The Fed is in very tough spot here.
With inflation on the rise, it has to take action to get that under control. If inflation is unchecked, it will destroy the US dollar. That’s a very extreme situation, of course, as we’re a ways off from hyperinflation, but once you get trapped in a real inflationary spiral, there’s really no way to get out.
Unfortunately, the only remedy for inflation that the Fed has in its monetary “toolbox” is higher interest rates, which will hurt the economy overall and send stock markets careening lower.
Stock valuations are at extremely elevated levels right now. As measured by the Shiller P/E ratio, the only time stock prices have been more inflated was at the very top of the tech bubble in late 1999/early 2000:
That chart runs all the way back to 1870. The median Shiller P/E ratio over the past 150 years is 15.86, and we’re at 35.9 right now even after this recent correction.
If you look at the drop in valuations during the Financial Crisis of 2008, you can see that valuations were, at the market peak in 2007, quite elevated compared to historical norms–just a bit shy of the 1929 peak.
After the bear market of ’08, valuations dropped down to about 15, but that was still pretty high compared to everything that happened pre-Tech Bubble. Again, the median Shiller P/E since 1870 is 15.86, meaning after the crash of ’08 (an over 50% drop in all major US indices), stocks were still only at their historical long-term median valuation. They did not get down to the point where they were dirt-ass cheap, like they were in the early 1980s, the late 1940s and the early 1920s.
This was because the Fed took drastic action to arrest the collapse of the markets. Interest rates cut to zero, a trillion dollars printed out of thin air and injected into the economy–and rates stayed low, and the money printer stayed brrrr’ing.
The market was not allowed to naturally reach its “fair value.” It probably would have crashed even lower than it did had the Fed not stepped in. We may have seen another Great Depression-style crash of 80% or more.
And so once that happened in 2008, a new era in the stock market began, and it was unlike any before it.
I will let the inestimable Dr. Fly take it from here, A. because he has forgotten more about markets than I will ever know, and B. because he’s older than I am and actually knows what things were like pre-2008:
For those new to this game, it never used to be like this. Before the dot com bubble burst the Fed was more or less a passive thought in the big scheme of things, tweaking rates here or there but for the most part no one paid too much attention to them. The Fed was always important, but we didn’t rely upon them for our stock prices. Stocks were guided up and down by earnings and analyst upgrades/downgrades and mergers and rumors of takeovers. Today, because of the zero-rate environment, all we care about is what the Fed is going to do next.
The reason why we are so reliant upon them is because we died in 2008 and the Fed replaced the economy with a Frankenstein bastardized version of something that should never have been created. Gone are the days when you could receive 5% interest in your savings account, even higher for a CD. Now you get NOTHING and if you want to earn a rate of return you must invest in stocks or bonds. The Fed has created a monster and every time they try to put the genie back into the bottle, said genie gets irate and does malevolent things.
Today is a Fed Day and we all wonder what can the Fed do with CPI at 7% and stocks down 40% off their 52-week highs? I think the answer is obvious — they should not be in a position to do anything. But they will and they shall ignore their mandate in favor of saving stocks. My confidence in this isn’t high, only because it defies logic and reason. But we are talking about the Fed here, not an organization with integrity.
Futures are way up and I suspect if the Fed accommodates traders we shall continue to go way up. But if the Fed sticks to their guns and tells us they mean business — this entire rally might wash away.
In late 2008, with the stock market down over 50% and the economy in tatters, the Fed decided enough was enough: it was going to do any and everything it possibly could to turn the market around.
This had never been done before in US history, or anywhere else. The idea of Quantitative Easing (QE), meaning money printing, was hatched in 2001 by the Bank of Japan. The US was in recession in 2001–a brief, mild one–but opted not to try out the Japanese approach of QE. But in 2008, with a much more terrifying recession playing out, the Fed decided to try the Japanese Model. And it worked–at least if you define “worked” as stopped the markets from crashing even further.
