There was some turbulence in the stock market recently.
It took a while for investors to realize that the Federal Reserve is serious about fighting inflation.
The S&P 500 fell over 16% in the first week of the year, its worst start to the year since 1939.
What has changed?
Last week was the end of the era of free money in central banking. The Fed has supported markets with near-zero interest rates and quantitative easing since the beginning of the epidemic. The stock market thrived under the loose monetary policies. The safety net was laid out for investors when the central bank injected money into the economy as an emergency measure.
When the Fed raised its benchmark interest rate in March, things changed. The rate hike on Wednesday signaled the end of the free money era.
Understanding how far stocks might fall as a result of a lack of Fed support is important.
The Fed has kept the cost of borrowing low in order to allow consumers to invest in homes, cars, and their education without the burden of high-interest payments. When inflation and wage growth were low, it made sense to encourage consumer spending wherever possible.
With unemployment rates near pre-pandemic lows, the central bank has shifted tactics, raising interest rates and signaling its intention to trim its balance sheet to the tune of billions of dollars each month.
Risk assets, including stocks and cryptocurrencies, have cratered as investors grapple with the new norm after the regime change. Many are wondering if the era of the Fed put is over.
The way the Fed enacted policy was like a put option contract, stepping in to prevent disaster when markets experienced serious turbulence by cutting interest rates and printing money.
When times are tough, the Fed must act to restore market order because they argue that a debt cascade and destabilizing banks could happen.
The Fed would come to the rescue if the stock market fell. Many are wondering if that is still the case under a new regime.
Will the Fed cut rates if the stock market continues to fall? Will the markets be left to fend for themselves?
The idea that the Fed will help in a downturn began under Greenspan. After the 1987 stock market crash, Greenspan lowered interest rates to help companies recover, setting a precedent that is still used today.
It was a huge change in policy from the era of Paul Volcker, who was Fed chair from 1979 to 1987. Volcker is credited with reining in the inflation of the 1970s and 1980s through the use of monetary policies.
His policies led to large Federal budget deficits as a result of the Reagan administration's tax cuts and record military spending.
After the dotcom bubble burst in 2001, Greenspan ushered in an era of more dovish monetary policy, lowering interest rates on several occasions when stocks fell.
Since Greenspan, every Fed chair has used interest rate cuts to improve investor sentiment and encourage investment when stocks fall. After the housing bubble burst in 2008, the Fed Chair, Ben Bernanke, instituted the first round of quantitative easing in the U.S. to help the country weather the economic storm.
Since the stock market went through serious downturns, investors have looked to the Fed for support, but that era may now be over as inflation pushes the central bank toward a new, more hawkish approach.
The current business cycle will likely be different for stocks if the Fed puts an end to it.
The relentless march of U.S. equities is one of the many themes that will be different going forward. The last decade was marked by record long periods without a correction, a don't fight the Fed mentality, and a buy the dip narrative.
The longest run without five consecutive down weeks in S&P 500 history came to an end last week.
The last decade has seen 61 runs of five or more weekly declines, so one every year and a third on average.
The phrase "Don't fight the Fed" was invented by Martin Zweig, a renowned investor and analyst who was well known for calling the 1987 market crash. The phrase "stay invested while the Fed is behind markets, acting as a safety net from downturns" has been used by investors for years. Don't fight the Fed may have a new meaning.
Zweig wrote in his book Winning on Wall Street.
The monetary climate is the main factor in determining the stock market's direction. A rising trend in rates is bearish for stocks, while a falling trend is bullish.
As long as the Fed kept interest rates low, it made sense to stay invested in risk assets.
It is a new era, one that might not be as kind to risk assets with the Fed raising rates.
The Fed can still be fought by investors. The central bank is no longer pushing them towards high-flying tech stocks and cryptocurrencies. It's making assets look more favorable. Short-term government bonds and value and dividend stocks are assets that typically perform well during rising-rate environments. Don't fight it.
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