After falling for six straight days, U.S. financial markets rallied on Friday, with all major stock indexes posting gains and the Nasdaq posting its biggest percentage gain — 3.8 percent — since November 2020. Some struggling cryptocurrency assets also surged, and the appearance of green on trading screens provided some much-needed relief for investors. However, all of this must be put into perspective.
Even after Friday’s rebound, the Dow, S.&P. 500 and Nasdaq all closed down at least two percent this week. The Dow has fallen for seven straight weeks, according to Reuters, the longest losing streak since 1980. Looking further back, the picture is even grimmer. Over the past six months, the Nasdaq Composite is down twenty-six percent, the S.&P. 500 is down fourteen percent, and the Dow is down eleven percent. Many individual stocks continued to fall: Netflix and Peloton are both down about seventy percent.
Cryptocurrency assets have seen some of the biggest declines. Since last November, Bitcoin has halved in value and Coinbase, a crypto exchange, has fallen nearly eighty percent. Earlier in the week, TerraUSD, a “stablecoin” — a cryptocurrency backed by assets including other cryptocurrencies — said to hold a dollar’s worth, fell to fourteen cents, and Luna, a cryptocurrency associated with Terra , lost practically all of its value.
Speculating in crypto has always been a pursuit of the intrepid or naïve. But as tens of millions of American households watch the values of their more conservative 401(k)s and other retirement accounts plummet month after month, many of them are wondering what is causing this slow slide and when it will end. The second question is more difficult to answer; The first can be answered in three words: the Federal Reserve.
In late November, Fed Chair Jerome Powell signaled that the central bank was preparing to dampen inflation, which had risen to a 31-year high of 6.2 percent. In March, after the Labor Department said inflation had hit a forty-year high of 7.9 percent, the Fed hiked the federal funds rate by a quarter of a percentage point and indicated it could introduce as many as six more rate hikes before the end of the year. Noting the sentiment at the March Fed meeting, which raised interest rates, Powell told reporters, “Looking around the table at today’s meeting, I saw a committee very conscious of the need for a return to price stability and is committed to using our tools to do just that.”
There are at least two reasons why stocks tend to fall when interest rates rise. The first involves arithmetic. In theory, a stock’s value is determined by a formula that has future dividend payments (or cash flows) in the numerator and an interest rate in the denominator. As the denominator increases, the value of the stock decreases. And what is true of individual stocks is also true of the market as a whole.
The second reason is more practical. By raising the cost of borrowing to buy houses, cars, and everything else, higher interest rates slow the economy and, in extreme cases, plunge it into recession. Four of the last five recessions were preceded by a period when the Fed raised interest rates: 1981-82, 1990-91, 2001, and 2007-2009. (The exception is the 2021 recession, which was a result of the coronavirus shutdown.) When investors saw the Fed commit to an open-ended series of rate hikes, they had good reason to be alarmed.
Another reason for the market crash is psychological, and perhaps the most important of all: Investors have lost their safety cover. Despite the historical link between rate hikes and recessions, many professional investors had come to believe that the Fed would always have their back — if the stock market ever got into serious trouble, the central bank would step in and prop things up. This reassuring belief was given a name: “Fed Put”. (A put is a financial contract that gives an investor the right to sell a stock at a specified time in the future at a specified price, limiting downside potential.)
This confidence in the Fed was not based on wishful thinking. In 1998, Long-Term Capital Management, a giant hedge fund, ran into trouble and markets plummeted. Under Alan Greenspan, aka the Maestro, the Fed orchestrated a Wall Street bailout for LTCM, and the dot-com bubble inflated for another year and a half. During the global financial crisis, the Fed, led by Ben Bernanke, cut interest rates to near zero and enacted quantitative easing – creating trillions of dollars to buy financial assets, mostly government bonds. In March 2020, as the outbreak of the pandemic prompted another bout of panic selling on Wall Street, the Fed quickly pulled its playbook out of the Great Recession. Between March 1, 2020 and December 1, 2021, the Nasdaq doubled, meme stocks skyrocketed, and the value of Bitcoin rose sixfold.
Many investors are concerned that the Fed put has now been withdrawn. As Powell and his colleagues have reversed course on interest rates and quantitative easing — next month the Fed will begin selling some of the securities it’s been buying for the past few years — their language has changed dramatically, too. Recently, Powell has said repeatedly that he would welcome “tighter monetary policy”; This statement can be roughly translated to mean higher lending rates and a lower stock market. At a press conference last week, he told a press conference: “If we don’t see that financial conditions have tightened appropriately, we’ll have to look around and move on”; this could be interpreted as the Fed believing the market needs to keep falling.
How far? Quite a lot if stock price valuations returned to historical norms. Take price-to-earnings ratio, a commonly used valuation metric. For the S.&P. 500, the average price-to-earnings, or P/E, ratio since 1880 has been about sixteen. Even after the recent market slumps, the P/E is currently around twenty. That discrepancy suggests shares could fall another twenty percent. However, history also tells us that markets often overshoot on the way down as they do on the way up, suggesting an even bigger drop could be on the way.
Of course, no one can be sure what will happen, and hope is eternal. Friday’s rebound reflected an ingrained “buy on the dip” mentality. But as long as the Fed is on the offensive against inflation, ordinary investors should be cautious. In times of rising interest rates and volatile markets, there is a risk that something will break and trigger a quick crash. TerraUSD’s spins along with Luna’s collapse provided an illustration. In all likelihood, the sums lost in this particular debacle were not enough to threaten the broader financial system. But it was a timely reminder of what an old-fashioned fast crash looks like.