Dow Jones: My Take On The Market

Thesis:

The Dow Jones and broader markets have run into significant headwinds amid rising interest rates, soaring inflation, and general economic turmoil. As a result, we’ve seen the Dow plummet from levels around 37,000 to around 30,000 as market close on October 5, 2022. That marks a 19% pullback in the Dow in roughly ten months; safe to say it hasn’t been a fun ride for most investors this year. Based on the economic turmoil catalysts mentioned above and analyzing previous market pullbacks, I am going to provide my take on the Dow Jones moving forward.

Interest rates – The gravity of financial markets:

Rising interest rates are not an investors friend when it comes to investing in the stock market, unless you’re an avid short seller. The federal funds target rate has increased from a target rate of 0% – 0.25% in March of 2020 to 3% – 3.25% as of September 2022. The massive rate hikes are being implemented as a measure to stave off inflation, which hasn’t seen rates this high since the early 80’s. The idea is that higher rates reduce consumer spending and borrowing, in turn reducing the demand and price of consumer goods. This in itself harms the market by reducing corporate revenues.

On top of revenue shortfalls, corporations take massive bottom-line hits as the cost of borrowing capital is appreciably more expensive. Based on the current federal funds rate, it’s 1,300% more expensive than it was roughly two years ago. Additionally, higher rates hit the housing market, as prospective home buyers either get knocked out of the market by higher mortgage rates, or simply hold off buying property in general. When corporations have to spend more to produce goods and services, and consumers have less money to buy said goods and services, the broader market doesn’t produce favorable returns.

Suffice to say rate hikes alone have played a major role in the Dow’s pullback this year. To add insult to injury, the Fed isn’t done with its rate hikes, as it plans to reach a federal funds rate target of 4.25% – 4.5% by the end of 2022.

To provide a basic analysis on how the additional 1.25% hike by the end of 2022 may affect the Dow Jones, I’ll break down how much each 100% level hike from the target rate of 0.25% dropped the index. From each 0.25% hike, the Dow Jones lost about 1.47% of market value. With five more 0.25% rate hikes (1.25% total) expected by the end of 2022, we could assume the Dow will lose another 7.35% in market value by the end of the year should it follow the current response trajectory from recent rate hikes. This would amount to the Dow dropping an additional $2,205, reflecting a price level around $27,795.

It’s also worth noting that it’s likely the Fed will continue to hike rates in 2023. Chairman Powell has mentioned “bracing” for hikes to 4.5% – 4.75%, with other officials estimating rates to reach 5%. In short, the Dow’s headwinds will appear to linger well into 2023.

Inflation remains rampant:

Above, I address interest rates, how they harm the stock market, and why inflation is the catalyst that drives rate hikes. It’s clear how and why interest rates and inflation work in tandem in causing economic turmoil and evaporating index market value. Adding further insult to injury, inflation rates are stilling running rampant. Interest rates have been increasing since March of 2020, yet inflation has gone from less than 1% in March of 2020 to still north of 8% today. It obviously takes time for the economy to reflect fiscal policy changes, however, the figures are relatively concerning.

To begin, it’s still not clear whether or not inflation has officially peaked. The current inflation rate is roughly 8.3% with the peak level reaching 9.1% in June of 2022. It took two years for inflation to elevate from levels below 1% to over 9%. Keep in mind rates were consistently rising during the same period that inflation was spiking. My concern is that it may take just as much time for inflation to drop back down to levels around 3%. This would take economic volatility out to June of 2024 if the 9.1% inflation level in June of 2022 was in fact the inflation peak. I believe inflation will take quite some time to stabilize based on the fact that inflation reached levels not seen in over 40 years in a time period where interest rates were consistently rising. I’m confident the inflation crisis would have been much worse if the Fed didn’t start hiking rates when they did.

To completely clarify my concerns, hiking interest rates is a financial measure to halt and reduce inflation. Inflation went from less than 1% in March of 2020 to 8.3% today. The federal funds target rate went from 0% – 0.25% in March of 2020 to 3% – 3.25% today. In just over a two-year period inflation reached 40-year highs while countermeasures were simultaneously in place. This leads me to draw three conclusions: One, the inflation crisis is currently serious and could have been significantly worse. Two, the severity of the inflation crisis leads me to believe it will take an ample amount of time before inflation levels normalize. Three, the Dow Jones and broader market will experience volatility and shortfalls until inflation levels normalize.

