Barring some kind of existential crash that knocks 50% off equities in a matter of days or weeks, the Federal Reserve’s not coming to rescue the bear market from itself. So, we’ve got lower to go.
The reason why centers around a phenomenon called the “wealth effect,” and the Fed knowing that what worked on the way up will work on the way down.
For those of you who’ve never heard of the wealth effect, the Fed explained it in a 2001 Board of Governors, Federal Reserve Economics Discussion Series (FEDS) paper. It said, “The movements in net worth and the saving rate are consistent with a direct view of the wealth effect (Note: their emphasis, not mine), in which an increase in wealth directly causes households to increase their consumption and decrease their saving.”
In other words, it’s a two-way street. The richer people feel, the more they spend. The poorer people feel, the less they spend. For years now, the Fed has been manipulating the elements of the economy under their control to enhance the wealth effect.
Now, they’re trying to do the opposite. And if you’re not paying attention, you could lose your shirt.
But I’m going to make it easy for you. It’s not actually that complicated, and knowing what’s really happening gives you an opportunity to make money.
Let’s dig in.
How We Got Here
In the aftermath of the financial crisis and Great Recession, to fight what the Fed declared was public enemy number one, deflation, it targeted a 2% inflation (emphasis mine this time) rate as its goal. It used the wealth effect to push that policy prescription.
By artificially manipulating interest rates to record lows by buying trillions of dollars of Treasuries and mortgage-backed securities (later known as quantitative easing) for years on end, the Fed pushed investors out of fixed income products, bonds, and savings that yielded nothing.
Simultaneously, that pushed them onto the risk curve – in other words, into the stock market.
There, they could hope for appreciation.
The more people that moved into stocks, the more markets rose, the more those markets made successive new highs, year after year, the more people piled into stocks, and so on.
As equities rose and headlines touted the rising stock market, and as people looked at their IRAs and 401Ks and investment accounts, the wealthier they felt, and in fact, were.
Even people with no stocks felt the rising stock market was a sign of solid economic growth and ramped up consumption. All that consumption charged economic growth for real.
That’s how the wealth effect is supposed to work, and in fact, how it did work.
Understand this: the Fed’s 2% inflation target was made up. It didn’t matter what inflation target the Fed set out to chase, because the financial crisis and Great Recession left huge holes to be filled which would naturally take years to fill.
We were never going to fall into a deflationary environment leading to a depression, as the Fed warned.
Housing speculation on leveraged steroids busted Wall Street and greedy banks who aided and abetted the bubble. When it burst, of course there was going to be widespread fallout because housing prices impact the whole economy, and so do failing banks.
But banks were shored up directly by the Fed, and then profited hand-over-fist thanks to quantitative easing. The economy was never headed for a depression or even deflation, it just needed a couple of years to return to normalcy.
But that didn’t happen. The Fed kept rates artificially too low for too long. Truth be told, they did it to flush up the country’s biggest banks, the Fed’s real constituents, with record profits.
Then the pandemic hit, and the Fed doubled down, buying another $4 trillion of “assets” to pump up the economy and stock market.
And that worked.
Until, that is, dormant but bubbling inflation exploded.
Now the Fed’s raising rates to combat out-of-control inflation.
But it’s not working.
Once again, the Fed’s targeting 2% inflation, but this time it has to come down from more than 8%, as opposed to up from zero inflation in 2008.
Raising rates, if they’re raised high enough for long enough, will eventually dampen demand, for sure.
But look at the current picture overall. The economy is still growing, unemployment is only at 3.6%, and we have a record strong labor market where there are two job openings for every person looking for a job, meaning employers will have to offer higher wages to attract workers. It’s going to take some time for higher rates to do what the Fed wants them to do.
In the meantime, there’s another transmission line available to the Fed to dampen demand: using the wealth effect in reverse.
Where We’re Going
Just as a rising stock market made people feel wealthier and promoted consumption, a falling market will make them more pessimistic and cause them to curtail consumption.
Watching your IRA or 401K shrink and reading headlines screaming about bear markets and crashing stocks is enough to make anyone think twice about discretionary spending.
And that’s fine with the Fed.
So, they’re not coming to rescue the stock market. They’re not going to say it, but they want to see the market fall further. And that’s what’s going to happen as long as they’re going to keep raising rates, which they’re going to do.
But don’t feel bad for the market or yourself. A down-trending market can be a money-making market, if you know how to play rising rates and what assets they’ll hit.
In my subscription services we’re making money, over and over again, betting on “zombie companies” going down and some going out of business. We’re making triple digit gains on rising volatility by trading the VIX. And we’re making money betting against bonds, and we’ll be making more money betting against emerging markets and some developed markets.
So, if you want to feel the wealth effect for real, do what we’re doing, and bank on the Fed not coming to the rescue.
— Shah Gilani
Source: Total Wealth