After a year where the stock averages have declined anywhere from 7 percent to 30 percent, the last thing investors want is to see further downside. The problem is that a surging stock market is the last thing the Fed wants to see in its battle to reduce inflation.

 

It is common knowledge that the Fed does not want to see a robust equity market. Fed Chairman Jerome Powell and his merry men have never said so explicitly, but they are monitoring the ups and downs of the market closely. When they perceive that price action is getting out of hand, one or more FOMC members step up and try to talk the markets down.

 

Several times this year when the animal spirits of traders and investors have pushed stocks up 10 percent or more, the Chairman has been able to squash the move effectively simply by jaw boning. These actions may be contrary to many investors' long-held belief that a stronger stock market is always good for the economy but that is not always the case.

 

The Fed has done a good job of explaining that inflation is their number one concern when it comes to the health of the economy. That sentiment has been echoed throughout the globe as central bankers everywhere are raising interest rates continuously. Readers should know that tightening monetary policy by raising interest rates and reducing liquidity in the credit markets by selling bonds are the main tools central bankers use to reduce demand.

 

The problem is that thus far, despite raising rates at a historical pace, the economy continues to grow. Employment remains stubbornly higher than expected as well. That combination continues to fuel consumer demand for goods and services. As a result, inflation remains substantially higher than the Fed's target of two percent.

 

But hasn't the stock market declined enough to warrant a more dovish Fed? Not really. Consider that the pre-pandemic low of the S&P 500 Index was 3,387 in February 2020. Since then, despite 2022 losses, the index is still 16 percent higher than that level. For the most part, meme stocks and other speculative assets are still alive and kicking. In every bear market rally thus far, investors have flocked back into these assets, despite the lack of earnings, profits, or even cash flow. In many of these companies.

 

It is only recently that highly speculative assets such as crypto have finally begun to fall substantially, but it took a major financial crisis and bankruptcy to trigger that event. None of this seems to have phased or altered the casino-like atmosphere of today's stock markets. In short, after years of buying the dip, it is taking much longer to convince traders that may not be the best investment strategy. It could require a recession to change that behavior.

 

Most financial professionals are expecting a recession in 2023 thanks to the Fed's tightening of monetary policy. A recession is one of the best ways to reduce economic demand and by doing so achieve the Fed's goal of lowering inflation. I'm hoping for a quick, couple of quarters of a moderate recession that will drive inflation lower without causing too much harm to the country's labor force.

 

So how would a substantial decline in the stock market help reduce inflation?

 

In the U.S., the stock market is normally the bailiwick of those considered well-off. They have enough money to both support their lifestyle and save for their eventual retirement.

 

When financial assets decline, there is less money in the system, so financial conditions automatically tighten.

 

At the same time, a sell-off in equities has a psychological effect on those who are invested. People feel poorer as their 401 (k) or IRA decline. Often, they tend to reduce spending on consumer goods and services, therefore reducing demand (and inflation). As prices decline substantially, savvy savers can also take advantage of fire sale prices. This is an especially good deal for younger retirement savers who can take advantage of a "buy low" period in order to beef up their retirement saving plans.

 

As for those living paycheck to paycheck, a plunge in the stock market means little to them, even if the selloff is caused by a recession. Hourly workers who are laid off will likely find another job quickly, especially if a recession is short and sharp in duration. 

 

Overall, a moderate recession and a cheaper stock market would hurt investors in the short term but help just about everyone in the long term. It would wring out speculative fever among investors, help the Fed accomplish its inflation goals sooner than later, and have comparatively little impact on both the long-term performance of one's retirement account and the stock market.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.