Why Is the Stock Market Crashing? - AlwaysWealthy

Why Is the Stock Market Crashing?

Markets are tumbling across the board. Stocks, commodities, gold, bitcoin and other assets are all tanking. The S&P 500 had its worst-performing beginning of the year since 1939. We are officially in a bear market. But how far will stocks fall? Why is the stock market crashing? And how can you survive this bear market? Let me break down what is happening and how to stay calm.

Table of Contents

Recency Bias in Investing

Last year was one of the best-performing years for stocks and bitcoin. The S&P was up over 26% and the technology-focused NASDAQ rose over 20%. Bitcoin climbed to a new all-time high.

Thanks to the popularity of apps like Robinhood, many new retail investors joined the space. A lot of new first-time investors bought stocks, options and cryptocurrencies. Everyone experienced FOMO. The market got greedy. And as with most booms, people thought the market would go up forever.

The famous meme “Stonks Only Go Up” shows retail investors’ sentiment during the recent bull market.

But if stonks only go up, why is the stock market crashing? Let’s take a closer look at what cased the recent bear market.

How the Federal Reserve Moves the Stock Market

Most seasoned investors and institutions understand that the Federal Reserve moves the market through its monetary policy. Markets aren’t “free” anymore. They are heavily influenced by the Federal Reserve.

The Federal Reserve conducts monetary policy by setting the federal funds rate and since 2008 through something called quantitative easing.

In March 2020, when the Covid-19 pandemic caused a great deal of uncertainty, the Federal Reserve stepped in by lowering interest rates to zero and starting its largest quantitative easing program in history.

Why is the stock market crashing? Chart of the QQQ ETF tanking heavily in 2022 provided by TradingView

This resulted in a swift V-shaped recovery. Markets crashed in March but rebounded by summer. And from then on, stocks and bitcoin went on an epic rally throughout the end of 2020 and most of 2021.

Anyone who bought the S&P 500, NASDAQ or bitcoin end of 2020 made a killing in the next few months. This wasn’t because the fundamentals of these companies, or even of bitcoin, changed that much.

It was mainly due to two factors:

1) Lots of cheap money entered the market
2) Investors took the Fed’s loose monetary policy as a “green light” to pile into stocks

Understanding the Federal Reserve’s Loose Monetary Policy

The first factor is monetary. By lowering the federal funds rate, individuals and companies could borrow money cheaply. Lowering interest rates is the equivalent of flooding the economy with money.

The Fed’s unprecedented quantitative easing program resulted in the purchase of $120 billion worth of government bonds, mortgage-backed securities and even corporate bonds per month.

The government then took that money and spent it as part of its fiscal policy. Specifically, a good chunk of the newly created money ended up in consumers’ bank accounts in the form of stimulus checks.

This money, apparently a lot of it, found its way into assets like stocks, real estate and cryptocurrencies. With all this new money entering the market, this bid up the price of assets.

This phenomenon is called asset price inflation. It means that asset prices didn’t increase because of fundamentals but because of an increase in the money supply.

How Psychological Factors Drive the Stock Market

The second factor, namely the fact that investors took the Fed’s loose monetary policy as “green light”, is psychological. The smart money knows that stocks tend to rally when the Fed is dovish.

Even before any money created by lowering the federal funds rate and quantitative easing found its way into the market, smart investors front-ran the Federal Reserve’s monetary policy.

In other words, investors bought stocks, bitcoin and other assets expecting they would rise. A big part of stock market investing today consists on waiting for each FOMC meeting and “reading the lips” of Jerome Powell.

As I mentioned earlier, markets are heavily influenced by the Federal Reserve. One could even make the point that markets are manipulated and centrally planned.

It’s not fundamentals and regular supply and demand that are causing higher asset prices. It’s the increased money supply and the psychological effect of anticipating this increase of money.

Average retail investors aren’t necessarily aware of this. They simply see asset prices rallying, believe it’s an opportunity to make money and pile into these assets expecting them to continue rising because “stonks only go up”.

But why is the stock market crashing now?

The Government and Federal Reserve Are Under Pressure

After engaging in unprecedented levels of quantitative easing, many would expect that this caused inflation. After all, inflation was clearly visible in assets.

But not mainstream economists. Most economists, including Steve Hanke, were taken by surprise when consumer price inflation rose to 8%.

Despite this, even to this day, many attribute the high inflation levels to supply chain disruptions and the war between Russia and Ukraine. Whether loose monetary policy causes inflation or not is not the point of this article. But the fact is, end of 2021, the Federal Reserve faced inflation levels not seen this high since 1980.

