The NASDAQ Composite Index is in a bear market, with the S&P 500 and the Dow Jones not far behind. We are on the edge of a bear market, the second one in about two years.
In 2020, we had the Federal Reserve System intervening to stop the bloodshed. Unfortunately, this time, the Fed is causing bloodshed.
Since the end of the recession in June 2009, the S&P 500 has been correlated with the Fed's balance sheet. Now that the Fed has finally decided to tighten the balance sheet, the market is worried about it. I don't think that the Fed is going to sell all the $9 trillion in assets all at once, it is going to take them a few years (if they ever decide to sell everything), but still, the Fed moving from the biggest buyer in the market to the biggest seller will have consequences.
The main reason the Fed has to tighten the balance sheet so fast and raise interest rates is because of inflation.
With the unemployment rate also falling, the Fed is lagging behind inflation, and they have no other choice than to raise interest rates rapidly. With a rapid increase in interest rates coupled with the tightening of its balance sheet, the Fed could send the US into a recession. The stock market, usually a leading indicator, is already reacting.
Recently the 10 Y - 2 Y Treasury spread has become negative. In other words, that part of the yield curve has inverted. In this scenario, the Fed is supposed to be cutting rates as it has done in the last 5 cases from 1980, but this time, because of inflation, the Fed cannot afford to cut rates and is instead raising it.
High inflation and rising interest rates are already putting pressure on sectors of the economy, for instance, mortgages. US mortgage origination is falling.
Nobody can predict if we will see a recession and when we will see it, but this is undoubtedly putting strain on the stock market.
Higher interest rates mean that bond and stock yields are rising. With earnings not increasing, the only way stock yields to rise is if stock prices fall. Soon, bonds might become better investments than stocks as they provide fewer risks.
What does all of this mean for stocks?
As I've talked about in a recent video, we cannot predict what will happen to the economy and the market, and we should focus on owning businesses.
If you own a good business with real earnings, you should not be worried about the stock price because, over the long term, you can be sure that it will go up.
Let's look at two examples in the same sector, Netflix and WarnerBros Discovery.
Both are down by more than 75% from an all-time high. But the main difference between the two businesses is that WarnerBros Discovery has positive cash flow and is currently trading at around X4 free cash flow, while Netflix has negative cash flow.
Why should you be worried about the price of WarnerBros Discovery if you own it? The business will keep doing well. They can use this cash flow to return cash to shareholders or reinvest in the business. Netflix, on the other hand, has fewer options in front of it.
Over the long term, value investing always wins.
Berkshire Hathaway is now beating ARK Innovation ETF since the latter has been incepted.
I know that it can be hard to see your portfolio crashing but investing is not an easy game. It is easier to win a gold medal in the Olympics than to beat the market over a 20-year period. Many can make money in a bull market, but in a 20-year period, one is bound to face at least two bear markets. That's when we know who can actually play and win at this game. To be in this game, one needs to have an insane psychological buildup. Very few have it. That’s why very few make it.
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