The chart below shows the magnitude of the current stock market sell-off before the recent bear market mini-rally: $7.6 trillion and counting. This is only a partial picture of global market losses suffered since the Federal Reserve shifted into tightening mode. Global equity and bond market capitalization declined by $23 trillion from their peak but still remain $17 trillion above trend according to Societe Generale, demonstrating the enormity of the asset bubble blown by central banks in recent years.

In order to destroy so much capital, you first must create it, which the Federal Reserve and other central banks did by conjuring trillions of dollars/yen/euros/yuan of debt out of thin air to keep the global economy afloat since the Great Financial Crisis. This effort went into overdrive in 2020 after governments shut down their economies to fight the pandemic.  But stock and bond market bubbles were well underway before policymakers poured even more fuel on the flames two years ago, igniting the fires of inflation that were burning under the surface for years.  In the United States, a significant portion of combined fiscal and monetary pandemic stimulus of ~$10 trillion found its way into financial markets, pushing the prices of risk assets to unsupportable heights.  Those assets could never sustain their valuations with their own internal resources (i.e. actual or potential earnings) so current downward price adjustments were inevitable.  And the timing of those adjustments was relatively easy to forecast – when the primary factors supporting those prices, monetary and fiscal stimulus, ended.  The question people should be asking of managers suffering losses in 2022 is why they failed to prepare for something that was obvious, knowable, and predictable.  After all, the Fed didn’t keep its plans a secret.  Readers of this publication were told precisely what would happen (and when) just as they were warned before the 2001-2 credit collapse and the Great Financial Crisis in 2008-9.  Those were not difficult forecasts to make and neither was this one.  All we had to do was look at the facts and ignore virtually everything said on Wall Street and in the financial media.

The question is what happens from here and what investors should do now.  The sell-off isn’t over though we will undoubtedly have bear market rallies on our way to the bottom.  Until the Fed is finished raising rates (and unless it fails miserably to do its job it is far from the end), markets are going to fall.  But not all parts of the market are created equal.  The most vulnerable stocks are infinite duration technology and pseudo-technology stocks (the latter are those of companies that apply technology to non-technological tasks) that have no earnings or reasonable prospects of earnings.  These stocks are not going to return to their previous valuations (or even close).  These are the stocks found in ARKK and similar portfolios.  Their valuations were always illusory and what was said about their prospects was almost exclusively nonsense.  Just because something is deemed “innovative” does not mean it is viable from a business standpoint or deserving of a high valuation.  If you still own these stocks (or ETFs or funds that own them), you should sell them before they lose all of their value.  Other parts of the market should be looked at differently.  With the S&P 500 trading at ~17x forward earnings (which are inflated by non-GAAP earnings and overoptimistic forecasts but that’s what everybody pays attention to), the overall market ex-technology is moving into the range of fair value but is still on the slightly expensive side. We could see this multiple fall as low as 14x by the time the Fed finishes raising rates (for it to fall lower than that, we would have to see a steep recession which the economic numbers don’t suggest for now). Long-term investors can start looking for companies with sustainable earnings trading below the overall market multiple or can simply wait for a better entry point when the smoke clears (which is what I would advise – one of the cardinal errors of many investors is their compulsion to be fully invested at all times and mandates that require them to do so are profoundly unwise). 

For now keep two things in mind.  First, don’t fight the Fed.  Second, investors who lose the least in a bear market do the best.  The Fed is tightening and we are in a bear market.  Don’t overcomplicate things and don’t try to outsmart the market. The market will always humble you. And the bear will always work to lure as many victims into the forest as it can because she is always looking for her next meal.

More detailed analysis is available for paid subscribers of The Credit Strategist.