The Fed Pricked the Everything Bubble

Some investors pray to their god for financial success. For the rest of us, there’s the Federal Reserve. After more than a decade in which the Fed giveth, it hath taken away. The markets quite rightly fear that Jerome Powell is in a smiting mood.

Monday brought the definitive evidence that the “Everything Bubble” is deflating, although it is better understood as the expected result of cheap money and low inflation rather than a true bubble. The S&P 500 finally closed more than 20% below its January high, the standard definition of a bear market, although on an intraday basis it was briefly there in May.

The most extreme speculative stocks led the way down, but even assets that haven’t so far fallen much, such as housing, are highly likely to follow suit. One way to think about it: the Fed is increasing the yield on the dollar, pushing up its value against everything. The gain against the yen is easily understood as the Fed tightening while the Bank of Japan stays easy. The “gain” in the dollar against Amazon stock shows up as a falling share price, rather than an exchange rate.

It isn’t just that investors are collateral damage in a campaign against inflation. Falling share, bond and other asset prices are actively helpful to the Fed. They make people poorer, encouraging them to save more and spend less.

This is the opposite of the so-called “wealth effect” the Fed relied on to boost inflation during the past dozen years. The policy of superlow interest rates and trillions of dollars of bond purchases created the Everything Bubble, with prices of virtually every US asset hitting new highs. As the Fed reverses course, the Everything Bubble is going away.

It is hard for investors to escape. But not every investment is equally exposed to the Fed. The next move depends to a large extent on how the Fed’s actions affect the real world, rather than what has been up until recently an effect almost exclusively in the financial world.

This shows up within assets. Until late April, the weakest junk bonds, those rated CCC, had fallen mostly in line with Treasurys. It was only last month that they sold off much more than safe government bonds, as fears rose that Fed tightening would create trouble in the economy.

The same effect is visible in the stock market. The pure financial effect of higher interest rates is to make highly valued stocks less attractive, with far less impact on cheap stocks, those that trade for a small multiple of their earnings. On April 20, cheap stocks, as measured by the Russell 1000 Value index, had made money for the year, including dividends, while expensive growth stocks had lost almost 14%. There was then a brief fall in cheap stocks amid the April panic about consumers, but the threat to the economy, and so to earnings, only really began to take its toll in the past week. Value stocks are off 9% since last Tuesday and growth down 10%.

What happens next depends both on the Fed and on the unknown routes by which its moves hit the real economy. There is also the potential for more things in the financial and especially the crypto world to break.

The market has recognized a lot of interest-rate risk. The next threat is that inflation is so entrenched that the Fed pushes the economy into recession to slow price rises. It is particularly dangerous to investors because they have only recently begun to prepare, so stocks and riskier corporate bonds could fall a lot if earnings are hit. Wall Street analysts are finally downgrading earnings more often than they upgrade them, but still predict higher earnings for the year.

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Investors need to consider which parts of the Everything Bubble will deflate when, and how fast. Already the bubbles in speculative assets have burst in spectacular fashion (see chart), taking many of them back to where they stood in 2020. Stocks favored by private investors flush with stimulus cash have plunged, taking Robinhood Markets, a broker that was a big recipient of “stimmy” money, down 90% from its high. Easy come, easy go.

In the dot-com bubble of 2000, it was six months after the bursting of the most-speculative areas that bigger companies suffered, as the consumer mood soured and Fed tightening started to bite into the real economy. This time it has taken more than a year, but investors are finally beginning to price in the danger that real world problems will hit their portfolios.

Mr. Powell may continue to strike down from on high and pound the economy, in which case earnings and cheap stocks should be hit as badly, perhaps worse, than growth stocks. But while the Fed is powerful, it is capricious, and could switch focus back to the economy if and when inflation fears are replaced by recession fears. We mortals can merely place our bets and hope the fates are on our side.

As markets react to interest-rate hikes and the threat of a recession, stocks are dropping closer to bear-market territory. WSJ’s Gunjan Banerji explains what it takes to push stocks back into a bull market and why it’s hard to predict when they’ll turn around. Illustration: Jacob Reynolds

Write to James Mackintosh at james.mackintosh@wsj.com

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