Is the market collapsing? No. Here’s what’s happening to stocks and bonds as the Fed aims to end the era of easy money, analysts say

As the stock market has fallen and bond yields have surged in recent weeks, culminating in a so-called correction in the Nasdaq Composite Index, average Americans are wondering what’s wrong with Wall Street.

Increasingly, Google searches have focused on the state of the market (and the economy), and for good reason.

The Dow Jones Industrial Average DJIA,
-1.30%
posted its worst weekly loss since October 2020 and the S&P 500 SPX,
-1.89%
and Nasdaq Composite COMP,
-2.72%
posted their worst weekly percentage declines since March 20, 2020, according to Dow Jones Market Data shows.

Read: First Federal Reserve meeting of 2022 looms as risk of inflation beyond policymakers’ control rises

Google searches included the following popular queries: Is the market collapsing? And why is the market collapsing?

What is a stock market crash?

Certainly, the market does not collapse insofar as the term “collapse” is even a quantifiable market condition. Declines in stocks and other assets are sometimes portrayed in hyperbolic terms that offer little real substance about the significance of the move.

There is no precise definition of an “accident”, but it is generally described in terms of duration, suddenness and/or severity.

Jay Hatfield, chief investment officer at Infrastructure Capital Management, told MarketWatch on Saturday that he could characterize a crash as a drop in an asset of at least 50%, which could happen quickly or over a year, but said recognized that the term is sometimes used too loosely to describe ordinary slowdowns. He saw Bitcoin’s BTCUSD,
-0.48%
move like an accident, for example.

He said the current global stock market crash by no means met his definition of a crash, but said stocks were in a fragile state.

“He doesn’t crash but he’s very weak,” Hatfield said.

What is happening?

Equity benchmarks are significantly recalibrated from high highs as the economy heads for a new monetary policy regime in the fight against the pandemic and soaring inflation. In addition to this, doubts about parts of the economy and events outside the country, such as China-US relations, the Russian-Ukrainian conflict and unrest in the Middle East, also contribute to a bearish tone or pessimistic to investors. .

The confluence of uncertainties has markets in or near a correction or heading into a bear market, which are terms that are used more accurately when discussing a market decline.

The recent decline in stocks, of course, is nothing new, but it may seem a little unsettling for new investors, and perhaps even for some veterans.

The Nasdaq Composite entered a correction last Wednesday, registering a drop of at least 10% from its recent peak on November 19, which is Wall Street’s commonly used definition of a correction. The Nasdaq Composite last entered a correction on March 8, 2021. On Friday, the Nasdaq Composite was up more than 14% from its November high and heading into a so-called bear market, generally described by the market techs like a drop of at least 20% from a recent high.

Meanwhile, blue chip Dow Jones industrials were 6.89% below their all-time high on Jan. 4, or 3.11 percentage points from a correction, as of Friday’s close; while the S&P 500 was down 8.31% from its record high on Jan. 3, putting it just 1.69 percentage points since entering a correction.

Also of note is the RUT Russell 2000 Small Cap Index,
-1.78%
was 18.6% from its recent peak.

The shift in bullish sentiment hinges on the Federal Reserve’s three-pronged approach to tighter monetary policy: 1) reduce market-friendly asset purchases, with a view to completing those purchases by March; 2) raise benchmark interest rates, which currently range between 0% and 0.25%, at least three times this year, based on market-based projections; 3) and shrinking its balance sheet by nearly $9 trillion, which grew significantly as the central bank sought to act as a safety net for markets during a March 2020 slump caused by the pandemic rocking the economy .

Taken together, the central bank’s tactics to fight a surge in high inflation would pull hundreds of billions of dollars of liquidity out of markets that have been flooded with Fed funds and government fiscal stimulus during the pandemic.

Uncertainty about economic growth this year and the prospect of higher interest rates are forcing investors to revalue technology and high-growth stocks, whose valuations are particularly tied to the present value of their cash flows, as well as undermining speculative assets, including crypto. like bitcoin BTCUSD,
-0.48%
and Ether ETHUSD,
-0.63%
on the Ethereum blockchain.

