As US stocks fall, a bear market is all but inevitable in 2022

Greed and fear are primal instincts, and greed has been red in tooth and claw in battling against fear during what amounts to the longest ever bull market in stocks. But fear, too, is powerful, and the smell of it is pervasive now as the rules of engagement change.

The great bull market on Wall Street and elsewhere roughly coincided with the adoption of quantitative easing by the US Fed and other central banks in the wake of the 2009 global financial crisis. The bull came roaring in with quantitative easing and is now about to exit, bloodied and bowed.

There has been little need for caution during the bull market. Investors could afford to jump off a cliff in taking risks knowing that the Fed’s parachute would slow their descent until a thermal updraft of monetary warm air or fiscal stimulus lofted them back up again.

The parachute, the updraft of air and even the safety net have gone now. This fact has not fully dawned and there are still many who are ready to make a suicidal leap into the dark. Faith in the “cult of the equity” will no longer guarantee them a safe landing, however.

There are plenty of rational reasons stock prices should finally resume contact with reality – but before coming to those, it’s worth thinking a little more about the role of greed and fear.

Markets are often said to “climb a wall of fear” on the way up, pausing now and then for breath until greed drives them upwards again. But when a fall begins, gravity takes over, panic sets in and a hard landing becomes inevitable.

That aside, what about the economic and financial underpinnings of stock prices now as they creak and crack like flimsy mineshaft supports while the ground shifts and a cave-in threatens? Or, as Merryn Somerset Webb puts it in the Financial Times, as “extreme market valuations” show stress.

As she points out, bubbles develop when investors “manage to convince themselves against all historical experience that it is possible for a high-profit and low-inflation environment [such as we have experienced in recent years] to be permanent. This always ends badly”. Quoting professor Russell Napier of Edinburgh Business School, Webb suggests that if investors assume corporate earnings will stay high and instead they fall, markets will experience a short, sharp correction. But if they get interest rates wrong, the result is a long, drawn-out bear market.

It’s already obvious that interest rates are beginning to shift out of zero or negative territory and into an upward cycle and that, for a variety of reasons, corporate earnings are set to decline in many sectors – not just for tech companies.

A screen displaying stock information in New York, US, on February 3 shows a shock price drop for Facebook’s parent company Meta. Photo: Bloomberg

Tobias Adrian, financial counsellor and director of the Monetary and Capital Markets Department at the International Monetary Fund and his colleague Nassira Abbas note in a recent blog that “a large and sudden jump in real interest rates could lead to a further sell-off in stocks”.

Such a jump is looking ominously likely now as the two or three rate hikes the Fed was expected to make this year are revised upwards by financial analysts to three or four or even more. The significance of this appears to have eluded those who continue to “buy the dip” in stocks.

As Adrian and Abbas observe, while monetary tightening has led to a sharp increase in nominal interest rates, markets look beyond nominal rates and base decisions on real or inflation-adjusted rates, which remain deeply negative in many regions supporting elevated prices for riskier assets. “Low real interest rates induce investors to take more risks,” they note, and that is precisely what many investors have been continuing to do, despite tighter monetary conditions and the resulting upward movements in rates.

But the sting in the tail is that further tightening may still be required to tame inflation and this puts asset prices at risk. “More and more investors could decide to sell risky assets as those would become less attractive,” they caution.

The “path of policy rates has important implications for financial markets and the economy. As a result of high inflation, real rates are historically low, despite the recent rebound in nominal interest rates,” Adrian and Abbas say.

“There is still a sharp difference between policymakers’ expectations of how high their benchmark rates will rise and where investors expect the tightening will end.” In other words, bond yields in the US and elsewhere are still behind the curve and as they catch up, equity prices will suffer.

Former US Treasury Secretary Lawrence Summers is urging the Fed to be more aggressive in fighting inflation even if this means the “very substantial increase in asset prices will crack”. The US “massively overstimulated” its economy in 2021 and needs to curb inflation expectations, he told a Global Counsel webinar on February 3.

Greed has been tamed but not entirely vanquished. Those who cannot (or will not) see what rising interest rates are signalling are blind to the dangers ahead. But as the smell of fear among more seasoned investors grows stronger, so too will the herd instinct to make for the door.

Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs