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What to know if you want to buy the stock market drop


Investors have long shared a dream: that the Federal Reserve would always flood the markets with cheap money whenever asset prices fall too low.

In 2022, this dream has turned into a nightmare.

As the Fed is determined to stifle inflation, the threat of higher interest rates has knocked $10 trillion off the market value of US stocks and hammered bonds with the worst yields since 1842.

You won’t be able to cross this kind of market as you have for the last few years. Buying the dips or hoarding stocks as they went down hoping they would recover quickly was almost a delight; now it will hurt. And forget about getting rich with a few finger swipes or mouse clicks. Those days are over, although disciplined, patient and courageous investors will always prevail.

For years, investors believed the Fed would listen to their cries of pain. Think 2018-19 when the Federal Reserve raised rates and then pulled back after stocks fell almost 20%, or early 2020 when the Fed cut interest rates again and injected liquidity in the markets. Investors celebrated.

Professional investors call this the “Fed put”, a concept derived from trading put option contracts. Owning a put allows you to sell the underlying asset at a specified price on a specified date. This protects you from falling below that price until the option expires.

Similarly, when the public thinks the Fed is ready to pour cheap money into the markets, it keeps stocks and other assets from crashing, creating a free put option for investors.

Of course, the central bank has no explicit policy of supporting stocks, bonds, real estate, etc. Former Fed Chairman Ben Bernanke warned that “the effects of such attempts on market psychology are dangerously unpredictable.”

Federal Reserve Chairman Jerome Powell said on Wednesday the central bank had approved a half-percentage-point hike in interest rates in a bid to curb inflation that is at an all-time high for four decades. Photo: Win McNamee/Getty Images

However, as William Poole, ex-president of the Federal Reserve Bank of St. Louis, once wrote, “There is a sense in which a Fed put exists,” namely that large losses in financial markets can undermine central bank objectives. low unemployment and stable prices. Steady economic growth is the end, but market support can be an indirect way to get there.

From 1994 to 2008, a 10% drop in stock prices, on average, was associated with rate cuts by the Fed of nearly 1.3 percentage points over the following 12 months, according to Anna Cieslak, a professor of finance at Duke University. The central bank has tended to cut rates in such downturns more than expected by investors, she said.

Tale of the Band

Investors face a big test as interest rates rise, inflation picks up and the Federal Reserve embarks on an aggressive campaign to tighten monetary policy.

Weekly fed funds target range*

But with inflation above 8%, cutting interest rates anytime soon would be like testing a flamethrower in a dynamite factory.

“The Fed’s put is kaput,” says Ed Yardeni, president of Yardeni Research Inc., a firm that advises on investment strategy. “The Fed can’t respond to the cries of the stock market when inflation is such a big deal.”

Moreover, even the newly aggressive Fed will probably not be able to calm inflation as quickly as it would like.

“The idea is that we can engineer a painless reversal of inflation without damaging the real economy,” says Carmen Reinhart, chief economist at the World Bank. “This idea is not based on prior historical experience, and I don’t think that’s in the cards.”

There is no modern precedent suggesting that the Fed can cut inflation by at least 4 percentage points without sending the economy into recession.

Anything can happen, of course. If the US dollar continues to appreciate, the cost of imports could fall. Russia could withdraw from Ukraine; Covid-19 could withdraw from China. Oil prices could fall.

But investors should always hope for the best while expecting the worst. Inflation is likely to intensify and last longer than recent decades have made us accustomed to. That means the Fed, long a paper tiger, will have to keep pushing rates higher until the cost of living finally comes down.

“It’s time to update that old adage, ‘Don’t fight the Fed,'” Yardeni says. “Now it’s ‘Don’t fight the Fed, especially when it’s fighting inflation.'”

With the expiry of the Fed put, what should you do?

First, avoid long bonds and bond funds, which are very sensitive to rising interest rates and have lost 20% or more so far this year.

SHARE YOUR THOUGHTS

With the Fed put expiring, what changes are you making to your portfolio, if any? Join the conversation below.

Be fully prepared, if you buy the dips, for the stock to fall further and stay longer. Dips can turn into dips, and recoveries won’t always be as quick as they have been over the past decade.

Put your purchases on autopilot, for example, automatically buy a fixed amount of dollars once a month, so you are not tempted to give up near the bottom. Ultimately, opportunistic buying should pay off, although it could take years.

Prioritize assets that can benefit from inflation. Returns on Series I Savings Bonds, or I Bonds, will track (but not exceed) the rate of inflation. Several issues of Treasury inflation-protected securities, while not cheap, currently provide a small cushion if the cost of living rises further. Although equities have been pounded this year, in the long run they are a decent hedge against subdued inflation. A small allocation to commodities could also help.

Above all, do not take big risks to try to catch up. The Fed will no longer patch up investors’ mistakes.

More from The Smart Investor

Write to Jason Zweig at [email protected]

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