This put immense pressure on the government and the Fed to get inflation under control. As a result, the Fed announced it would begin tapering its asset purchases and conduct several interest rate hikes.

The Fed also mentioned it would begin quantitative tightening, which means it will remove assets from its balance sheet.

On a side note: If inflation is caused by supply chains and Putin, targeting inflation through monetary policy seems pointless? Surely if inflation can be reversed by slowing the expansion of the money supply or even contracting the money supply, one must assume that inflation can be caused by doing the opposite, namely speeding up the rate at which new money is created and expanding the money supply.

Why Is the Stock Market Crashing?

As soon as the Fed began tapering its asset purchases and showed that it was serious about raising interest rates and shrinking its balance sheet, markets became fearful.

But why is the stock market crashing now instead of a year ago?

As the Fed continued with its hawkish policy, and investors realized the Fed wasn’t just bluffing, a sharp sell off in stocks and bitcoin began.

Once again, the reason for this fall in asset prices is twofold. On the one hand, the Fed is walking its talk and reversing the asset price inflation it caused earlier by slowing down the rate at which new money is created and even contracting the money supply.

On the other hand, the psychological effect of the Fed staying firm and consistent with its hawkish policy was enough to spook investors and get them to pull out of the market.

The Vicious Circle that Keeps the Stock Market Crashing

As the selloff began, the psychological effect spiraled out of control and turned into a vicious circle. Less experienced investors saw that the market was selling off and panicked as well. This led to a further drop in stock prices.

The more markets fall, the more investors get spooked. Again, little of this has to do with fundamentals. This is a chain reaction to monetary policy and its psychological effects. It goes without saying, however, that many stocks and cryptocurrencies were wildly overvalued by the summer of 2021.

In some sense, now that asset price inflation is reversed, this reveals the true value of assets. Or in the words of Warren Buffet: “Only when the tide goes out do you discover who’s been swimming naked.”

In this case, anyone who made investment decisions based on the Fed alone and not on fundamentals, has been swimming naked.

This includes people who bought Dogecoin, meme stocks and other investments with weak or questionable fundamentals, expecting to make a quick buck. However, many of these assets only rallied due to the speculative mania surrounding the Fed-induced cheap-money boom.

When the Fed turns off the money faucet, the speculative mania stops and assets get destroyed. Assets with weak fundamentals get hit first and hardest.

But what happens if the stock market keeps crashing without an end in sight?

The Risks of a Deflationary Depression

Since the Fed began tapering, rising interest rates and shrinking its balance sheet, markets have been in free fall. Usually, there are some safe haven assets like gold and certain commodities that do well during these times.

But in the last week, almost all assets were down, including gold, bitcoin and the stock market. At the same time, the US dollar has been strengthening.

If asset prices fall too much, this can put pressure on companies and on the economy as a whole. Many companies are over-leveraged, meaning they have large amounts of debt.

If interest rates increase too much, or if a company gets hit severely due to their stock price being crushed, this can lead to companies facing insolvency.

This is generally not a problem, and none of the Fed’s responsibility. It’s not the Fed’s job to save investors, or even prevent individual insolvencies. Its dual mandate is to keep inflation in check and aim for full employment.

But if a “Too Big To Fail” company or GSE (Government Sponsored Enterprise), gets hit too hard by the Fed’s aggressive reversal of monetary policy, this can lead to a systemically important company facing bankruptcy. These companies are called “Too Big To Fail” for a reason. It’s because they act as the first domino stone.

What Happens If the Stock Market Crashes Too Severely?

If certain domino stones are tipped over in the economy, this leads to many others falling. We’re talking about a chain reaction that leads to many companies failing, trust in the economy being shattered and lending, investing and spending coming to a standstill.

This would have a similar effect as what happened after the stock market crash of 1929. Back then, a deflationary depression set in, which lasted around ten years. It was dubbed the Great Depression.

In response to the Great Depression, the Fed literally changed its outlook on how to conduct monetary policy. Fed chairman Ben Bernanke pledged that he, and later on his colleagues, would make sure deflation didn’t happen on their watch.

The Fed wants to prevent an event like the Great Depression from ever occurring again. And if it did, it wants to make sure it’s over quickly.

Of course, one of the mandates of the Fed is price stability. This includes preventing deflation. But if asset prices continue crashing the way they are, and one or a few systemically important companies get in trouble, this could lead to a far worse outcome than the current 8% inflation.