However, at that point, the US stock market–and many others around the world that followed suit with QE and zero interest rate policies (ZIRP)–ceased to be a “free market” and became a manipulated market; a rigged market; a fake market, I guess you could say. That’s what Fly was referring to when he said that in 2008, the Fed replaced the economy with a “Frankenstein bastardized version of something that never should have been created.” The Fed was putting its thumb on the scale.
Now, looking forward from 2008, I’m sure this wasn’t always the plan the Fed had in mind–print exorbitant amounts of money to keep the stock market propped up for a decade-plus. But every time they turned off the spigot of cash, stocks would plummet.
This chart shows both the Fed Balance Sheet and the S&P 500 from 2009-2017, and you will see just how much the market has been propped up by the money printer:
The blue line shows the expansion of the Fed Balance sheet, the orange line shows the S&P 500 index. You can see all the way in the bottom left that as the Fed was unwinding its balance sheet slightly, the market was tanking. So the Fed switched the printer back on and left it on for a good while, and the markets took off.
But it switched the printer off in 2010, and as you can see markets sharply corrected. The printer went back on in late 2010, and the markets popped higher. But then the money printer was shut off again in the summer of 2011, and stocks were slammed. The Fed left the printer off for the rest of 2011 and most of 2012, and markets grinded higher a bit, climbing out of the hole they were in, but it was choppy trading.
But the Fed began QE3 in late 2012, and 2013 was a banner year for the stock market. 2014 was good as well. But then when the money printing stopped in late 2014, stocks stopped going up. There were some sharp corrections in 2015, and from about late 2014 to late 2016, markets really didn’t go anywhere. In late October of 2016, the S&P 500 was at the same level it was back in December 2014.
Finally, by the end of 2016, the market was able to go up without ZIRP and without and money being pumped into the economy by the Fed. This, I think, was in part because of Trump getting elected (seen as very pro-business as opposed to Obama) and part because finally after 8 long years the economy was back on its feet again after the Great Recession.
But as you can see from this next chart, as soon as the Fed began unwinding its enormous balance sheet (blue line), the market started panicking, undergoing two sharp corrections in 2018 alone:
The market skyrocketed in 2017 despite no money printing, but then as you see that blue line start to creep lower, the market gets really choppy. Between January 2018 and October 2019–almost 2 years–the market went nowhere and had some serious drops during that span. That’s because in addition to the Fed unwinding its assets, the Fed was also hiking interest rates.
In mid-2019, the Fed quietly began printing money once again, and as you can see, stocks took off. But shortly after, Covid-19 hit, sent the markets plummeting, and the Fed responded with a massive round of QE and money printing, which has been ongoing since March 2020 and will only wrap up this coming March.
It’s pretty obvious that when the money printer is on, the market is going up. And when the money printer is off, the market is in rough shape.
See what I mean about the market being manipulated? And what Fly means about a “Frankenstein economy”? You could know absolutely nothing about the stock market other than “when the blue line starts to go up, buy stocks, and when the blue line starts going down, sell stocks,” and you would have made a killing.
This has largely been enabled by rock-bottom interest rates and the Fed’s money printer. The stock market environment we’ve been in since the 2008 financial crisis has been very different from the prior 130+ years, because this one has been Fed-driven.
It was not like this prior to 2008.
The only thing even remotely close to the level of Fed support we see today is what was known as the “Greenspan Put,” named after former Fed Chairman Alan Greenspan who held the role from 1987-2006. Greenspan was known to cut interest rates anytime the market fell 20%, and as a result of investors believing Greenspan had their backs and would not let the market fall, they piled in, and the market went on a spectacular bull run from 1988-2000. Other than a 20% drop in 1990 and a 22% drop in 1998, it was basically straight up.
Of course, Greenspan wasn’t blasting the money printer back then, and interest rates during his tenure were well above zero. It was nothing like we have had these past 13 years.
