With 41.9% Of Wealth In Stocks, 28% NASDAQ Plunge Could Tank Economy

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After eyeing yesterday’s 4% plunge in the tech-heavy NASDAQ NDAQ , the contents of my stomach surged upwards and I imagined the people behind those trades screaming the immortal words of Howard Beale: “I’m mad as hell and I’m not gonna take it anymore!”

The May 9 market dive left no stone unturned. According to Kiplinger, here are the lowlights:

  • S&P 500: -3.2% to lowest point in over a year
  • NASDAQ: -4.3%, 28% below its peak with the biggest tech companies having shed $1 trillion in market capitalization in the last three trading sessions, according to SeekingAlpha
  • Dow Jones: -2%
  • Russell 2000: -4.2%
  • Consumer discretionary stocks: -4.3%
  • Energy stocks: -8.3% as crude fell 6.1% on fears of China’s Covid lockdowns crimping demand
  • Bitcoin: 13.4% to $31,153 — 52% below its high

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-fee stock index fund.

Nevertheless, the 28% dive in the NASDAQ since it peaked last November is painful and is likely to get worse as most listed technology companies report disappointing growth for the next several 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 downturn in stocks?
  • What could propel stock prices to head back up?
  • When will that happen?

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History of Market Corrections

One investing story is that stocks forecast the economy. I do not really buy that notion — especially since with a record 41.9% of household wealth coming from stocks, according to CNBC, it is more accurate to say that the distinction between the stock market and the economy is blurring.

Nevertheless, if the stock market is forecasting the economy, then a steep recession — strictly speaking two consecutive quarters of negative GDP growth — could be imminent.

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

How do recessions affect stock prices? In April, I took a look at recessions over the last 40 years, how much they drove down stock prices, 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 is predicting will not last more than 18 months and the stock market will surpass its previous high once the recession ends. In recessions since 1980, it has taken the S&P 500 anywhere between seven and 76 months to surpass the pre-recession high.

How so? 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 surpass its previous high after it fell during that recession:

  • 1980. Six months recession and seven months for S&P 500 to reach pre-recession high of 422 reached in January 1980
  • 1981 to 1982. 16 month recession and 27 months for S&P 500 to reach pre-recession high of 452 reached in December 1980
  • 1990 to 1991. Nine month recession and 12 months for S&P 500 to reach pre-recession high of 804 in May 1990
  • 2001. Eight month recession and 69 months for S&P 500 to reach pre-recession high of 2,525 reached in August 2000
  • 2008 to 2009. Six month recession, 76 months for S&P 500 to reach pre-recession high of 2,117 reached in May 2007
  • 2020. Six month recession, seven months for S&P 500 to reach 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 technology company growth.

Fear of Tight Money

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

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

My hunch is that it will be more like a combination of the Volcker and dot-com crash downturns and less like the financial crisis.

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

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

Reappointing Powell told the market that inflation would be here to stay unless the Fed raised interest rates substantially — after they had been near zero since 2009 (with a temporary increase to over 2% in 2019).

I think one reason stocks have fallen is the uncertainty around 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 the Fed Funds rate will be 2.8% by the end of 2022 (from the current range of 0.75% to 1%).

Disappointing Technology Company Growth

Those fears have been colliding with technology companies that enjoyed tremendous revenue growth during the pandemic — however, in the first quarter of 2022, they reported a sharp reversal of fortune. Post-pandemic losers include:

  • Peloton: – 91% from high of $163
  • Carvana: – 90% from $377
  • Zoom: – 84% from $559
  • Wayfair: – 82% from $344
  • Netflix NFLX : – 75% from $701

While there is a different reason why each of these stocks disappointed, the general explanation for the drop in these shares is that as consumers left pandemic-induced home confinement, these companies could not sustain the very rapid growth they enjoyed in 2020 and early 2021.

What Could Propel Stocks Back Up

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

Inflation will go down if demand drops and/or supply increases. Demand could drop if consumers and businesses spend less. A drop in consumer spending could happen if the unemployment rate rises and/or the reverse wealth effect from plunging stocks and much higher gas and other prices convince people to spend less.

Businesses will cut back on spending if demand drops — possibly due to layoffs — or if the cost of capital — due to higher interest rates and increased investor risk aversion — gets too high to justify increased capital investment.

Supply increases could result from

  • Loosening of supply chain constraints — such as ending Covid lockdowns in China and boost in workers to unload cargo and truck it to distribution centers
  • Increased supply of oil and gas
  • Boosting of food supply — abetted by the end of Russia’s war on the Ukraine
  • Rise in semiconductor production

When Stocks Will Bottom Out

I have no idea when stocks will bottom out. The only thing I know for sure is that in the last 40 years, stocks have always recovered from recessions and over the very long-term they average about 7% annual returns.

If you enjoy suffering — as you did during the pandemic lockdowns — you can make the recession happen sooner by cutting way back on your spending. If everyone did that, demand and ultimately prices would drop. Sadly that could mean that your employer cuts your job to reduce costs.

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

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