Financial assets have become increasingly volatile since the Federal Reserve and, eventually, Central Banks around the world began interfering with natural market price discovery. At the onset of the financial crisis it was deemed that large businesses integral to the economy were too big to fail.
Accordingly, government bailout money flowed into the system. Then it was decided that investor confidence needed to be bolstered. The answer was Quantitative Easing, a form of injecting money into the economy. This policy was intended to be a last resort, but over time it became a staple. Few complained because the result of more money sloshing around in the economy was higher asset prices and the feeling of more wealth for those holding stocks, bonds, or real estate.
The wealth effect is real, and it felt good for a long time. So good, investors and speculators were able to allocate substantial amounts of money to risky assets causing valuations to balloon to inexplicable levels. We are all now paying for those sins and if the Federal Reserve is truly exiting the game of market manipulation, we will eventually see a massive decrease in volatility, not an increase.
Further, that means the days of wild stock market rallies are behind us. Instead, we would be back to the slow grinding environment in which investors focus on yield and income rather than capital gains.
S&P 500
A monthly chart of the E-mini S&P offers a good reminder of how bull markets behaved in the past before the Fed intervened. While there will be those that bring up the dot.com bubble, and that is a valid point, even that market rally didn't have the steep slope witnessed in recent years. Further, the dot.com bubble was followed by a lost decade, so the piper always gets paid.
Chart Source: QST
There are two ways for a market to work off froth: time and price. For the sake of long-term investment accounts, the most attractive of the two is undoubtedly time. This means either the equity markets need to consolidate or we will get another leg down at some point - probably when the masses are least expecting it.
If the bull market is still intact, the monthly chart and a typical sloping trendline drawn upon it, suggest there is a bit of an equilibrium level near 3,500ish (realistically between 3,500 and 3,200). The trending channel that existed prior to the Covid-stimulus campaign suggests the rally "should" have been contained in late 2020 to about 3,600, instead of running out of bounds to just over 4,800!
Prices have since fallen back into the channel with the lower support level suggesting that the correction could extend into the high-2,000s without violating the long-term-bull market. We doubt that happens as we go into a seasonally supportive time of year, but it might be something to keep on the Bingo card for 2023.
Will Treasuries Stabilize?
The Treasury market has taught long-term investors some painful lessons this year, me included. For starters, it was a reminder that popping bubbles don't have rules to abide by.
For instance, this year's performance in the 10-year note Treasury is the worst since 1788 (that isn't a typo). The historical route is the result of an artificial interest rate bubble popping as the Federal Reserve taketh away what it has given for more than a decade. Not only did the practice of Quantitative Easing combined with loose monetary policy allow a bubble to form in fixed income, but it also increased market volatility substantially.
A monthly chart of the 30-year bond depicts an environment of euphoric rallies and soul-crushing selloffs. I think we can all agree, this is not the type of behavior we want to see in a "risk-off" asset.
Who Is TINA?
The idea that interest rates were too low to justify allocating money to fixed income forcing investors of all sizes, ages and risk levels into riskier equity assets is referred to as TINA (There is No Alternative). It is widely accepted that TINA is dead because even investors who aren't comfortable with duration - the price and interest rate risk that comes with long-term fixed-income securities - can obtain relatively high yields of 4% or higher for short-term and high-quality bonds.
As we entered 2022, this was not possible but as 2022 concludes, bond investors are being presented with opportunities that have not been available in well over a decade.
Accordingly, long-term investment dollars making their way to the financial markets monthly, quarterly, or yearly depending on individual retirement account stipulations or savings behavior, will undoubtedly be spread to asset classes other than stocks. This likely differs from what we saw in 2020 and 2021 in which most new money coming into investment accounts was used to purchase momentum stocks or even cryptocurrencies.
The Fed draining excess liquidity from the markets and offering investors a safer alternative returning a decent yield, will likely put an end to the heyday of stocks. Thus, going forward, equity rallies will likely be of the slow grinding type we saw before the Federal Reserve's entrance, rather than the instant riches type we've seen during the Fed intervention era.
This should be a queue for speculators and investors to recalibrate their expectations of upside volatility. The good news is that with a decline in upside volatility, the pullbacks should be less devastating as well because, in such an environment, market participants are less likely to be of the meme stock variety and more of the retirement account type.
