With the Nasdaq 100 (QQQ) down 15% and the S&P 500 (SPY) nearing correction territory (as of the time of this writing—things are changing very fast!), younger and less experienced market participants might be freaking out. Older people have cooler heads, having seen corrections like this many many times before, which is why few pros are worried that something is fundamentally different and it’s time to pull back.
Active traders might want to hedge and find ways to opportunistically play this downturn, while asset allocators might suggest a pivot of sector weightings from one group to another. In any case, no professional is going 100% cash and waiting for an apocalypse; we came as close as we’re likely to ever come to that kind of scenario in 2020, and the market very quickly recovered. While the Omicron wave has caused a spike in infections and increased the death rate, greater knowledge about COVID-19, the existence of the vaccines, and improvements in treatments mean that the end-of-world scenario feared in March 2020 is not feared now, so the downturn then looks like a natural floor now.
The “this time is different” crowd points to the Federal Reserve and their plan to increase interest rates four times in 2022. While the mechanism behind monetary policy and stock prices is debated amongst academics in finance, the market expectations of a relationship means that, at least in the short term, sentiment will create that relationship no matter how strong or weak it is in reality. Furthermore, it is important to remember that the stock market dipped heavily in late 2015 and early 2016, the last time the Fed began to raise rates, but stocks ended 2016 very positive and stayed positive until 2018, near the end of the Fed’s rate hike cycle.
Thus, it should be noted, the market dips at the beginning of a rate hike cycle, shortly before or after it has begun, but that dip does not last very long—at least, that’s how it’s worked in history. This time could be different, of course, but if it were, a viable hypothesis would need to take three issues into consideration to build a model to explain exactly how much it is different now and how material it will be to the market.
The first issue, of course, is the impact of interest rates on investor activity. Will higher rates cause lower margin lending and thus less demand for stocks? If so, how material will this be to stock demand and thus stock prices? Furthermore, how will higher interest rates disincentivize stock trading as people go back to higher yielding and thus more relatively attractive alternatives?
Secondly, the impact of interest rates on corporate behavior needs to be considered. will higher interest rates affect corporate bonds and loans, making them pricier and thus, as the cost of capital rises, capital investments fall? How much could this impact future earnings, and thus the S&P 500’s (or other index’s) P/E ratio?
The final issue is a bit more subtle, and it has to do with timing. Remember that the backbone of finance is the theory of the time value of money (TVM), which says that a dollar now is worth more than a dollar next year—but the difference in value can vary significantly according to context. So a model needs to consider how the different value of money now relative to the future as rates change will impact investor, business, and consumer behavior. Will these rates happen so fast as to shut consumption down? At the extreme, when borrowing rates are raised to 100%, all borrowing will stop. If rates go up to 2% by the end of 2022, how much will borrowing stop? What if it goes up to 0.5% in June, then 2% by the end of 2022, or some other rate of change? These will all impact borrowing behavior and demand, and timelines need to be factored into the equation.
None of this is to say this correction is over or that it is going to get worse, but that your theory between those two hypotheses depends on how you answer these three questions, and by trying to make a mathematical analysis to get a real answer to that question you can do more than just guess in the dark, but be illuminated by theory and analysis.
