The stock market is currently on a downward trend since the start of the year, and it doesn’t show any sign of slowing down. This makes many investors feel uneasy and unwilling to keep their money invested.
So what makes the stock market tank?
Well, one of the big reasons is that the Federal Reserve has been raising interest rates since March, and there are a few reasons why the stock market cares about interest rates.
But what are interest rates? When I say interest rate, I mainly refer to the federal fund rate. It is the rate at which institutions, such as banks and credit unions, charge when borrowing from each other. It is also a tool for the Fed to control inflation.
In general, when the Fed increases interest rates, it makes it more expensive for institutions to borrow money. So institutions like banks will in turn also increase the rates (think mortgages, credit card interest, etc.) they charge for consumers to borrow money.
With their bills potentially increased, consumers will have less leftover money to spend on other stuff, which in return will potentially lead to inflation decreasing. And the reverse is true as well.
So why is the Fed raising interest rates?
It is because inflation is on the rise ever since the lockdown restriction loosened.
When the COVID-19 pandemic started and lockdowns were implemented, households started to spend less and save more due to the uncertainties at that time. Meanwhile, companies lowered production due to lower forecasted demands, leading to a slowing economy. To prevent the economy from collapsing, the Fed lowered interest rates.
This makes it cheaper for companies to borrow money and fund their future growth. As investors started to expect higher growth, the market boomed in 2020 and 2021.
When lockdown restrictions started to ease, people increased spending even more. Companies could not keep up with this sudden increase in demand alongside supply chain issues and labor shortage issues. High demand and low supply led to price increases and higher inflation.
Now, high inflation is a bad thing. This makes it more expensive for us as consumers to buy things, so we will eventually be able to buy fewer things for the same amount of money. Also, companies will also experience inflation because it makes it more expensive to produce stuff.
As inflation continues rising, the Fed increased interest rates rapidly with the hope to keep consumer spending in check, in turn keeping inflation in check and eventually lowering it.
And the result…?
Inflation is still high, and the stock market tanked 🙂 When interest rate increases, it’s more expensive for companies to borrow money to fund their growth, which would lead to lower growth expectations and lower future cash flows. So investors will price this in, leading to market prices drop.
Not only that, higher interest rate means lower bond prices and higher bond yields, so investors will start to migrate from stocks to bonds, leading to further market drops.
Other problems?
What makes this year interesting to us as investors is that there are big problems everywhere we look.
On one hand, we have a record high inflation of 9.1% in 2022 so far, the highest in 40 years. On the other, we have high interest rates, and the Fed doesn’t show any sign of slowing the rate hikes. We also have many companies doing mass layoffs in an attempt to reduce their overhead costs.
Furthermore, we have global events that bring more uncertainties to the global market.
Most notable is the war in Ukraine that has been going on since February. We also have rising tension between the U.S. and China over Taiwan and the semiconductor industry. Not only that, but people are also paying attention to the real estate crisis currently going on in China as well as the effects of China’s Zero-COVID policy rippling through the global supply chain.
So what am I doing in this market environment?
I am still buying, and I will continue to buy even more if I have more money (not financial advice) 🙂 Despite the fact that there are currently many uncertainties in the stock market, I am not particularly concerned about the stock market in the long run.
We always hear the phrase “buy low, sell high”, which seems like common sense and easy to follow. But in reality, the average investors always do the opposite. People feel more comfortable buying when prices are high and get scared when prices fall.
As I see it, the stock market is “de-risking”. As prices fall, it becomes less risky to invest in the market because you are paying less for shares. Companies’ valuations are actually going back to pre-pandemic levels. Also, historically, despite interest rates increasing or decreasing, the market overall still performs well over the long run.
What I am trying to say is that I will not try to time the market. I do not know how the macro events will play out, and I do not know how the market will react to the changes. What I do know is that high-quality companies are getting cheaper, and the market tends to go up over a long period of time.
Good post.