What's Happening to the Stock Market?
In general mainstream journalism outlets do a pretty decent job of delivering factual information. It’s a difficult thing to be a reporter. They have to be able to quickly learn a lot of stuff, sometimes about really complex issues that people like me get PhDs in, then try to explain this lot of stuff to people who haven’t learned a lot of stuff in a way that they can understand. This gets even more complicated when talking about issues like finance and economics.
Sometimes this process means things get oversimplified, and sometimes it means that a journalist has to rely on old information that may not necessarily apply to current conditions.
One result of this dynamic is that in the last few decades the New York Times and the Wall Street Journal seem to have successfully convinced a whole lot of Americans that the stock market and the economy are the same thing.
While it may have once been true that the performance of one company’s stock reflected the overall performance of that company, this isn’t the case any longer. You may remember I said something about Tesla stock relative to the companies making way more cars. Trading on speculation is now a career in and of itself. This might shock you (what’s the sarcasm font), but market sentiment is often not related1 to market returns; something not limited to only the stock market.
So, you may have read about a 1.4% drop in first quarter GDP, and the drop in the stock market since December. You may have read that this means investors are not confident in the economy going forward. You may have read that the stock market is going down because investors aren’t bullish on the outlook of the Federal Reserve raising interest rates.
Maybe this is how traders are actually feeling (they’re such a fickle group I’d never try to actually guess their thoughts), but there is an alternative explanation that accounts for the facts a little better. In the past, it has generally been true that a drop in the stock market like we have seen over the last few months is a reflection of a gloomy outlook from investors. But this present drop may also be a case of reporters recycling old understandings, when they don’t necessarily apply to current conditions.
For starters, the drop in GDP isn’t concerning to me or almost any other economist I have spoken to. GDP isn’t necessarily a great tool for analysis because the whole economy is too complex to really give you the whole picture in one number. GDP is really just how much stuff people do, plus how much stuff businesses do, plus how much stuff government does, plus (or minus) how much stuff we export (or import).
If we take the position that GDP always going up is a good thing (I’m not saying otherwise), then baked in to this equation is the assumption that government doing less stuff, and importing more stuff are both bad things. This isn’t necessarily true, which is why a drop in GDP isn’t necessarily always bad. This is why economists aren’t bothered by the recent 1.4% drop in GDP.
The GDP change from the first quarter shows steady growth in Personal Consumption Expenditures and Gross Private Domestic Investment, and a drop in Government Consumption Expenditures and Gross Investment and Net Exports of Goods and Services. So, stuff people do and stuff businesses do grew at a steady rate. But, we imported a lot more stuff—which led to net exports going down—and government didn’t do as much—this time last year there were Covid stimulus checks going out, and we saw a drop in military spending. Neither of these things necessarily means the economy is in trouble, particularly since people and businesses did more stuff.
So, back to that stock market drop. Since people and businesses are still doing more stuff, the economy likely isn’t the reason for the sell-off. It’s much more likely the Federal Reserve raising interest rates by .75% recently.
Now, I know just a few paragraphs ago I said it wasn’t the case that “the stock market is going down because investors aren’t bullish on the outlook of the Federal Reserve raising interest rates.” But there is another explanation besides a negative outlook.
Economists call it opportunity cost, but for this purpose I’ll just call it it the relative price.
I hope you’re enjoying this letter so far. You can subscribe to make sure to catch every edition of The Constituent. It’s completely free!
How to Run Monetary Policy
To understand what I mean by relative price we first have to understand what higher interest rates mean. For most people, their mind goes to mortgages. Instead of paying 3% on a 30-year fixed rate loan, you will have to pay 5%.
Side note: The relationship between the rate set by the Federal Reserve, and the rate you get from your mortgage lender aren’t necessarily perfectly related. So, a .75% increase in the Fed rate does not mean you will get a .75% increase in the mortgage rate. The actual increase could vary due to a lot of other stuff.
If you were an investment banker (God have mercy on your soul), your thought would be on the other side of mortgages. Now, instead of making 3% on a mortgage, you will make 5%. That’s a pretty sweet deal. But it’s not just on mortgages. The Federal Reserve will also start to cut down their bond buying program called Quantitative Easing (QE). QE is just the Fed deciding to buy bonds or securities to increase the supply of money in the economy.
If the Fed is running a program to buy bonds and securities, and everyone knows the Fed is running a program to buy bonds and securities, then the people selling bonds and securities are able to do so at a lower interest rate than the market would naturally allow. Why pay you 4% on a security if I know the Fed is eager to buy, and I only have to pay them 2.5%? So, you take the security and earn only 2.5%, or you take your money somewhere else.
The goal here is for the Fed to buy all these securities to set the market rate for lending lower, making borrowing money easier. If the Fed buys a Trillion, with a T, dollars of securities, then whoever sells them the securities now has an extra Trillion dollars to lend out. Because the supply of money is increased, the demand for it decreases—which in this case means these lenders can’t charge as much in interest on a mortgage or a business/capital loan.
So, now the Fed is both ending QE, and raising interest rates. The goal is to decrease the supply of money, which will increase the demand for it. That means people and businesses will have to pay higher interest rates to borrow. This makes borrowing, and therefore spending, less attractive because higher interest makes it cost more.