Deflation is the Bogeyman

At least in the eyes of the Federal Reserve, deflation is a much greater evil than inflation. Inflation is unpopular, but deflation is the real bogeyman.

As soon as there is deflation, the entire debt-based economy starts to unwind. When there is deflation, anyone who borrowed money gets crushed. The debt burden grows as the currency appreciates in value against goods, services and assets.

Our economy is more leveraged than ever before. Governments themselves are the largest borrowers, so they suffer most from deflation, raising the risks of government default.

Large companies with lots of debt, followed by individuals that have mortgages, are hit next. The pain a deflationary depression would cause today would likely be far worse than what happened during the Great Depression.

This is why the Fed and no politician wants deflation to happen on their watch.

The Federal Reserve Is Stuck Between a Rock and a Hard Place

Due to the constant threat of deflation, the Fed can only crash markets until something breaks. As soon as a “Too Big to Fail” institution gives notice that they are facing insolvency, pressure will grow to reverse monetary policy.

The Fed is currently crashing markets as a side effect of its policy to try to get inflation under control. They would prefer to get consumer price inflation under control without crashing financial markets, but they can’t.

It’s a very delicate situation. If the pendulum swings too much in the opposite direction, the threat of a deflationary depression gets real. This is the Fed’s worst nightmare.

But if they do nothing and let inflation run at 8%, this will further shatter trust in the US dollar as world-reserve currency. And increasing consumer prices are unpopular. This is why the current administration is putting pressure on the Fed to control inflation.

Elections are coming up in 2024, so inflation has to be handled until then.

Inflation isn’t usually a problem if the general public doesn’t feel its effects too much. Inflation at 2% acts as a “hidden” tax. But at 8%, the inflation tax isn’t so hidden anymore. It’s hard to ignore the fact that prices of gas, food and other basic necessities have suddenly jumped significantly.

The Fed is stuck between a rock and a hard place. It has to do something about inflation, but if it overdoes it, the whole system might come crashing down and the Fed could catapult the world into a deflationary depression.

Should You Bet On Inflation or Deflation?

The likely outcome, in my opinion, is that inflation continues to be treated as the lesser evil. As soon as the risk of an economic meltdown and debt deflation gets too big, the Fed will have to reverse its hawkish policy.

Maybe the narrative changes and inflation is blamed on external factors, which is already happening. Maybe the government introduces price controls to mask inflation.

Or Americans will just have to get used to higher inflation. A vast majority of the world lives in economies with double-digit inflation. It’s possible that the United States, once the Fed reverses its policy, will have to “accept” this as a new fact of life in the near future as well.

In my opinion, the likelihood of heightened inflation or even hyperinflation is still much higher than that of deflation.

Inflation, and even hyperinflation, are the chosen ways governments with central banks that issue their own currencies lessen their debt burden. If credit markets dry up and nobody wants to hold US government bonds, the government won’t just default on its outstanding debt.

The Federal Reserve will step in to monetize the government debt, which increases inflationary pressures. An outright government default of the United States would be far worse, and is pretty much guaranteed not to happen. All of this points towards inflation and not deflation in the long-term.

However, it’s never a good idea to become overly confident that one particular scenario will unfold. Managing risk is about weighing probabilities.

How to Survive a Stock Market Crash

When there is inflation, particularly asset price inflation, owning stocks, bitcoin and real estate should be a good way to protect purchasing power. However, whatever assets you buy, they still need to have good fundamentals.

In a deflationary environment, cash is king. The best “asset” to own during deflation is cash, since the purchasing power of the money increases drastically.

During deflation consumer prices and asset prices fall, meaning you can buy more goods, services and assets with the same amount of money. In other words, you can scoop up real estate properties, stocks, bitcoin and other assets at a deep discount. This is why bear markets are great opportunity to make money. Assets usually move from weak hands to strong hands when the stock market is crashing.

But if there is inflation, cash loses purchasing power. Despite inflation, it’s probably a good idea to have a good amount of cash.

Even when markets are going up like they did in 2021, not getting overly greedy and putting all cash into assets would have saved many people in the current situation.

Figuring out how much you invest and how much cash you hold is a personal decision. It depends on your unique circumstances, risk tolerance and goals.

How Much Should You Save For a Rainy Day?

Personally, I like the idea of having 75% invested and 25% in cash.

This would be the equivalent of saying I believe there is a 75% chance there will be inflation and 25% chance there will be deflation.

This way, a majority of wealth is allocated to assets that are expected to appreciate in the long-term if I’m right about inflation. But whenever there is a market crash, or if there’s deflation, the stress level is lower.

