And as the smart ship grew
In stature, grace, and hue,
In shadowy silent distance grew the Iceberg too.
Thomas Hardy, The Convergence of the Twain (Lines on the loss of the Titanic)
Thomas Hardy’s poem makes sardonic note that, while the Titanic was taking form in Liverpool shipyards, so, too, was the iceberg that doomed it. And, while each bull market grows, so do the forces that will eventually cause it to stop.
What will cause the death of this bull market? No one really knows, and the nature of a bear market is that few see it coming. But if I were to put money on it, the most likely assassin would be the Federal Reserve, rather than disappointing Facebook earnings.
The Fed’s job is to keep the economy on a sustainable growth rate, which means that the economy should grow fast enough to keep unemployment low without inflation. (To the cognici, this is the non-accelerating inflation rate of employment, or NAIRU, which sounds like something out of the Mork and Mindy Show.) Just what NAIRU is is a matter of debate among economists. It’s enough to know it exists.
When the economy is sluggish, the Fed lowers short-term interest rates, which makes it cheaper for companies to borrow and invest. It allows people to refinance mortgages and other debts at a lower rates – essentially, putting money into their pockets.
When the economy is growing too fast and inflation is rising, the Fed raises short-term interest rates to slow the economy. When rates rise, it’s more expensive to borrow, which slows the housing market and makes companies more wary of borrowing.
While the Fed may say that it doesn’t want to cause a recession or slow down the stock market, rising interest rates often do both. A recession wipes out wage inflation: You can’t have wage inflation if people are getting laid off, and you can’t have a wage-price spiral without rising wages. Most stock investors know that higher rates can augur recession, and they tend to sell stocks as rates creep higher. And, on a technical note, stock analysts tend to reduce price targets when interest rates rise.
The most famous example of the Fed crushing stocks and the economy was in 1981, when the Fed hiked short-term interest rates to the highest in modern history: The three-month Treasury bill yielded 16.3% in May of that year, and a sharp recession followed. Inflation, as measured by the Consumer Price Index, fell from 9.79% in May 1981 to 2.36% by July 1983.
But most other bear markets have been preceded by rising rates: The 1987 market crash, for example, as well as the 2000-2002 tech wreck and the 2007 financial meltdown all had rising rates at their backs. While none of those rate hikes were as severe as in 1981 – and you can debate whether they were the proximate cause of the bear market – few bear markets start after a prolonged period of the Fed cutting rates.
What does all this mean? If you have ten or more years to reach your savings goals, not a thing. In fact, a bear market is a good thing if you’re young and contributing regularly to a stock fund in a retirement account. You get the chance to buy stocks cheap over a long period of time.
If you’re close to your goal, however, you should at least think about how much you have in stocks. The most logical way is to rebalance: If you set a goal of 60% stocks and 40% bonds, for example, you’re probably out of balance now. It wouldn’t hurt to sell enough stocks and buy enough bonds to get back to that 60% and 40% risk.