Investors should prepare for the wonderland of rising stocks to end

The stock market has had it rough since the start of the new year. Buckle in. Stock prices are sure to go up, down and all around, but I suspect a lot more down days are dead ahead.

Stock prices had been on a tear. Last year alone they rose a stunning almost 30%, among the best performances of the last century. And last year wasn’t a one-year wonder. Stock prices have more than doubled over the last five years and have enjoyed close to double-digit annual gains in the last forty years. For context, inflation over this period has been less than 3%.

The wealth this represents is eye-popping. At the stock market’s peak at the start of this year, the value of all publicly traded stocks was close to $50 trillion, up almost $10 trillion over the prior year and $25 trillion over five years. Consider that the U.S. economy produced $21 trillion in goods and services last year.

To be sure, much of this wealth is owned by a small share of Americans. Families with incomes that put them in the top 10% of all families own close to $2 million in stocks, on average. But more than half of families own at least some stock, and middle income families own well over $100,000 in stocks. Stocks have become an important part of many peoples’ nest eggs.

Don’t get me wrong. Stock prices should be high. That’s because the economy is recovering strongly from the severe recession caused by the pandemic, and company profits — the ultimate source of the cash that goes to stockholders — have grown even more strongly.

The share of the economic pie going to businesses through their profits has never been so large. This, despite the pandemic and the resulting labor shortages and global supply chain disruptions that have added to their costs. But they’ve been resourceful, improving workforce productivity and raising prices.

Rock-bottom interest rates have also supported high stock prices. Low interest rates increase the present value of future corporate profits. In other words, when rates are low, the profits that businesses are expected to earn in the future are worth more today, and thus stock prices are high.

But stock prices appear much too high. Signs of speculation, when investors purchase stocks with the intent of selling quickly at a profit, are increasingly evident. There are so-called meme stocks, SPACs, and the wave of initial public offerings, particularly of high-flying technology companies. And margin debt — what stock investors have borrowed to finance their investments — has gone straight up since the pandemic hit.

So, stocks are highly vulnerable to a significant sell-off, and the catalyst may be the pending dramatic shift in monetary policy. The Federal Reserve made it crystal clear that interest rates are headed higher. The debate is about how high and how fast.

The federal funds rate, the rate the Fed directly controls, is effectively zero, where policymakers put it when the pandemic first hit. But with unemployment back almost where it was pre-pandemic and inflation so uncomfortably high, zero no longer makes sense.

The recent decline in stock prices thus feels like just the beginning. Given the wild swings in stock prices in recent days, it’s a bit surprising that the market is down by less than 10% from its all-time high at the start of the year. So far, this isn’t even a garden-variety correction — the kind that happens every several years.

Investors have become conditioned to buy on stock market dips. In its monster rally of recent years, if you had the courage to buy when prices fell, you were quickly rewarded as stock prices rebounded. Indeed, the biggest rewards went to those who took the biggest risks and bought stocks when prices cratered as the pandemic first hit and the economy shut down.

However, this strategy seems a much bigger gamble now. The Fed no longer has investors’ backs. Arguably the opposite. If stock prices don’t go down and stay down, at least for a while, it is less likely that the economic recovery and inflation will cool off. A weaker stock market is what the Fed needs to get what it wants on growth and inflation. Thus, the more resilient the stock market, the more aggressive the Fed will need to be in raising rates.

There is an age-old stock market adage: “Don’t fight the Fed.” Best to heed it.

Having said this, timing the ups and downs in the stock market is an intrepid and ultimately losing affair. Most of us should ignore the volatility in the stock market, don’t look, and invest for the long run. The American economy and businesses, as always, will prevail. Stock prices will rise.

But if you are a baby boomer like me or older and close to or in retirement, the long run isn’t that long. For you, this is a good time to make sure you are very comfortable with your stock investments.

Mark Zandi is chief economist for Moody’s Analytics.