If you have cash on the sideline and can invest when prices go down, this feels less devastating than if 100% of your wealth is parked in assets and you see your net worth plummet. There is already suicide talk on Twitter and Reddit. This is unfortunate and my heart goes out to anyone that has lost a lot.

But it’s something that could have been prevented with better position sizing and macroeconomic understanding. If you have a majority of wealth invested in the stock market and are asking yourself “why is the stock market crashing?”, it’s probably a good idea to study macroeconomics and monetary policy, and how the Fed’s decisions affect the stock market.

But then again, I don’t blame anyone that got pulled in by the recent bull market. Almost everyone did. And we aren’t exactly taught in school that the Fed plays the stock market like a puppet master plays a puppet.

How to Use Limit Orders to Cautiously Buy the Dip

When the stock market is crashing, or when there is deflation, don’t buy the dip too quickly thinking the bottom is in. As people learned during the Great Depression, what they thought was the bottom was only the beginning of the crash.

Asset prices can plummet a lot more than you think, especially in a deflationary depression. We’re talking about a 80-90% drop or more. A good practice might be setting limit orders at predetermined price levels but not allocating too much to each limit order.

For example, in case Bitcoin crashes from $30,000 to $10,000, one could create limit orders at $25,000, $20,000, $15,000 and $10,000. Instead of placing a too big limit order at $25,000, you could allocate more to lower prices.

This is of course not financial advice, or a recommendation to buy bitcoin or a particular stock. You can replace bitcoin with any asset of your choice and the price with any worst-case price drop you think is possible.

In case you need the cash for other reasons, for example if you also lose your job during a financial crisis, you might want to hold back completely from investing or “buying the dip”. Again, each situation is different.

The bottom line is, cash is king when there is deflation. What you do with that cash is up to you. Everything will be cheaper than it was, meaning your relative wealth measured in goods, services and assets you can acquire increases.

In times of inflation the opposite is the case. This is why it’s important to plan for both scenarios and assess your own risk tolerance and probabilities for each scenario.

Focus On Increasing Your Income and Savings Rate

When the stock market is crashing, not only is it a good idea to have cash on the sidelines, but it’s also important to work on increasing your income and savings rate.

When you work on increasing your income and save more money, it’s less stressful when the stock market is crashing.

If you live paycheck to paycheck, or have all money invested in stocks without generating any surplus every month, this can be stressful. Without cash on the sidelines and enough income and savings, you might be forced to liquidate some of your investments and realize a major loss during an economic crisis.

This is very common during market drawdowns and economic crises. People overinvest during good times because they believe markets will continue going up.

Once the crash begins, other factors in the economy might also lead to a person losing their income, job or business. This leads to a need for money, resulting in forcefully panic-selling assets to protect ones remaining wealth and have enough money to pay for everyday things like food and rent.

Historically, it was almost always a bad idea to panic-sell assets during an economic crisis, at least in the United States. This excludes assets with poor fundamentals.

But assets with strong fundamentals almost always come back stronger in the long-term. This is why in general, it’s probably not a good idea to panic-sell.

Why You Should Only Invest in High-Conviction Assets that You Understand

If you invested in assets with weak fundamentals and you’re scared an asset won’t ever recover its original value, this is an important lesson.

But if you have enough cash and income to be able to wait it out and see if your asset recovers, waiting might be a good idea. In case you have new information, or the fundamentals of an asset have changed or look irreversibly bad, liquidating the asset and cutting your losses might be the only reasonable thing to do.

Bear markets are never fun. The hype and euphoria turns into fear and panic. Recency bias makes us believe the bad times will last forever.

In the same way that recency bias makes us believe that good times last forever, our mind will trick us into believing that bear markets never end. In both cases, we need to take a step back and calmly look at our own bias.

How to Become a Better Investor During Bear Markets

It’s also a good time to take notes and review what we could have done better. Should we have kept more money on the sidelines? Did we get greedy? Did we invest in assets with poor fundamentals? You will learn more from bear markets than bull markets.

Take this time to review your own investment strategy, reassess your risk tolerance and think about how you should have allocated your funds.

Why is the stock market crashing? Now you know. And you’ll know most likely why the stock market is crashing in the future. With markets at the mercy of the Fed’s actions, being a good investor is just as much about understanding monetary policy and macroeconomic factors as it is about understanding an investment’s fundamentals.

When the stock market is crashing, this can help you become a better investor. As the saying goes, a smooth sea never made a skilled sailor. And a smooth market never made a skilled investor.

This is the time to learn and grow.

May 13, 2022