Some people (me, I’m some people) would have liked to see the Fed gradually begin to raise interest rates and taper off QE years ago. Like, starting some time between 2014 and 2017. If that had been the case the Fed could raise interest rates .25% per year—or even every two years—when we didn’t have supply chain issues. The idea is that a gradual change is less likely to create adverse impacts; and we would have had higher interest rates that we could have then lowered as a tool to protect against the pandemic recession.
But, the people at the Fed are way smarter than I am, so hopefully they know what they’re doing.
Having fun? Learning something new? If so, do me a favor and let your friends know about The Constituent.
Relative Price
Let’s get back to the stock market and relative price.
If you were a professional investor, like at a bank or a pension fund or a hedge fund of some kind, your job would be to grow your stack of cash. The more you grow your stack of cash the better you are at your job. Ideally this would mean you’d get paid more, but in reality a lot of investment bankers get paid by commission from selling certain products—even if those products grow your stack of cash less than another would. This is the basis for my view on investment bankers.
Side note: If you don't want this to happen when you invest your money, make sure whoever you give you money to is a fiduciary. It's a fancy term meaning they are legally obligated to do what is best for your money, not for their commission. It can't get rid of all the bad incentives, but it helps a lot.
Because of these easy money policies by the Fed, professional investors who want to grow their stacks of cash faster can’t do so by investing in the types of bonds and securities the Fed is buying. The Fed has lowered interest rates for these by increasing demand for them. Also, by setting rates so low, the ripple effects are that all other types of investments likely pay less in interest than they otherwise would.
The stock market is a place you can put your money that is an exception to this lower payout trend. This is the idea of relative price. Relative to other types of possible investments, each with their own balance of risks and yields, the stock market’s price becomes more rewarding. It’s a measure of value compared to your other options.
Ideally, when interest rates and QE are not being used so aggressively by the Fed, people growing stacks of cash diversify their investment portfolios. Some of the money they put into lower interest—but safer—investments; some of the money they put into higher interest—but riskier—investments. The stock market has traditionally been a somewhat higher interest and somewhat higher risk option. But, in the face of low interest rates and high QE the less risky options don’t grow money very fast. Every investment house will have (I mean, at least hopefully they’re not winging it) some fancy math to decide the balance of risk vs. interest. With low interest rates and high QE this fancy math likely pushes money toward the stock market. It’s not terribly risky, and the yields are high enough to meet fund growth targets.
But, if every investment house’s fancy math tells them to put more money in the stock market then the stock market becomes a much safer, and much higher paying, investment. The supply of money would grow, and the number of fancy maths telling people to buy more stocks would make stocks less risky.
Maybe this isn’t what happened, but here is some historical context for you.
If the picture is hard to read, click on it and play around with the graph. You know what you’ll find?
In the “Roaring 20s”, the 10 years leading up to the Great Depression the stock market index rose from $102.81 to $343.45. That’s an increase of 234%.
In the 90s, during the 10 years before the widely recognized .com bubble burst, the index grew from $2590.54 to $10,940.54. That’s an increase of 322%.
from the end of Great Recession to its peak in December the index grew from $8,447 to $36,338.30. That’s an increase of 330%.
Please note what I am not saying. I am not saying that because these other two periods of high growth led to a crash that our current stock market must crash. What I am saying is that the growth we have seen under the Fed’s low interest and QE is unprecedented, and if the Fed had not done these things the stock market would likely be lower—not crashed!
So, why might this monetary policy explain the drop in the last few months? Because if interest rates are rising in other areas when the Fed tightens its monetary policy, then everyone’s fancy math changes. It is now possible to earn higher interest rates with other types of investments than it was previously. This takes stocks back in the direction of the risk-return on investment (ROI) balance they used to be.
The way to understand this is a concept called expected value. This is the way to think about how much something “costs” an investor. If I can earn 10% on a fund, but have a 50% chance of losing my money, my expected value is 5%. If I can earn 6% on a fund, but only have a 10% chance of losing my money, my expected value is 5.4% So, the 10% fund actually costs me .4% relative to the 6% fund. This is the risk-ROI balance I’m talking about.
If the fancy math says a safe bond or security isn’t worth it at 2% return on investment, but is worth it at, say 4.5% then we are getting to a place where people’s fancy math want’s them to put a smaller percentage of their fund in the stock market. Same with risky investments. If it was possible to earn 10% per year over the last decade in the stock market, why invest in a riskier security that pays 11%? Now, with interest rates rising, that riskier security might pay 14%. Some firms’ fancy math might say that extra 4% is worth the extra risk. So, relative to other investments the stock market is now riskier than the safe investments because the safe investments are paying more in interest without the increased risk of the stock market. The stock market is now also more expensive than the risky investments because the risky investments pay more, and ROI is now high enough to justify the risk.
If this is what is happening then the fall in the stock market doesn’t actually reflect investors’ concerns about the future of the economy.
In reality, it’s probably a mix of both. The Fed tightening it’s monetary policy does carry some risk of hurting the economy. But, it also changes the fancy investment math and makes investments outside the stock market more attractive relative to the stock market. Some mix of both of these is the most likely explanation, but since the GDP drop had nothing to do with stuff people do, or stuff businesses do, I find it hard to believe economic concerns are really the bulk of the explanation.
Thanks for reading The Constituent. If you’d like to support the newsletter, here are a few options.
-Thanks,
Das, Prashant, Roland Füss, Benjamin Hanle, and Isabel Nina Russ. "The cross-over effect of irrational sentiments in housing, commercial property, and stock markets." Journal of Banking & Finance 114 (2020): 105799.