I have found that the terms recession and bear market are used interchangeably by some people. The two tend to occur at the same time, but are in fact independent events. Part 1 taught you that a recession is a time period in which the economy produces 2 straight quarters of negative GDP growth. A bear market is defined as a time when the stock market declines by at least 20%. When the economy is contracting it is quite likely that stocks will decline by at least 20%.
This can be explained via the PE ratio. A PE ratio is a price to earnings ratio. It is a valuation metric, and it tells you the multiple that each share of stock costs in relation to earnings. Intuitively, one can assume that when an economy is contracting (producing less goods and services) that earnings will come down. With this in mind, declining earnings (denominator of the PE ratio) will cause PE ratios to signal that stocks are overvalued, which will result in selling to adjust valuations to current earnings.
In Part 2, I would like to assume that a recession is on the horizon and discuss what the roadmap forward may look like. If we are assuming that recession is on the horizon, then we are also assuming that earnings are due to come down.
I previously discussed how rising interests rates have an effect on the consumer. I would like to now discuss the effect that rising interest rates have on stock prices.
Every decision you make has an opportunity cost. The opportunity cost is what you could have done instead of doing what you did. For example, when you buy stocks, your opportunity cost is effectively the rate of return on bonds. This comes into play in a calculation known as the Net Present Value formula. What you need to know is that if bonds are paying more, then stocks should be less valued today.
@ttmygh
Author, Things That Make You Go Hmmm…, Co-Founder, Real Vision Group, Advisor to Vulpes Inv Mgt. & Matterhorn AM.
With the NPV formula and consumer access to debt for spending in mind, one can see how rising interest rates are a headwind for both the stock market and the economy.
I suppose it is necessary to touch upon why interest rates rise. Interest rates are the compensation that lenders get for not spending their money today. Borrowers compete for funding by offering to pay higher interest rates. If two companies that are totally the same need money, then you will choose to lend to the company that will pay you more interest for borrowing your money.
Another thing to understand in the determination of interest rates is inflation. Inflation is when the central bank expands the money supply, and eventually this expansion of the money supply shows up in the prices of everyday goods. If you lend someone money for 3% interest, but prices rise 4% during that time period, then you have lost purchasing power. The basic rule of thumb is that interest rates should be higher than the rise in prices for the same period. For the record, most people call inflation the rise in prices. I stress that the rise in prices is the result of the inflation of the money supply. When you want to look up what the government proposes the price rise to be, you will use the Consumer Price Inflation statistic though.
So companies and governments that would like to borrow money should offer an interest rate to compensate the lender for the price rise at the least.
For reference, the Federal Reserve sets the Federal Funds Rate for the US, which sets a standard for other interest rates. The Federal Funds Rate is the rate that depository institutions lend to each other. One way to think of this is as the wholesale interest rate.
The Federal Reserve uses the Federal Funds Rate to pursue its “dual mandate” of “price stability” and “full employment.” Unfortunately, I am of the opinion that over the years the FED has been politically corrupted to also include asset price preservation in that mandate. Differing ideologies make this a difficult topic to tackle. The bottomline is these mandates cause the Federal Reserve to react when situations take place in the world.
Below, for example, you will see that bear markets and recessions are met with cuts to the Federal Funds Rate. Since 1957, the average crisis Federal Funds Rate cut has been 4.7%.
@EconguyRosie
Author of the daily economic report, Breakfast with Dave, and Chief Economist & Strategist at Gluskin Sheff + Associates Inc.
Simplistically, each crisis causes interest rates to be cut, which creates asset bubbles that lead to crises when they pop. The game has become, “Can the Federal Reserve raise interest rates high enough without causing a crisis, so that when there is a crisis they can cut rates to get us out?” This game appears to have run its course. With the stock market already crashing from small interest rate hikes and the Federal Funds Rate only at 2.5%, it does not appear that interest rates can be cut by the historical average theoretically needed to get out of a crisis.
In Part 3, I will discuss where we currently are and examine the Federal Reserve’s decision making process with respect to rate hikes and cuts.