The Silver Lining of Market Corrections: Opportunity or Threat?

“That Depends . . .”

In a nutshell, how one deals with market corrections can be highly individualized.

The idea that there will never be another major market correction ignores the lessons learned from historical events like the 2008 housing crisis. During the mid-2000s, there was widespread belief that housing prices could only go up, fueling risky lending and investment practices. The eventual burst of the housing bubble served as a harsh reminder that markets can and do correct, and often in dramatic fashion. Assumptions of ever-rising asset prices led to risky behavior, such as subprime lending and excessive leveraging, which eventually resulted in a significant market correction and triggered a global financial crisis.

Another angle to consider is the role of complex financial instruments, like mortgage-backed securities in the case of 2008. These instruments contributed to systemic risks that were not fully understood until it was too late. A belief in never-ending growth or market stability can encourage the development and proliferation of such financial products that may seem safe during good times but can be catastrophic in a downturn. Overconfidence in market stability can blind investors and regulators to these kinds of systemic risks.

Markets are influenced by a complex interplay of factors, including economic indicators, investor sentiment, and global events.

Even if some parameters suggest stability or growth, others can quickly lead to a downturn.

In 2008, issues in the U.S. housing market had a ripple effect across various other sectors and even countries, proving that no market operates in a vacuum.

The belief in an eternal bull market disregards this complexity and interconnectedness, leaving investors unprepared for the inevitable downturns that history shows us are a natural part of economic cycles.

The Fed Giveth, and The Fed Taketh Away

Certain things that are happening in this environment of inflation defy accepted conventional wisdom, such as the idea that equities are a good way to protect against inflation. It turns out that since QE began in 2008, all previous wisdom has had to be disregarded, and the new wisdom is focused on QE and QT: regardless of what happens with inflation and the real economy, QE drives stock prices up and QT drives them lower.

The S&P 500 index ended the week at 4,117, down 14.6% from its January 3, 2022 peak and back to its April 9, 2021 starting point.

Put another way, after around 2.5 years, nothing has changed despite all these gyrations. And the massive surge, which was fueled by the Federal Reserve's $400 billion in bank-panic relief measures, petered out at the start of August and has been plunging downhill ever since.

The Russell 2000 index, which measures small-cap firms that frequently outpace large-cap stocks, closed at 1,637 on Friday, a three-year low. Since its peak on November 8, 2021, the index has dropped 33.4%, returning to its October 9, 2020 level. It is becoming increasingly inquisitive.

The largest stocks in the index saw enormous price spikes due to the Fed's $400 billion liquidity injection, causing the smaller stocks to be largely overlooked. These giants, known as the Magnificent 7, carried the majority of the market until they too began to decline.

Around the same time frame, the Fed used massive quantitative easing (QE) to drive the stock market's rise until the end of 2021, when it started to taper QE. Early in 2022, QE came to a conclusion, while QT began in July of the same year. Its balance sheet is now at its lowest point since May 2021, having decreased by $1.06 trillion since then to $7.91 trillion.

When QE was pushing up stock prices, everyone who invested in stocks thought they were brilliant, and they came up with all kinds of explanations as to why the market was rising, when in reality, the Fed's QE was the only thing driving up stock prices.

Then something major went wrong, affecting price stability, the main responsibility of the Fed.

The greatest consumer price inflation in forty years hit, and even the Federal Reserve, which had been in denial about the problem for far too long, had to admit it. It responded by hiking policy rates sharply, from 0.25% to 5.5%, and by adding $1.06 trillion in QT to the balance. -WolfStreet

As a result, expectations of an abrupt Fed turn, which have been raised since June 2022, have essentially faded.

Rates and inflation are rising for an extended period, QT is operating automatically in the background, and for the first time in a long time, stocks are on their own after being supported by the Fed since 2008—a situation that isn't working out well for them.