The Nasdaq 100 (QQQ) and Russell 2000 (IWM) are in bear market territory, and the S&P 500 (SPY) is pretty close, with almost a 17% drop as of the time of writing. I say “time of writing” because things are happening really fast, like late last week when QQQ fell almost 5% in a day (it’s fallen 10% in less than a week).
This is a lot like early 2020, when a pandemic forced large scale closures around the world and economic activity effectively stopped, which resulted in the necessary repricing of sales and earnings growth potential for many companies. It also resulted in a panic in debt markets, causing bonds and loans to plunge in value.
That is, until the central banks stepped in.
Promising a stopgap to ensure these declines didn’t continue, those banks provided a cushion in the form of monetary policy. At the same time, many major governments, most crucially the United States, offered a variety of programs such as direct cash payments, eviction moratoriums, and other programs to ensure money kept flowing and companies didn’t go bankrupt.
This helped asset prices recover, and in the eyes of some it helped a bit too much; by the end of 2020 stocks had fully recovered and there was financial optimism as vaccines came on the scene.
Things are very different this time, of course. The pandemic is not an economic issue in much of the world, but it is in China—where lockdowns have gotten more severe and more economically disastrous than ever before, with ripple effects impacting consumer goods around the world. The Federal Reserve is raising interest rates aggressively to combat price growth, which is itself being driven by shortages of all kinds. Known as cost-pull inflation, this is a very economically disastrous kind of inflation caused by a lack of goods to meet demand.
Its cousin, demand-pull inflation, is the result of extreme demand from across the economy driving prices up. That can cause bubbles, while cost-pull inflation can often cause stagflation.
Not really seen since the 1970s, stagflation is an ugly beast. A lack of goods and services means a lower living standard within the economy while rising prices for the few that can afford it means greater discontent. That can turn into political upheaval, riots, or worse. Stagflation is in itself terrifying.
Of course, the real question now is how long this bout of stagflation will last. A quick glance at core-CPI numbers indicates that we have hit peak inflation and, unless there is a massive upset in the data in May, price growth is going to start to moderate. In a few months a trend could be established and relief could return to markets.
But until then, that macroeconomic story is not yet written, and animal spirits are at work. The market is pricing in several worst-case scenarios, and a lot of investors are bailing just to avoid the freefall they’re seeing (which, ironically, creates more freefall). Thus we see how the macroeconomic picture is driving market behavior past the point of rationality and towards naked fear.
Savvy long-term investors tend to buy at those points; as Warren Buffett famously said, “be greedy when others are fearful,” but that is very, very hard to do. Psychologically, the pain of seeing massive financial losses is a roadblock that puts rational decision making on pause.
In short, people freak out.
How long they will keep freaking out is now the real question in markets—and it is the one that most of the pros are betting on most aggressively. This isn’t just a time to buy or sell stocks, but to use options to bet on a recursive loop of fear begetting fear until everything is oversold and the market steps away from the brink—as we have seen it do many, many times in the past.
This kind of extremely aggressive investing—not on the market’s fundamentals but on perceptions of fundamentals—is not for the faint hearted or for investors without deep pockets. But it is a cornerstone of some of the most famous hedge fund billionaires on Earth. It is perhaps best articulated by George Soros in a late-2009 article titled the “General Theory of Reflexivity”. Part philosophy and part financial theory, it is, in Soros’s words, a framework about money and “about the relationship between thinking and reality, a subject that has been extensively studied by philosophers from early on”. And while that may sound pretentious and silly, Soros says it “enabled me both to anticipate the crisis [of 2008] and to deal with it when it finally struck”. Which is not a revision of history; Soros, with several other hedge funds, did very well in the Great Recession by playing on market behavior—and it is something that remains the stalwart of great investors around the world.