Thursday, June 16, 2022

The S&P 500 closed down every single trading day from June 7th through yesterday, and during that time it shed a total of 436.20 points. Yesterday, however, the same day the Federal Reserve raised interest rates by ¾ of a percent (the largest move it has made since 1994), the S&P closed up 54.41 points (or 1.46%). What gives? Isn’t the stock market supposed to go down when interest rates go up?

As interest rates rise, the cost of borrowing goes up. So, it becomes costlier to borrow money. This is true for companies (even the most stable companies commonly borrow money in the course of their normal operations), and also true for consumers.

A company that must pay more interest to borrow money is not going to be as profitable as it would be if it paid less in interest. Consumers that have to pay higher interest on their credit cards are more likely to start spending less. When consumers spend less, companies sell less. And when companies sell less, they usually are not as profitable.

If you want to understand this stuff, really understand it, watch How The Economic Machine Works by Ray Dalio. It will take you 30 minutes. You’re welcome.

So what gives? Why did the stock market go up yesterday even though interest rates rose? It’s simply that the news about the Fed’s interest rate hike was already priced into the market. What does that mean? It refers to a well known (if you studied finance, that is) investment theory, widely known as the efficient market hypothesis (“EMH”).

EMH originated largely from research by Eugene Fama’s. Fama, a Nobel laureate in economic sciences, a professor at the University of Chicago Booth School of Business, and widely recognized as the "father of modern finance," wrote a book that was published in 1970. That book is “Efficient Capital Markets: A Review of Theory and Empirical Work.”

Fama put forth the basic idea that it is virtually impossible to consistently ‘beat the market.’ That is, to achieve better returns by investing in individual stocks than one would earn by investing in the overall stock market (as reflected by major stock indexes such as the S&P 500).

If you don’t know of Fama, you may know of Burton Malkiel. He is also an academic (he is a professor of economics at Princeton University and is a leading proponent of EMH but unlike Fama, his most classic book, A Random Walk Down Wall Street, has been read by millions of people (and is also one of Financial Poise’s list of 15 best books for beginning investors).

Yesterday's rate hike was predictable given that the latest Consumer Price Index was released last Friday and it showed that that inflation soared in May. As noted above, the markets have been down since then. According to EMH, the reason the market did not go down yesterday is that although the Fed's announcement was yesterday, the news of the announcement was already priced into the market. In yesterday's case, however, another force was also at play: the market essentially reacted well to the the Fed's proactive response to inflation and the clear guidance it provided as to its policy intentions.

Generally considered one of the main barometers of the overall stock market, the S&P 500 is simply a stock market index that tracks the performance of 500 large companies listed on stock exchanges in the United States. It was created in 1957, and was the first U.S. market-cap-weighted index (so that more valuable companies account for relatively more weight in the index).

The Federal Reserve System (“Fed”) is the central bank of the United States. It performs five general functions to promote the effective operation of the U.S. economy and, more generally, the public interest. The Fed:

1. Conducts the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy.

2. Promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad.

3. Promotes the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole.

4. Fosters payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitate U.S.-dollar transactions and payments.

5. Promotes consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and the administration of consumer laws and regulations.

This description is borrowed directly from the Fed’s website. There are large number of critics of the Fed (such as FreedomWorks) that argue, among other things, that the Fed:

• has too much power of the U.S. economy;

• is run by unelected and unaccountable bureaucrats;

• has significantly devalued the U.S. dollar; and

• benefits the privileged and hurts the poor and middle class

Anyway, what happened yesterday is this: The Fed increased the Discount Rate (also referred to as the Fed's "Policy Interest Rate"). The Discount Rate is the interest rate that Federal Reserve Banks charge when they make collateralized loans—usually overnight—to depository institutions. That increase has a snowball effect. For example, it directly impacts the Federal Funds Rate, which is the interest rate that depository institutions—banks, savings and loans, and credit unions—charge each other for overnight loans. There’s a lot more to the story, but the bottom line is that increasing interest rates is designed to fight inflation.

A bear market is one in which market indices (such as the S&P 500) have declined at least 20% over a two-month period or longer. Since 1932, bear markets have occurred every 56 months on average (we borrow this explanation from John Drachman’s article, Alternative Asset Investments May Help When Stocks Decline).

First, do not sell stock in a panic.

Second, the wise, patient, and informed investor could use the downturn to purchase shares in companies that they viewed as good investments before the downturn, but for less than they would have had to pay before. Just as you should not sell in a panic, however, you should neither buy in a frenzy. Trying to time the market usually does not work out well. Watch this video to understand why.

Third, as Drachman explains in his article, having an investment portfolio that is diversified on an asset-class basis is critical to help cushion your portfolio against stock market volatility. Many people do not appreciate the distinction diversifying within an asset class (and example of which is investing in a number of stocks that are not likely to go up or down in value at the same time) and diversifying among asset classes (which is important because when the stock market goes down generally, most stocks will go down to some extent). If you do not understand the distinction perfectly, then we urge you to read Investing Basics for Beginners Installment #3: Never Put All Your Eggs in One Basket.

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