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Markets Suffer the Worst Week In a Long Time - What Happened?

Editor, TRANSFIN
Jan 22, 2022 3:04 PM 5 min read
Editorial

The stock market may be a casino but it looks like the free drinks are coming to an end. 

Yesterday, all major US indices took a dive for the third consecutive week. The S&P 500 and the Nasdaq Composite Index faced their worst declines since March 2020 while the Dow Jones Industrial Average faced its worst since October 2020. 

London's FTSE dipped 0.69% and indices in Paris and Frankfurt dropped by 1.12% and 1.29% respectively in a single day. In India, the Sensex and Nifty took sizable hits too with investors losing almost ₹10Lcr ($134.5bn) in market cap within a span of four days. 

And if that wasn't enough, Bitcoin reached its lowest since July 2021 by diving below $39,000 (14% decline YTD) along with most other cryptocurrencies. With this, the global cryptocurrency market cap plummeted below the $2trn mark.

Suffice it to say that 2022 has started off as a challenging year for investors. Following the massive crash in the US bond market in the first week of the year itself, we are now witnessing a relatively large stock market correction. And even though nobody can predict these crashes, a growing number of signals and patterns seem to suggest that the decline in stocks is just beginning. 

What caused this relentless bloodbath? And what should investors expect going further into the year?

The Fed Has Made Its Bed… And We'll All Sleep On It

After throwing a much-needed lifeline in the form of rate cuts, stimuli and quantitative easing to resuscitate the economy from pandemic lows in 2020, the US Federal Reserve finally threw in the towel by announcing planned and multiple rate hikes in 2022. 

This has depressed investors who had been piggybacking off of the Fed's discounts and the bullish market rallies that lasted during most of 2021. The reality of living in a world where the Fed is likely incapable of supplying further liquidity into the markets has become a prospect too unsettling for them.

And then there is inflation. Soaring prices of goods and commodities is a dynamic phenomenon that comes and goes. But what's different this time around is that there are forces beyond the central bank's printing press which are driving inflation. 

Last year, most of the price rises resulted from pandemic-related disruptions (aka supply chain crises). This is the type of non-monetary inflation that results from administrative inefficiencies, political considerations and most importantly, recurring COVID waves which seem to have synced with seasonal changes in the Northern Hemisphere at this point. In short, as long as bottlenecks in supply chains exist, so will inflation and so will the Fed's compulsion to skim liquidity from the markets through taper.

 

Just Like the Dot-Com Bubble?

Another aspect of the current stock market aberration lies in the sudden rout in technology stocks. Any protracted selloffs in tech have come to reverberate across the broader equity market easily given the weight tech stocks have on major indices now, as opposed to a decade ago. 

Basically, the frothiness in the tech sector has been compared by experts to the dotcom bubble of the 1990s. Some also predict that it could hit at least 50% of the market if this bubble pops. 

That is a startling assertion, if true. But is it likely to happen that easily? Let's see. 

So, when the Fed hikes rates, borrowing cost increases and consumer spending decreases. You and I are buying less which means companies are selling less which affects their revenues. Now, tech companies are more sensitive to this trend because their valuations are driven more by top-line growth rather than cash generation. Which is why even the "talk of a taper" (before actual taper begins) sends them on a downward spiral. 

So yes, if interest rates hike, tech stocks go down. Bubble. Pop. 

Especially when there are multiple hikes imminent (three to four, expectedly).

 

The Crypto Crash Machine

What began in the first week of the year intensified yesterday in a more vicious pullback from the crypto market. January 21st turned out to be the brand new "Black Friday" with the Bitcoin market witnessing one of the highest-ever single-day liquidations (topping $880m).

This is what happened. Russia, one of the world's largest economies, proposed banning the activity of cryptocurrency mining in the country. It became the second major country to do so following China. So, not a totally unprecedented market reaction given that this is similar to what happened in May 2021 when the People's Bank of China proposed the same ban. 

Next contributor was the dip in Wall Street. The S&P 500 lost as much as 4% in a span of 72 hours. And given Bitcoin and the S&P 500 have come to correlate to a degree as high as 0.59, a dip in one was bound to affect the other. The rising macro-level trend in "risk-off" moves by the market is also hitting crypto hard lately (what does this mean?).

 

The Greenback Boogie Break-off

There is only so long that the extend and pretend exercise of near-zero interest rates and money-minting can go before causing damage. The Fed's balance sheet is approaching an astounding high of $9trn. The Buffett Indicator is at 211% which basically signals that stocks are too expensive and a crash is imminent. (What is the Buffett Indicator?)

There is also another discrepancy that seems to have surfaced, this time in the bond market. A comparison of the 20-year Treasury bond interest rates vs. CPI Inflation rates in the US shows that long-term US bonds are completely mispriced at the moment and are gradually entering bearish territory. 

This is a disconnect that won't be solved even if the pandemic resolves itself overnight or supply chain issues disappear quickly in 2022. The only way to combat this and the stubbornly-high inflation (and stave off the consequent currency crisis) is to hike and hike interest rates for the foreseeable future. 

In late 2008, Queen Elizabeth II asked a room full of academics in the London School of Economics as to why no one seemed to have anticipated the world's worst economic crisis in the post-war period. Perhaps, many economists and analysts of today are repeating the same by being too sanguine about the market bubbles of today. 

Despite moonshot stocks coming back to Earth, pandemic bets like SPACs dropping sharply and cash-burning tech firms staring peril in the face, the MicroStrategys, Nayib Bukeles and Jim Cramers of the world continue to remain unfazed. Perhaps the market's correction could bring a silver lining that we all need - showing that the valuation calculus on entities that don't turn profits is finally running out!

FIN.
 

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