An old Chinese curse says, “May you live in interesting times.” Well, we certainly have that today with the Dow Jones Industrial Average dropping 981 points (2.8%) today. The S&P 500 also dropped 2.8% and the NASDAQ composite declined by only 2.6%. The drop in the equity averages was largely attributed to higher interest rates. Where do we go from here?
For the record, I am not an investment advisor of any sort
anymore. I did spend 20 years of my life in the investments business and have
maintained an interest in the financial markets. The drop today caught my
attention. For a little perspective, the most dramatic day in stock market
history had to be October 19, 1987, which saw the Dow drop 508 points, which
was 22% of its value at the time. Think about that – investors saw 20% of their
value wiped away in one day. I was a junior at Baylor that day, so I did not
appreciate the enormity of that day like I do now. The Dow closed at 1,722 after
that carnage. Today, after a 981-point drop, the Dow closed at 33,811, which is
a 32,089-point increase since October 19, 1987. And consider all that has gone
on since. Two Iraq wars. 9/11. A near depression in the 2008-2009 timeframe. A
global pandemic. War between Russia and Ukraine. All manner of terrorist
attacks, whether in Paris, Madrid, or Orlando among others. All that sandwiched
in between two stock market crashes. And yet equities have managed a compounded
annual growth rate of about 8.8%. Stocks are resilient and I expect they will
recover from this as well.
Is this a buying opportunity? Just my opinion, so take it
for what it is worth here, but my answer is not yet. When the market crashed in
front of the pandemic in 2020, I believed that created a good buying
opportunity. Turned out to be a better buying opportunity than I ever imagined.
This time feels different. One of the pithy sayings that the old-timers like to
say is “Don’t fight the fed.” Let the Federal Reserve be your guide. In 2020,
the Fed unleashed the spigots and money gushed out. Today, they are tightening
the spigot to the point where one wonders if they will ever put another dollar
into circulation. Interest rates are rising, and now is not the time to get
courageous and stand in front of that.
Why do interest rates matter? Anyone who has ever done a
discounted cash flow analysis on a stock knows that Treasury rates (i.e. the
risk-free rate) are tied to equity valuations. A discounted cash flow analysis
yields an intrinsic value for a stock. As rates go up, that intrinsic value goes
down. With the federal reserve sounding more hawkish than ever on rates,
investors are betting that rates go much higher than originally expected. Higher interest rates get built into the DCF equation. Hence, the drop in stock prices.
Why do interest rates have to rise? Interest rates are the
price of money. Back in 2020, interest rates fell to zero as money was injected
into the economy to help fight the effects of the pandemic. Money was needed as millions of people were put out of work. When rates fall,
more money is available from the banks, and credit becomes easier to obtain. With
a low price of money, demand for money increases. When a wide swath of the population
has more money, due to obtaining low-interest easy credit, it allows suppliers
of good and services to raise their prices a bit. When there is a shortage of
goods, it allows prices to be raised a lot. Supply shortages soon hit during the pandemic as
production was either halted or slowed to a crawl. Lumber was the first
shortage, but the most pronounced and longest lasting of the supply shortages
has been in semiconductors. Semiconductors are used in a wide variety of products,
with the big three being computers, phones and cars. When the supply shortages
hit, prices rise dramatically and that shows up in the inflation numbers. In
order to slow inflation, rates must rise, thereby reducing demand for credit,
and bringing the supply/demand imbalances back into balance.
What is inflation? The best definition of inflation I ever
heard is that it is too many dollars chasing too few goods. This hits at the
causes of inflation. Too much money in the system on the one hand. Supply
shortages on the other. We saw that in the 1970’s and we see it again today. The
problem we have today is that the Federal Reserve tried to tell us last year
that inflation was “transitory.” In the process, they continued to feed money into
the system, making the inflation worse. By the time Jerome Powell realized what
was going on, it was too late. Because the Federal Reserve was behind the curve
all year, they made the inflation situation far worse. I believe that prices
have gone far higher than necessary. The actions needed to correct the Fed
created inflation will be far more drastic now than they would have been had
the Fed started taking corrective action last year.
Would I recommend stocks at this point? First, like I
mentioned at the beginning, I am not an investment advisor any longer. I do
have thoughts and ideas. I still like to do my own research. Every person’s situation,
preferences and risk tolerance are different. If you like to purchase
individual securities, do your research first. If you have a financial/wealth
advisor whose expertise you depend upon, consult him/her and develop your plan
of action together. Or maybe you just invest in index funds and call it good.
Nothing wrong with any of these approaches. My preference at this time to raise
investable cash, and wait for the right buying time. In other words, don’t
fight the fed. I’ll be getting my list together. For me, I like regional banks,
semiconductors and a smattering of industrials.
Understand that this too shall pass. If today were as bad as
1987, the Dow would have dropped about 7,600 points today. It did not, it dropped
1,000. To believe that stocks will come back, as I do, is to believe in the
resiliency of people. We will go on making widgets, working diligently at our
jobs and being forever optimistic about the future.
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