With 41.9% of Wealth in Stocks, 28% Drop in NASDAQ Could Sink the Economy

After noting yesterday’s 4% drop in the tech-heavy NASDAQ

NDAQ
my stomach contents shot up and I imagined the people behind those trades shouting the immortal words of Howard Beale: “I’m fucking angry and I’m not going to take it anymore!”

The market crash on May 9 left no stone unturned. According Kiplingerhere are the low points:

• S&P 500: -3.2% to the lowest point in more than a year
• NASDAQ: -4.3%, down 28% from its peak, as the largest tech companies have lost $1 trillion in market capitalization in the last three trading sessions, according to SeekingAlpha
• Dow-Jones: -two%
• Russell 2000: -4.2%
• Consumer Discretionary Stocks: -4.3%
• Power reserves: -8.3% as crude fell 6.1% on fears China’s covid lockdowns will hit demand
• bitcoin: 13.4% to $31,153 — 52% below its maximum

Should you follow them to the exits? If history is any guide, you should either do nothing or continue to make monthly investments in a low-cost stock index fund.

However, the 28% drop in the NASDAQ since peaking last November is painful and likely to get worse as most publicly traded tech companies report disappointing growth for the coming quarters.

To explain why I think the best strategy is to stay the course, let’s examine these questions:

• What does history tell us about market corrections?
• What is causing the current drop in stocks?
• What could drive stock prices back up?
• When will that happen?

History of market corrections

An investment story is that stocks forecast the economy. I don’t really buy into that notion, especially since with a record 41.9% of household wealth coming from stocks, according to CNBCit is more accurate to say that the distinction between the stock market and the economy is blurring.

However, if the stock market is forecasting the economy, then a deep recession (strictly speaking, two consecutive quarters of negative GDP growth) could be imminent.

After all, GDP contracted 1.4% in the first quarter, largely due to a decline in exports. However, consumer spending, which accounts for about 70% of economic growth, remained strong. It helped that wages rose more than 5% and the unemployment rate was 3.6% in April.

How do recessions affect stock prices? In April, I took a look at the recessions of the past 40 years, how far stock prices have dropped, and how many months it took for the market to get back to where it was before.

Based on that analysis, if history is any guide, the recession that the current correction predicts will not last more than 18 months and the stock market will surpass its previous high once the recession ends. In recessions since 1980, the S&P 500 has taken between seven and 76 months to break above the pre-recession high.

How is that? Below are the six recessions since 1980, how long they lasted, and my estimate of how long it took for the S&P 500 to exceed its previous high after it fell during that recession:

• 1980. Six months into the recession and seven months for the S&P 500 to reach the pre-recession high of 422 reached in January 1980
• 1981 to 1982. 16 months into recession and 27 months for the S&P 500 to reach the pre-recession high of 452 reached in December 1980
• 1990 to 1991. Nine-month recession and 12 months for the S&P 500 to reach the pre-recession high of 804 in May 1990
• 2001. Eight months into the recession and 69 months for the S&P 500 to reach the pre-recession high of 2,525 reached in August 2000
• 2008 to 2009. Six months into recession, 76 months for the S&P 500 to reach the pre-recession high of 2117 reached in May 2007
• 2020. Six months into recession, seven months for the S&P 500 to reach the pre-recession high of 3,593 reached in January 2000

Cause of the current market downturn

There are two causes for the current market downturn: fear of tight money and disappointing growth in technology companies.

Fear of tight money

To paraphrase Mark Twain, history does not repeat itself, but sometimes it does rhyme.

This raises a question in my mind: Is the current market downturn more like the one associated with the near 20% Volcker interest rate downturns between 1980 and 1982, the downturn of the 2001 dotcom crash, or the downturn? financial year 2008/9? ?

My hunch is that it will be more like a combination of the Volcker recessions and the dotcom bust and less like the financial crisis.

The main reason is that the current market downturn started in early November when it became clear that the White House had decided to nominate Jerome Powell for another term as Fed chairman.

This move signaled that inflation would not be cured by letting the free market work. Initially, it was popular to assume that inflation was a short-term blip caused by a pandemic-related mismatch between a surge in demand from people working on stimulus checks for household spending and supply chains crippled by lockdowns. related to the pandemic.

Powell’s re-election told the market that inflation was here to stay unless the Fed raised interest rates substantially, after they had been near zero since 2009 (with a temporary rise to more than 2% in 2019).

I think one of the reasons stocks have fallen is uncertainty about how much the Fed will need to raise interest rates to control inflation, which hit 8.5% in March. How high could they go? CNBC reports that the fed funds rate will be 2.8% by the end of 2022 (from the current range of 0.75% to 1%).

Tech company’s disappointing growth

Those fears collided with tech companies that enjoyed tremendous revenue growth during the pandemic; however, in the first quarter of 2022, they reported a sharp reversal of fortunes. Post-pandemic losers include:

• Platoon: – 91% from a maximum of $163
• Caravan: – 90% from $377
• Zoom: – 84% from $559
• fair way: – 82% from $344
• Netflix
  
  NFLX
  : – 75% from $701

While there is a different reason why each of these stocks disappointed, the general explanation for these stocks’ decline is that as consumers moved out of pandemic-induced home confinement, these companies were unable to sustain the rapid growth they enjoyed in 2020 and early 2021.

What could drive stocks to rally?

I am convinced that money will flow into equities once the Fed decides to stop raising interest rates, which it will do when inflation falls from its current 8.5% to below 2%.

Inflation will fall if demand falls and/or supply increases. Demand could fall if consumers and businesses spend less. A drop in consumer spending could occur if the unemployment rate rises and/or the reverse wealth effect of falling stocks and much higher gas prices and others convince people to spend less.

Companies will reduce their expenses if demand falls, possibly due to layoffs, or if the cost of capital, due to higher interest rates and investors’ greater risk aversion, is too high to justify further capital investment.

Supply increases could result from

• Relaxation of supply chain restrictions, such as ending Covid lockdowns in China and/or more workers to unload cargo and truck it to distribution centers.
• More oil and gas production (rather than Wall Street’s preference for dividends and share buybacks)
• Increased food supply, instigated by the end of Russia’s war against Ukraine
• Increased production of the semiconductor factory

When will stocks bottom out?

I have no idea when stocks will bottom out. I know that over the last 40 years, stocks have always bounced back from recessions and, in the very long run, they average around 7% annual return.

If you enjoy suffering, as you did during the pandemic lockdowns, you can make the recession happen sooner by cutting your spending. If everyone did that, demand and ultimately prices would fall. Unfortunately, that could mean your employer cuts your work to cut costs.

The sooner a recession hits, the more likely it is that inflation will be under control and the Fed will seek to cut rates to stimulate economic growth, sending stocks back higher.