The generally accepted definition of a bear market is a twenty percent drop in price from a previous high. Today’s ugly market action has pushed the precious S&P 500 beyond that threshold and into bear market territory. Historically, bear markets are part of the normal and healthy process markets go through over time. The chart below shows the fourteen bear markets the S&P 500 has endured since 1929. Every bear market up until October 2007 recovered through natural processes that enabled the beginning of a new healthy bull market.
The Fed to the Rescue
This all changed during the Great Financial Crisis of 2007-2009 when the US Federal Reserve acted to artificially stop the carnage by injecting liquidity (a nice way of saying printing money out of thin air) into the financial system through the use of their infinite checking account. Simple, problem solved. If it worked once, why not make it an unofficial policy for the Fed to step in and save the stock market each time it faltered thereby keeping the wealth effect going indefinitely? And that is exactly what has happened since 2007 thereby creating an unprecedented bull market in stocks, bonds, and real estate.
So now we have a new bear market and the Fed has not come to the rescue. Not only are they not rescuing the market by injecting liquidity and lowering interest rates, but they are also doing the exact opposite by selling assets from their balance sheet and raising interest rates. The party was so much fun and now they are taking away the punch bowl. What’s going on? Have they lost their mind? Why would they do such a thing?
An Impotent Fed
The reason the Fed is not acting as in the past is simple – inflation. This is the Fed’s kryptonite in terms of them not being able to step in to save the stock market. They can print all the money they want when inflation is tame but that certainly is not the case today. One of their two mandates is stable prices. So the Fed has painted itself into a corner with its reckless policies and made the exact environment that leaves them powerless. They will likely have to continue to raise rates well beyond what they have indicated to combat the very politically inconvenient inflation they created. No more “Fed put” for a mild correction like in the past. They will also not reverse their tightening policy as they did during the Taper Tantrum of 2018. They are stuck between high inflation on the one hand and the popping of several market bubbles (stock, bond, real estate) on the other. If they fight inflation they could pop the bubbles. If they choose to save the markets then inflation rages on.
So what will they do? They are likely to fight inflation at the expense of the markets in the short term and then step in at much lower prices to save the market when the screaming becomes too loud. They may ultimately fail to squash inflation and save the market. Financial markets are complex systems that cannot be controlled forever.
Like all of the past bear markets, this one will eventually resolve itself and create fantastic investment opportunities for those that can protect their capital from catastrophic losses. Good times will come to those that are educated and prepared.