This 'Dip' Is Different
Editor's note: Investors are in no rush to get back into the market...
The broad market has been hampered this entire year due to global supply-chain disruptions, heightened geopolitical tensions, and high inflation. As a result, investors have been selling off stocks en masse to avoid today's rampant market volatility.
And with the Federal Reserve determined to continue raising interest rates – causing inflationary pressure to weigh on the markets – Income Intelligence editor Dr. David "Doc" Eifrig believes that this sell-off could drag on for a while...
In today's Masters Series, adapted from the June issue of Income Intelligence, Doc details why the market has been struggling this year... explains why the Fed's interest-rate hikes could prolong this downtrend... and reveals why investors will be reluctant to put their money to work moving forward...
This 'Dip' Is Different
For more than a dozen years, successful investing needed just three simple words...
Buy the dip.
Investors came out of the 2008 financial crisis convinced stocks would never go up again and petrified of a "double dip" recession that never came.
But the market kept rising...
Sometimes we'd see an economic slowdown, or the Federal Reserve would raise rates a bit. The market would fall... and the best move every time was to buy stocks with both hands.
Mr. Market's final lesson was the COVID-19 panic in 2020... Man, you'd better have bought that dip.
It took nearly a decade, but investors learned to buy the dip again and again.
As you know, markets are down again this year. The S&P 500 Index is down around 16% year to date. And in mid-June, it sank into the common definition of a bear market – a decline of 20%.
But this dip hasn't been like the others.
As the crash began, it looked like another buying opportunity. Great tech companies were on sale. Other stocks followed.
But they've kept falling. The drop stands out even on a long-term chart...
Investors who buy the dip today are overlooking a key change from the past few decades of market struggles...
Starting in the 1990s, if the market crashed, Fed Chairman Alan Greenspan would swoop in, cut rates, and turn stocks around. It was like having the protection of buying a put option... leading to the term "Greenspan put."
Then it was called the "Bernanke put."
By the time Janet Yellen and Jerome Powell came along, we were only hearing the phrase "Fed put." Why keep updating it for each chairman?
When the Fed is there to save you, buy the dip.
But the Federal Reserve has other priorities today...
Now, the Fed must fight inflation – and do so aggressively. That removes the put. It's as simple as that. The economy needs to cool enough to tame inflation before the Federal Reserve can even consider worrying about stock prices again.
In the long run, this will be healthy... We can proceed from the era of the "everything bubble" to a time when fundamentals and growth dictate the direction of asset prices.
But we have to get there from here. And that will take more time.
So what are we waiting for? A proper risk premium...
When we parse out the risk and return in stocks, it just looks like there is too much risk of this market falling further.
The "equity risk premium" is the way that academics often think about stock prices. The thinking is that since stocks (also known as equities) are riskier than Treasury bonds, stock investors will require a higher rate of return (the premium) to compensate for their risk.
When investors are bullish, they'll be happy to buy stocks even when there's just a bit more return than they'd get from safe government bonds.
But if they sense danger, they demand a higher risk premium. In other words, they'll only buy stocks once stocks are cheap enough to be worth the greater risk. This dynamic pushes down stock prices.
Now, you can't look up the equity risk premium as a simple number. It's something that you estimate with some assumptions.
The simplest way is to use forward earnings yield (the inverse of price-to-earnings ratio) and subtract the interest rate on a 10-year Treasury bond. That gets you around 2.7%. Here's how that looks historically...
Aswath Damodaran, a professor at New York University who focuses on valuation, publishes his estimated equity risk premium each month. He's always higher than the simple calculation we make. As of early September, his estimate is 5.45%. And here's how that looks since September 2008...
Next, here's our year-to-date calculation using daily data...
Why so many charts? We want to show that whichever method and time frame you check, you'll see that the risk premium is only starting to rise.
With the market falling, you'd think the perception of risk must be shooting higher. But we're not really seeing that yet.
Remember, the premium reflects expected return above bonds. So as 10-year interest rates are rising, that's pushing stocks down.
In other words, stocks are falling largely due to rising interest rates... not necessarily a move of fear based on economics.
None of the four charts we showed you indicates a particularly high risk premium today.
That leads us to two bearish conclusions...
First, interest rates will get a lot higher.
It's clear we're on an aggressive path to higher rates. And the "terminal rate" at which the Federal Reserve will finally stop hiking rates now looks like it will be about 3.5% to 4%.
Add in about 2% to get the federal-funds rate to the 10-year rate, and you've got 5.5% to 6% there.
If the equity risk premium remains at 2.7%, that would mean stocks falling another 25% to 30% from here.
There's even a second risk... The equity risk premium is not very high.
Look around you and think about the risks we face... inflation, supply-chain troubles, war in Ukraine, and COVID-19 lockdowns in China. Those are the solid facts. Then add the potential risks we face... a housing bubble, slowing earnings growth, and a full-on recession.
It's entirely possible that the equity risk premium needs to go higher if these are true threats – meaning that investors will demand a greater premium to compensate for the risk of buying stocks over Treasury bonds. And again, a higher premium means lower stock prices.
You could look at the historical charts and think the right premium is more like 3% or 3.5% or so. Paired with the 4% terminal rate, that premium would mean a 32% to 35% decline from here.
Now, this outlook on the equity risk premium is not a perfect predictor of the stock market. Nothing is. But a simple accounting of the numbers makes it look like there's more risk in the market than we're comfortable taking.
Put another way, there are reasons for this sell-off. It's not a market panic. It's a repricing of what we should consider paying for stocks.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Editor's note: With inflation remaining high, a massive sell-off taking place in the broad market, and the Federal Reserve still raising rates, investors can't decide whether to buy the dip or keep their money on the sidelines...
But regardless of all this turmoil, Doc has continued to deliver winning recommendations to his readers with his "stock-free strategy" – boasting a 94% accuracy rate over the past 12 years. And now, you can add this strategy to your toolkit. Get the full details here.