Two words – “The Fed.” The two primary goals of the Federal Reserve’s Quantitative Easing efforts over the past few years were to inflate asset prices (stocks, real estate, etc.) and lower interest rates. They call this the “wealth effect.” In theory, they think that higher asset prices will increase confidence, which will increase spending, business expansion plans, hiring, etc. We do feel better when the value of our home and our portfolios are rising, right? But it hasn’t exactly led to a booming economy, largely because people and businesses continue to get slapped in the face by higher taxes, rising healthcare costs and more regulations. It’s a balancing act and unfortunately the negative fiscal effects are outweighing the positive impact of rising asset prices.
So how does this lead to a sharp decline in the stock market? Well, the Fed is no longer implementing Quantitative Easing. This is why the stock market’s climb turned into a slow crawl this year. Once you turn off the pump that is inflating asset prices, it leaves a very fragile market that is at risk of a sudden shock deflating prices back toward fair value.
Liquidity also continues to shrink because of… regulations! The Dodd Frank Act changed reserve requirements for banks so primary dealers and investment banks are no longer holding the same amount of inventory of bonds and stocks that they used to and are no longer willing to step in to make a market or absorb big moves in the markets. And on top of this we have the high frequency traders (HFT’s), computer-driven algorithms and investor’s love of ETF’s and mutual funds. All of these lead to “trend following” markets, meaning selling can beget selling. The computer algo’s were the reason the Dow opened down 1,100 points Monday morning (with certain individual stocks down 20%+!!, which we took advantage of, thank you) but then immediately recovered half the ground. And yesterday’s big sell-off during the last hour of trading was caused by massive amounts of sell orders hitting the market by funds needing to liquidate positions to meet investor redemptions.
To sum it up, the structure and driving forces of the markets have changed dramatically and we’ve been primed for this type of volatility for months now. Once the Fed turned off the liquidity taps and started talking about raising rates, the dollar stated rising, commodities collapsed, emerging markets got squeezed, currency devaluations started, and the deflationary spiral began. To be honest, I was surprised the US stock market held on as long as it did before this pullback.
This is why I’ve been saying for over a year now that volatility was going to rise. See:
- What China’s Currency Devaluation Means for Markets
- What the Stock Market Seems to be Ignoring
- The Stock Market is Approaching Another Turning Point
- Portfolio Update: Options & Volatility
- Why I’m Revamping our Income Holdings
- High Alert on US Stocks
- Why the Volatility is only just Beginning
- Buckle Up, Why it’s About to Become a Wild Ride
I know my posts might seem like random topics but I promise it’s all connected…
The fact that the stock market has been struggling to bounce is a bit alarming and says this volatility will probably continue for a few more weeks. Fortunately though, I don’t think this is the beginning of a big bear market for US stocks, just a sharp pullback which means buying opportunity. Obviously I’ll keep you posted as things progress over the next few weeks.
Thanks for following!
-Nick
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What do you predict the fed will do with rates later this year? And what do you think they SHOULD do? Need to raise the rates to prevent the loss of credibility of forward guidances and due to low unemployment; but could keep them low due to low inflation and current global economic downturn.
That is the dilemma, my friend. They are absolutely stuck between a rock and a hard place. I have no idea what they’ll actually do but I think it would be a huge mistake for them to raise rates at this point. Because of that, I’m betting that they will and all indications suggest that they will. The problem is that their job is to focus on US unemployment and US inflation – but the US dollar is the world’s reserve currency so their actions have global implications. They’ve stated in speeches that they are not the world’s central bank and that other countries need to plan accordingly. This leads me to believe they’ll try to “normalize” rates despite the implications for markets, which means we as investors have to be prepared. They say that it’s not their job to worry about investment markets, yet they’ve manipulated prices for the past 20 years… At this point, they’re concerned about not having any bullets left in the gun for the next economic slowdown as well as the long-term negative impact of low rates for savers, pension funds, insurance companies, etc. As you suggested, the real problems will arise if the markets lose faith in the Fed’s credibility and ability to “manage” all the risks out there. To be honest, I don’t see how they get out of this without additional QE down the road. This is what happens when you don’t let the system reset but instead try to bail out everyone for their mistakes and end up creating a system of moral hazard. They try to put out one fire and end up creating an even bigger one somewhere else. Sometimes you just gotta let the forest burn down in order to start fresh and clear the space for new growth. It’s the natural cycle of life.