meaning that we could see a robust snap back this coming week to relieve some heavily over-sold market conditions. Think of this as your opportunity to unload any losing stocks that have come down so much and have little chance of recovering in the next bull market. If you’re invested too heavily and have been losing sleep over the current market turmoil, take advantage of the rally to lighten up on some stocks/funds (Disclaimer: this is not a recommendation to buy or sell any securities. Please consult with your own financial advisor or talk to us).
I can’t rule out that the markets test lower levels in the weeks ahead; in fact, they likely will. But eventually, this bear market shall come to an end and a great buy point will emerge with a new bull (uptrending) market.
For our client portfolios, we took additional defensive action this past week and plan more defensive action in the coming week, depending on the weight of evidence presented by any coming bounce in the markets. If you’re managing your own portfolio, consider whether your own invested percentage is consistent with your risk tolerance and adjust it if you think your portfolio risk level is too high.
For now we’re taking our medicine, and boy, does it taste awful. We are also, collectively, suffering an economic illness. Anybody who has come down with a bug and taken medicine to cure it knows that the former unpleasantness doesn’t last forever, and therefore neither does the latter.
If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.