Never before in history have we seen interest rates at 0% for this long. Never. The Bank of England did a study some time ago, and they were able to piece together interest rate data from historical sources going all the way back to the time of the Pharaohs of Old Egypt, and found that interest rates today are the lowest they’ve ever been:
Now, obviously there are some big gaps in the chart–it cuts from 3000BC to 300AD, and then cuts from 300AD to 1720, but at the very least, these are the lowest interest rates of the past 300 years. Quite remarkable times we’re living in. You can see that very, very briefly during the Great Depression around 1930, short-term interest rates touched 0%, but then were hiked up.
We had 0% interest rates from late 2008 to late 2015, by contrast. And then, when rates went up, they only went up to about 2.5% before being slashed down to zero once again in March 2020.
And when you couple this with the fact that the US Federal Reserve has printed more than $8 trillion since 2008, it becomes obvious that this is no ordinary market cycle we’ve been in the past 13 years or so.
This is the Dow Jones Industrial Average going back 100 years:
We can see that this is one of the longest bull runs in US history.
Every time it has wobbled, or taken a breather, or even fallen into chaos, the Fed was there to bail everybody out: 2010 with the printer, 2013 with the printer, 2019 with the printer, and now 2020-present with the printer.
And now they’re saying to the market: no more printer.
Not only that, but interest rates are going up in a hurry. And if that’s not enough, we’re going to quickly begin unwinding our balance sheet. We’re not going to wait 3 years to do it this time. They might not even wait 3 months to unwind.
It should be no surprise, then, that the market looks like this now:
Look at that: straight up since March 2020: from 2200 on the S&P to 4800 in less than 2 years.
The reason Fly said he believes the Fed will change course at the last minute and begin the old familiar policies of ZIRP and QE is because for the past 13 years, the Fed has done so every time the market started to look as if it were in trouble.
The Fed has never allowed the market to fall significantly since 2009. When the market started freaking out over the Fed’s interest rate hikes back in 2018 and the S&P 500 dropped 20%, the Fed immediately ceased hiking and began cutting rates–and then in 2019 started printing money once again to send the market back up.
The only time the market has done anything resembling “crashing” was when Covid hit and the S&P fell over 30% in less than a month, but as we know the Fed took drastic action and went balls-to-the-wall in an effort to rescue the stock market and the economy. On February 20, 2020, the day before the Covid Crash began, the S&P stood at 3390, an all-time high. Within about a month, it was at 2200, but due to the Fed’s intervention, the market would set a new all-time high–above where it was before the Covid Crash–in less than 6 months.
It would not be a surprise if the Fed backs down here, changes course and comes to the market’s rescue. It’s what the Fed has consistently done for the past 13 years.
However, at no point in the last 13 years has inflation ever been running as hot as it is now. The official figure is 7%, but if you measure CPI the way they used to back in the early 1980s, the inflation rate would be around 15%, meaning inflation is as bad now as it was back in the early 1980s.
Back then Fed Chair Paul Volcker jacked interest rates all the way up to 20% in an effort to bring inflation down. We are currently at 0% interest rates right now.
I’m not saying it would require 20% interest rates to get inflation under control today. I don’t think that’s the case, nor do I think the Fed would go anywhere near 20% interest rates. We would have to be undergoing massive, Venezuela-like inflation for the Fed to impose 20% interest rates.
But I also don’t think it would require anywhere near 20% interest rates to send this stock market into a massive tailspin. Again, the stock market is today about as richly valued as it has ever been in history.
At some point this bull run is going to have to end. The market can’t just keep going up indefinitely. At some point the Fed is going to have to allow the market to fall and find a real, true price point. And when that happens, it won’t just fall, it’ll crash. It’ll be one of the most spectacular crashes in history. The Fed has guaranteed that by spending the past 13 years never allowing the market to set prices organically and without manipulation.
The Fed could’ve prevented this a long time ago by simply stopping QE despite the market throwing a tantrum. They could have said, in like 2010 or 2011: that’s it. No more QE. Deal with it. The market would have been thrown into turmoil, but it would have eventually stabilized and found an equilibrium. But the Fed was never willing to do that. Simply too much at stake: both economically and politically.