“Excessive Fed liquidity has had the effect of inflating many asset classes, including meme stocks, unprofitable tech stocks, SPACs[special-purpose acquisition companies]and cryptocurrency,” Hatfield said.

He said that the rise in yields of the 10-year Treasury note TMUBMUSD10Y,
1.762%,
which climbed more than 20 basis points in 2022, marking the strongest advance at the start of a new year since 2009, is more a symptom of the expectation of a liquidity squeeze.

“Liquidity is the main driver, not interest rates, as almost all publicly traded stocks have about the same duration/interest rate sensitivity, so tech stocks are unaffected disproportionately by rate hikes, despite market comments to the contrary,” Hatfield said.

Either way, the Federal Open Market Committee responsible for setting rates will likely spend its Jan. 25-26 meeting laying the groundwork for another policy shift, which the market is trying to price into valuations.

How often does the market collapse

Investors should be forgiven for thinking that markets are only going up. The stock market has shown resilience, even during the pandemic.

Yet declines of 5% or more are common on Wall Street.

Sam Stovall, chief investment strategist at CFRA, said he viewed the current market drop as “a very typical drop.”

“Is it an accident? No. But it’s an average drop, believe it or not, it is,” he told MarketWatch over the weekend.

“I would say the market does what it does. A bull market goes up the escalator but bear markets go down the elevator, and as a result people are very scared when the market goes down,” he said.

Stovall prefers to categorize market declines by overall magnitude and does not offer specific criteria for a “crash”.

“[Declines of] zero to 5% I call noise, but the closer we get to 5% the louder the noise,” he said. He said a drop of 5-10% is considered a pullback, a drop of at least 10% is a correction for him, and a drop of 20% or more is a bear market.

Salil Mehta, a statistician and former director of analysis for the U.S. Treasury Department’s TARP program following the 2008 financial crisis, told MarketWatch that given the more than 8% decline in the S&P 500, the likelihood of a 10-14% decline from here is 31%, while there is a one in five chance of a total decline of 30% or more from current levels.

The statistician said there is “a similar probability that the current decline will eventually turn into something twice as large. And a similar probability that the current pullback will be over.

Stovall said it’s important to know that markets can come back quickly after a downturn. He said it took the S&P 500 an average of 135 days to come to a peak-to-trough correction and only 116 days on average to break even based on data dating back to World War II.

Stovall says this slowdown may also be exacerbated by seasonal factors. The researcher said markets tend to fare poorly in a president’s second year in office. “We call it the second crisis,” he said.

“The volatility was 40% higher in the second year, compared to the other three years of the presidential term,” he said.

Stovall said another factor to consider is that markets tend to digest a lot after a year when returns have been 20% or more. The S&P 500 has posted a 26.89% gain in 2021 and is down 7.7% so far in 2022.

There were 20 other occasions when the S&P 500 index posted a gain of 20% or more over the calendar year and fell by at least 5% the following year. When such a drop, after a big gain the previous year, happened in the first half of the new year, and did so on 12 occasions, the market returned to equilibrium 100% of the time.

Stovall notes that this is not statistically significant but still noticeable.

What should investors do?

The best strategy in a downturn may be no strategy at all, but it all depends on your risk tolerance and time horizon. “Doing nothing is often the best strategy,” Hatfield said.

He also highlighted defensive sectors, such as consumer staples XLP,
+0.08%,
XLU utilities,
-0.19%
and XLE energy,
-1.98%,
which often pay healthy dividends and higher yielding investments like preferred stocks as a good option for investors looking to hedge against possibly greater volatility.

Financial experts normally warn against rash action, but they also say some Americans have more reason to worry than others, depending on their age and investment profile. An older person may want to discuss the situation with their financial advisor and a younger investor may be able to hold their own if they are comfortable with their current investment setup, strategists say.

Withdrawals can be opportunities for asset accumulation if an investor is careful and judicious in selecting their investments. However, slowdowns often result in hive thinking, with market players selling in droves.

Market declines “shake investor confidence and tend to drive more sales,” Hatfield said.

Ultimately, though, investors need to be careful and smart about how they think about the market, even in the face of so-called crashes.

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