Background
So stonks have underperformed lately. The S&P is down ~20% from its peak, growth stocks are much worse off, and the negativity is building. The consensus is that interest rates have remained too low for too long and now there’s too much money. Giving away $1 trillion in cash was a bad idea, and people who make money off of money got greedy again. Who woulda thought?
To the Fed, keeping inflation under control is like growing apples is to an apple farmer. It’s like half of your job. Because they didn’t act when inflation started climbing last year, the Fed now has the impossible task of raising interest rates without causing a recession. According to NPR, 2/3 of the previous US recessions were caused by the Fed raising interest rates, which is exactly what they plan on doing over the next year.
Ideally the Fed Funds Rate should be non-zero if the equity and labor markets are doing well, because you should have something to fall back to when you hit a bear market.
During the Great Recession the U.S. was forced to cut rates to zero, and discovered that it’s pretty awesome when the entire market go up by 10% every year, so they kept them near zero. The next 10 years and 8 months was the longest expansion in U.S. history, followed by a 2-month Covid downturn which caused rates to return to zero and your garbage man to start collecting NFTs. The last time the Fed had 3%+ interest rates George Bush was in office, so we’re in a bit of a bubble. A sticky one at that. A big sticky bubble.
Where’s the bottom?
Since 1946, the average bear market has seen a 35.8% drop from peak to trough when it’s accompanied by a recession, or 28% without a an accompanying recession [1]. Apparently we’re not technically in a recession yet, but NBER’s calculation is based on government employees walking into grocery stores and writing down the prices of milk every month - so the announcement is usually late.
Earlier this year I asked my dad what he thought. He said he expected it to fall further, and that depending on Fed’s action it could get much worse. I told him my plan of putting money back into equites soon, because in a few years from now we’ll probably be at new highs. It will always go up in the long run, right? “Well yeah, that’s the pattern but it’s not always the case. You should look up a chart of the Nikkei.”
What's the Nikkei?
The Nikkei
The Nikkei Stock Average is the index for the Tokyo Stock Exchange, which is a pre-weighted index of 225 of the largest publicly-traded companies in Japan. In other words, the Japanese equivalent of the S&P 500.
In the early 1980’s, both the US and Japanese economies were expanding, but the value of the US dollar grew rapidly relative to other currencies and the US was left with a massive trade gap. So in 1985, the US, UK, France, Germany and Japan signed the Plaza Accord, which aimed to even the trade gap and depreciate the value of the U.S. dollar.
It worked - maybe too well. The result was that the value of the dollar fell dramatically against the yen. In turn, Japan started spending like crazy, scooping up assets across the world including U.S. companies and real estate. Americans began to get the impression that Japan would overtake the United States as the world’s economic super power. American entertainment started depicting a future where all Americans work for Japanese companies like in Back to the Future 2, and Japanese cartoons like Transformers and Thundercats became mainstream.
Then in 1989 as the party was raging, a man named Yasushi Mieno took over as president of the Bank of Japan, unplugged the sound system and told everyone to go home. He raised rates, and the party stopped. Then he raised rates even more, proverbially asking all his hungover friends to help clean up from the night before and also Venmo Josh for the beer.
The bubble burst, and the Japanese economy went pffft. The Nikkei reached 38,957 at the peak in December 1989. A year later, it was around 24,000.
Why did my dad mention the Nikkei? Because it never recovered. It continued to drop until it fell below 8,000 in 2003, and returned to that level in 2009. Over three decades later, the index still hasn’t reached its artificially-high peak, only barely breaking 30,000 last year (2021) before the current downturn:
And while the situation is quite different than Japan in 1990, the S&P is starting to look like the Japanese stock market around that time:
The long run
The United States has gone through 23 recessions since 1900 and it’s always gone back up. Boom and bust cycles are unavoidable and are a reflection of human nature. And just like a forest fire burning through dead trees, bear markets are often necessary for the healthy, nimble companies to get sunlight and grow. This recession - and it is a recession - will probably last 12-18 months and look like an amalgamation of the previous ones, with earnings, wages and employment to drop as inflation gets under control. Of course, I don't know, and anyone who tells you they do is lying.
But based on all historical evidence, in the long run the S&P will be much higher than it is today. I also believe the Nikkei will break 40,000 at some point. But despite my confidence I don’t want to forget: the world’s third largest economy experienced a bubble 5 years before I was born, and they still haven't recovered. That is: when finance gurus talk about the “long run”, they don’t say how long you’ll have to wait.