And so here we are today.
People have been pointing this stuff out since 2009. None of what I’m saying here is new. People have known the stock market is manipulated and that prices are artificial since the Bernanke Fed unleashed ZIRP and QE for the first time back in 2008. People have been calling this a bubble and a fake market and predicting calamity for 13 years now.
The reason these doubters have been wrong about the market for 13 years is because the Fed has always stepped into provide the safety net for the market. The Fed hasn’t allowed the market to crash.
But all along, the skeptics have been saying that eventually, the Fed will become trapped and no longer able to rescue the market. Their argument for 13 years has been: when inflation starts running too hot, the Fed will have no choice but to let the market crash. In fact, the Fed will have to instigate the market crash by hiking rates and unwinding its balance sheet in order to fight inflation.
The skeptics–often referred to as “permabears”–have for 13 years been telling us this moment was coming, and now it appears it’s here.
The Fed has to stop inflation. It has to. It’s part of its mandate. The Fed’s job is to keep inflation under control. It cannot simply allow inflation to continue unchecked because it doesn’t want to wreck the stock market.
The “permabears” have been saying all along that the Fed would eventually have to choose between wrecking the stock market and allowing inflation to get out of control, and now that day is here.
Assuming the Fed does indeed go through with its plans and begin hiking and unwinding its balance sheet, the question then becomes not if the market will collapse, but how big of a market collapse will the Fed allow?
At what point will the Fed step in and save the day? In 2018, the Fed stepped in to save the market when it was down about 20%. But inflation back then was running at about 2.7% per official figures. Today it’s 7%.
In my view, the Fed cannot rescue the market until inflation is tamed and sitting in the 2-3% range. But who knows how long that will take?
And who knows how much the market will be down by that point? Will it be 25%? 40%? 50%? 60%?
Stock valuations are extravagantly high right now. When valuations are stretched like they are now, markets can fall fast and hard. Total freefall. The bigger they are, the harder they fall.
We could be looking at a situation like when the Nasdaq bubble popped back in 2000. Back then, the Nasdaq fell 41% in barely 2 months between March and May. It recovered slightly, but by April 2001, it was down 68%.
Are we looking at a situation like that? Based on valuations alone, the answer would be yes, but again, the Fed is way more prone to intervene and save the day now than it was back then.
But the Fed also has inflation to worry about, too. I just don’t know.
I’m sure the Fed wants to get inflation under control and then come to the rescue of the markets, but by that time, the market could be completely gripped by fear and relentless selling.
And the interest rates hikes may well send the economy into recession, which would exacerbate the selling in the market, to the point where the Fed’s actions would have little effect–like in 2008.
In 2008, the Fed actually began QE in September while markets were in complete freefall. Things stabilized a bit at -45% from 2007 highs, but even with QE and ZIRP, the markets would still fall another 23% by the time March 2009 rolled around.
I really have no idea what’s going to happen. The Fed may yet change course and come to the market’s rescue, but this time is different from all the other times the Fed stepped in because of the inflation.
And I haven’t even mentioned all the mechanical factors that would exacerbate any significant market crash. Hedge funds would blow up, traders would get margin-called, stop-losses would be triggered–there might even be banks that blow up and have to be bailed out. The housing market would crash as well. There are a lot of complicated factors that go into the movements of the markets.
To say that we haven’t yet seen the worst of this market selloff is to put it lightly: the S&P is only down 9.8% right now. Assuming the Fed goes ahead with its plans to tighten, things will get considerably worse.
I doubt the Fed would ever let the market fall the point where it bottoms out on its own and finds its own equilibrium–that could be 60% or more, maybe even 70% or more. During the Crash of 1929, when all was said and done, the market had fallen over 80% from its peak.
I don’t think the Fed would allow something like that to happen ever again. But who really knows? Nobody but the Fed.
The next few months are going to be interesting, to say the least.