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Selloff In The Stock Market May Be Far From Over

Published 05/06/2022, 06:16 AM
Updated 09/20/2023, 06:34 AM

Stocks ripped higher following the Fed meeting on May 4, but that didn't last long. The move higher seems to have been premature, reversing gains on May 5. Investors seemed to have refocused their attention on the critical pieces of the meeting: the Fed would be raising rates and, more importantly, as a result tightening financial conditions.

Financial conditions have already tightened as measured by the Chicago Fed National Financial Condition Index. Since the beginning of this year, those conditions have tightened materially, rising to -27 bps as of Apr. 28, up from roughly -60 bps. Over the same time, the S&P 500 has dropped almost 14%.

Conditions Are Still Easy

However, financial conditions will probably need to tighten even more and head towards neutral for the Fed to succeed. The Chicago Fed notes that when the index is below 0, it is historically associated with looser-than-average financial conditions. In contrast, positive values are traditionally related to tighter-than-average financial conditions.

Despite the current rise in the index, financial conditions are at least historically easy and suggest there will need to be even more tightening to come. We can see the damage that has been caused in the market with the current move higher in financial conditions, which has been around a 32-basis point increase. The pain could be massive, given that we have nearly the same amount of tightening ahead of us.

Financial Conditions Index

Tighter Conditions Create Pain for Stocks

Historically the data shows that when financial conditions tighten, they tend to be associated with volatility in the S&P 500, which is not different from what we have experienced recently. For example, in 2018, financial conditions tightened dramatically as the Fed raised rates, which sent the S&P 500 plunging by almost 20%.

Similarly, during the rate hiking cycle that started in late 2015, financial conditions increased dramatically in 2014. That period of tightening led to a long period of instability in the S&P 500, and it wasn't until conditions began to ease that stocks finally started to move higher again.

This would indicate that a meaningful equity market rally seems unlikely as long as financial conditions remain tight. Even worse than that, if they tighten further, it will likely lead to more pain for stocks.

How Far Will The Fed Go?

When the Fed talks about tightening financial conditions, it can only mean bad news for stock prices. Given the amount of tightening that is still ahead of us, the problem for stocks can only grow worse. If the Fed intends to tighten conditions beyond the neutral level, making financial conditions restrictive, things could worsen.

This could become particularly painful for stocks with high multiples and little earnings to show for it. The tightening financial conditions will further decline key valuation ratios like the price-to-earnings or price-to-sales. As these valuations compress, their future earnings become worth less, and when a company has no earnings, it makes valuing those stocks even riskier since there may be an uncertain path forward.

Of course, another question is how far will the Fed ultimately go in this process. Still, unless something changes quickly on the inflation front, it seems very hard to imagine financial conditions easing anytime soon.

When these financial conditions peak and begin to turn lower, that will be a clue that perhaps the worst of the equity market selloff is over.

Latest comments

Most analysts are apologists for wall street sharks and will write anything. Ignore their stories
if one looks at all of your articles..they would more then 90% be bearish cals.. I have no problems unless you're shorting the market..
Probably short and wish you were even more short
Speculation of inflation risk is overblown Dumping of 10 yr Treasury is fueling the fire
I assume you are all cash, otherwise you wouldnt say that.?
Can you retire with all those tips... Lol
Thanks Michaelgreat job
I don't have money so how I can start
Start small
Buy a $10 growth stock like PLTR for a long term investment and keep on buying
Big ticket stocks started showing cracks this week. Correction is now in on way in real sense
He discovered warm water. It's since I work, about 30 years, I see this trick: rates up/stocks down and viceversa
It’s in reverse to prepandemic and during the pandemic when it would be -1.5% and EOD +2% now do the opposite… 10 year 3.09 first time in a decade, 2 year 3.17 wait until 4, equities getting slaughtered as is crypto as it seems to be running alongside market conditions best thing to do is hedge, straddle, or buy puts if you’re long not advice just my opinion on research and due diligence
Market crashes for sure
More happy days for GU bears
That means sell off is almost OVER
The main point is ‘almost’. LOL
Lost 40 percent of my portfolio. I am out!!
Wise. Valuations are too far stretched. While no one can predict bottom but wait for another 10% correction in broader market
Lol.......what if that 10% correction doesn't come? Youll be out or buying back higher. Go ahead and take that chance if you feel you can time the market
investing its all about timing. if the analyst are so accurate they wouldnt even share with u.
The FED will not raise the rates above 3%, but the market is and will go much further. Just keep an eye on the 10 yr. yield, if it goes beyond 4%, the over leveraged economy will go kaput
Indeed, the selloff in these markets has only just begun. The real bleeding is yet to come. I sold in May and went away.
will see
Down to $2,000 I suppose.
for the S&P I mean
Current damage has much more tightening priced in already.
Doesn't help that the hedggies all have massive puts bets
7+%...that is how far the FED will go...
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