<I’m genuinely curious how a bearish investor decides low is low enough.>
The Federal Reserve created massive monetary stimulus after the 2008 financial crisis by keeping the real fed funds rate negative (effective rate minus inflation) for long periods of time.
They suppressed the longer-term debt yields with breathtaking Quantitative Easing.
This led to asset bubbles in stocks, bonds and real estate. This is described in the book, “The Lords of Easy Money,” by Christopher Leonard.
The Fed’s largesse went to the banks, not to consumers. The banks loaned relatively little of the Fed’s monetary stimulus to consumers. Consumer price inflation didn’t start until consumer demand was kick-started by fiscal stimulus in 2020-2021 coupled with reduction of supply related to Covid-19 supply chain problems, Covid in China and Russia’s invasion of Ukraine.
The Fed is determined to reduce inflation by raising interest rates. They are not in control of the root causes of inflation – consumer demand and actual supply of goods and services. One of their models predicts an 80% chance of recession by the end of 2023. They plan to reduce consumer demand by removing money from consumer pockets, hopefully with a “softish” landing but actually with the harsh reality of recession where many people will lose jobs.
The asset markets at the start of 2022 resembled the 2000 dot-com bubble except the 2022 bubble included stocks, bonds, real estate, crypto and all kinds of new assets like NFTs. The economy, with inflation roaring, resembled the mid-1970s.
I expect that the Fed will raise rates until the stock market really begins to understand that the Fed isn’t playing around this time. High inflation is disastrous to working people. Controlling inflation is part of the Fed’s mandate.
The MSM is already starting to complain that “The Fed’s Newfound Aggressiveness Is Concerning” and, gee, maybe they should stop raising rates right now before a recession starts. As if the Fed doesn’t know that it will cause a recession.
The Fed is determined to be transparent. This year, so far, they have done exactly what they said they would do – raise the fed funds rate strongly to address inflation. (Fed Chairman Powell has done public confession that they were wrong in 2021 about inflation and should have started raising rates earlier.)
The Fed will definitely raise the fed funds rate up to and past 4Q2022 if inflation is still high. They will also allow their immense book of longer-maturity Treasury and mortgage bonds to roll off (Quantitative Tightening). This has already caused longer-term yields and mortgage rates to rise.
All the assets the Fed pumped way past the historic mean will now begin to revert to the mean.
Some stock market participants weren’t even born when the Fed started unusual, long-lasting monetary stimulus after the 2000 stock market bubble burst. (That stimulus led to the housing bubble and 2008 financial crisis.) Many market participants (including stock and cryptocurrency) only recently began investing due to fast, easy methods like Robinhood. They have never lived through a bear market, let alone a crash. It’s really pathetic how many young people and minorities “invested” their Covid stimulus money without understanding the risk.
In many past market routs, speculators who bought on margin were forced to sell good stocks when their losers received margin calls. Not surprisingly, margin debt reached an all-time high in January 2022 just as the stock market reached its all-time high. Since January 2022, margin debt has been falling but it is still high by historic standards.
At some point later this year, many speculators will realize that they are in serious trouble. Many will suffer revulsion and sell out in earnest. The market indexes will plunge. VIX will rise over 40. Financial Stress will rise above 0.5. If there is a crisis Financial Stress will spike above 5 but that has only happened twice since 1990 (2008 and 2020) so I don’t expect to see that later in 2022.
When that happens the stock indexes will fall and carry many solid companies along in the downdraft. That will be the signal for me that it will be safe to buy stocks.
As a conservative investor, I’m looking for stable, low beta, dividend-yielding stocks that are bond-like in nature. I’m not a speculator or looking for high capital gains. I would be just as happy if my stocks yielded reasonable and gradually-growing dividends and never increased in price faster than the inflation rate.
When the markets take their swan dive (probably in September or October after the Fed’s second fed funds raise from now) I will look at the CAPE chart. If it looks like the market is approaching historic averages, I will buy QQQE and shares in dividend stock funds from Vanguard and Fidelity. To get to that historic average the losses from the peak will be truly massive. There will be blood in Wall Street.
I hope that the Fed has learned its lesson to avoid excess monetary pumping. But I don’t really believe it has. When the next recession starts to bite worse than the Fed predicted (just like inflation turned out to be worse than the Fed predicted) the Fed will probably cave to pressure to cut the Fed funds rate again and maybe even re-start QE. Then the stock market will begin to perk up again.
But by that time I will have already bought my intended allocation. Which will be perhaps 20% of my financial assets.