Opinion: The painful market sell-off should be over soon

Despite investor gloom, the worst of the bear market is near. Of course, stock prices are sure to go up and down in the coming days and weeks. And while they won’t be roaring back anytime soon, the downward pressure in prices is almost over.

Looking ahead to the next five years – the shortest horizon wise for stocks given their volatility and therefore risk – an annual stock return in the middle single digits seems likely. Of course, these aren’t the double-digit returns of the two decades since the dotcom bubble burst, but they’re solid returns nonetheless.

My optimism reflects the view that equity investors have taken on a grim reality: To fight high inflation, the Federal Reserve will have to raise interest rates aggressively in the coming months. Fed officials have made it clear that they plan to double the Federal Funds rate, the rate they directly control, early next year. If they continue as investors commonly expect, fund yields will eventually be at their all-time high since the financial crisis that happened over a decade ago.

Much of the fall in stock prices this year is due to investors anticipating higher interest rates. Higher interest rates lower the present value of future corporate profits, from which stocks ultimately derive their value. In other words, higher rates mean that the profits companies are expected to earn in the future are worth less today – and so stock prices fall.

This helps explain why previously high-flying technology stocks, such as Meta and Amazon, have suffered the biggest gains in this bear market. The stock prices of stratospheric technology companies reflected high expectations that those companies would make big money in the future. They can still make a lot of money, but higher rates mean those profits earned long into the future are less valuable.
Equity investors are rightly concerned about the outlook for the economy and what that means for corporate earnings. Investors seem almost certain of a recession, as current price declines line up with the median peak-to-depth decline in stock prices around every recession since World War II. And a growing list of investment firms on Wall Street is warning of an impending economic downturn.

The good news is that stock investors have completely bought into all this bad news about interest rates and the outlook for the economy. That sounds strange, but to put it another way, the current low stock prices fully reflect all that has gone wrong. If the Fed can just raise interest rates as expected, and the economy can avoid an outright downturn, equity investors will stop selling and the bear market will end.

This is undoubtedly a big ‘if’, largely dependent on inflation steadily declining from its June high in 40 years. But it should. Oil and petrol prices are falling rapidly as the worst effects of the Russian invasion of Ukraine appear to be behind us. Meanwhile, the pandemic continues to fade, allowing global supply chains to smooth themselves out, which will reduce shortages for everything from wood to vehicles. Potential workers sidelined by the virus are also slowly returning to work, reducing rising labor costs.
Most encouragingly, inflation expectations — what consumers, businesses and investors think inflation will be in the future — have declined significantly since the jump in the wake of the Russian invasion. Connect this to the Fed’s aggressive actions. Expectations tend to be self-fulfilling, and with inflation expectations back towards the Fed’s target of 2%, it’s a good bet that actual inflation will soon move in the same direction.

While there are good reasons to be optimistic about the end of the bear market, stock prices are unlikely to rise significantly until it is clear that the Fed is done raising interest rates. There is no need to get in and buy shares now.

But it’s also important to remember that timing ups and downs in the stock market is a daring and ultimately losing game. Most of us should ignore the volatility of the market. Do not look. Invest for the long term. The US economy and businesses, as always, will prevail. It may take a while, but stock prices will rise again.

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