Global supply chain disruptions:

Tied to inflation, supply chain disruptions have plagued countries around the globe. From computer components, automotive parts, food, and oil, the Covid-19 pandemic and Russian-Ukrainian conflict have significantly impaired global supply chains. These supply chain disruptions are the culprit behind why inflation got out of hand so abruptly. Luckily, supply chain issues to appear to be on path to stabilizing as Covid-19’s containment and transition to an endemic virus progresses.

Recent bear markets and why they occurred:

I’m going to compare the current market correction to that of the dot.com, financial crisis, and Covid-19 bear markets to hypothesize how steep this one might be.

The dot.com bear market at the turn of the millennium was a result of optimistic speculation. Investors would pour capital into tech startups with hopes of hitting a grand slam. This led to tech startups nearly tripling in value the day of an IPO. As prices reached absurd levels, these companies began selling their own stock, sparking panic selling and market turmoil. On top of that, many of the startups simply failed to produce profits, and in some cases even a product. The result was the dot.com bubble, reflecting a decline of roughly 39% for the Dow Jones. It’s worth noting a large majority of these companies were listed on the Nasdaq, which fell over 75%, however, my focus here is on the Dow Jones.

The subprime mortgage crisis came in 2008. This was a result of predatory lending, as lenders would essentially give a mortgage loan to anyone, regardless of risk factors. The lenders then wrapped up these high-risk mortgages in collateralized debt obligations (CDOs) and sold them on the secondary market with false credit ratings. Essentially, secondary investors were investing in what they thought were low risk CDO’s, when in fact they were investing in high-risk, mortgage-backed securities. Millions of Americans ended up defaulting on their mortgage loans, leading to the market crisis in 2008. The Dow Jones lost 54% of its market value as a result.

The Covid-19 bear market hit us just a couple of years ago in 2020. A virus originating in China made its way to U.S., wreaking havoc on the economy. Businesses and travel came to a halt, and even curfews were implemented to mitigate the spread of Covid-19. Stimulus and boosted unemployment benefits were implemented to assist Americans unable to work. The panic-fueled pandemic sent the Dow Jones into a nosedive, wiping out 38% of its market value.

The mean correction percentage of the last three market corrections comes to roughly 44%, with each resulting from different catalysts. Similarly, the correction we’re experiencing now appears to be driven by inflation and interest rates. Considering the former bear markets were driven by more abrupt circumstances, I don’t believe this bear market will correct as significantly. I also think the fact that there was a market correction in 2020 is relatively beneficial. The market pullback we’re observing now appears to be more natural in nature.

Additional thoughts and prediction:

Interest rates quite low for an extended period of time, leading to great corporate performance while priming inflation issues. The Fed should have begun hiking rates a bit earlier, but I think hikes came promptly enough to avoid significant damage. I personally believe the Dow Jones is going to drop roughly 25% – 35% from all-time highs just under $37,000. This reflects a price range between $24,000 – $27,750. I also expect this pullback to persist well into 2023.

My initial reasoning for this is the fact that rates are still expected to go up and inflation levels are still quite elevated. I also believe it’s going to take some time for inflation levels to normalize. The more time in an elevated inflation and interest rate market, the more time consumer spending will be reduced, and corporate bottom-lines will be hindered.

I also have issues with the lofty valuation of the broader market. The total stock market capitalization to gross domestic product (GDP) ratio is roughly 149%. This means the U.S. stock market is valued 49% higher than the goods and services it produces and sells. This figure accounts for the 19% of value lost by the Dow as well. While it’s reasonable for the U.S. stock market capitalization to trade above GDP, it was pushing close to trading at a ratio of 200%. The current market correction is necessary, as it’s realigning value and price. An additional 10% drop in the market would put the stock market capitalization to GDP ratio around 135%, which is far more reasonable and attractive.

Conclusion:

In conclusion, I believe the Dow Jones is due for additional declines. Interest rates are still on the rise, inflation levels are still significantly elevated, supply chain disruptions will take time to recover, and economic weakness will linger. On the bright side, bear markets provide exceptional opportunities for long-term investors. Per Buffett, be fearful when others are greedy and greedy when others are fearful. My prediction is that the Dow is going to fall to price levels between 24,000 – 28,000 over the next 12 – 18 months. I would rate the Dow Jones bullish under 28,000 and very bullish at 24,000 or less.