The COVID Crash, the Fed, the Stock Market, and Beyond!
After both of my parents asked me what’s going on with the Federal Reserve’s response to COVID, the stock market, and a few other larger financial questions I’m writing this to try and help out.¹
Going back into time and revisiting the riveting time of early 2020!
What happened with COVID and the market
February 25th San Francisco declares a state of emergency for COVID. At this time the market is beginning to sense this is not isolated in China. There are breakouts in Italy, Iran, and South Korea. The market (measured by the S&P 500) is starting to react to this news and is down 7–8% from all-time highs:
S&P 500 % performance 1/1/2020–2/1/2020
As the ramifications of COVID were becoming more evident the market started tumbling. Late February the biggest weekly decline in the market since 2008 and craters during March:
S&P 500 % performance 1/1/2020–3/1/2020
The Federal Reserve’s Response
What happens during a market crash is everyone wants to raise cash. Common sense would say I want to sell my riskiest holdings. But you will lose a lot of money when you do that. If the market is down 10–15%, then riskier holdings are probably down more. A good example of this is in the graph above the orange line is Small-Cap stocks. They’re smaller-sized companies than say Apple, are riskier and have historically higher upside potential. The market is down 30% and they’re down 40%. Yikes! So, you start selling your GOOD holdings to create cash.
Little counterintuitive.
Good (think high quality and usually high liquidity²) holdings are mainly US Treasurys. US Treasurys are extremely important to the functioning of the global market. It’s one of the largest asset classes in the world and has the most liquid market. So, everyone is out there selling their most liquid holdings — Treasurys. But, uhhh, the Treasury market starts running into issues in early March because everyone is selling and no one is buying!
Enter the Fed. Their job is to be the lender of last resort and maintain orderly markets (along with keeping unemployment low).
They start rolling out a bunch of programs called facilities for each layer of the market: money markets, commercial paper, credit markets, etc. They did this because of what they learned in 2008. They didn’t want the market to stop functioning and insanity to follow. If y’all remember, GE nearly went bankrupt because the commercial paper market stopped working and they potentially couldn’t meet their payroll.
On top of the facilities, on March 23rd (the market bottom actually), they start buying Treasurys and mortgages to support those markets, too.
The Fed gets a bad rep from 2008 for “bailing out the banks”. But with the way the Fed is set up one of the few ways it can support Main Street (you and me) is to support the banking system. And then crossing their fingers hoping the financial support of banks trickles to us and supports the whole system. That’s what they did in March 2020.
Did that create a bubble?!
Great question! I would say as of this writing we are not in a “bubble” (famous last words). The market is currently tracking corporate profits pretty closely. The blue line is the S&P 500 and the red line is reported profits:
S&P 500 performance and Corporate Profits
As you can see, the market rightfully predicted the quick rebound in corporate profits. The next question I get is around valuations. Yes, valuations are higher than historical averages. Lots of factors around that. Quickly the companies that people are worried about are usually large tech companies. Those are fantastic businesses and generate TONS of profits and cash flows. There are “little” bubbles going on in the periphery around Electric Vehicles, possibly crypto, and other smaller parts of the market. But the overall market isn’t insane. Yes, it’s higher, which makes me predict returns would be lower than the last ten years. The S&P 500 has averaged around +15% annualized over ten years. Seems reasonable we would get lower returns. Historically, depending on the data set you’re looking at, the market averages ~8–10% a year.
Can we have another crash/2008?!
Of course. I expect every 10 years we will have some major disruption in the market. We’ve had one in2020, 2008, 2001 dot-com bubble, 1987 crash, and the Oil Embargo related poor stock returns in the ’70s. From Hartford funds, if you have a “50-year investment horizon, you can expect to live through about 14 bear markets.” So, it’s going to happen. Preparing for it through a well-diversified portfolio that mixes in bonds, which generally keep their value during market crashes, will help you stay invested for the long term. Yes, sadly the best advice I’ve seen isn’t the sexiest.
My favorite quote is from Peter Lynch, “More people have lost money waiting for corrections and anticipating corrections than in the actual corrections.” A correction is a -10% drop in the market. On average that happens once a year!
The best chance for solid returns is having a plan, sticking with it through corrections, and not making major changes.
Where did all of the stuff the Fed buy go?
Welp, actually it sits on the Federal Reserves balance sheet:
Federal Reserve Balance Sheet
The Fed’s balance sheet ballooned from ~$4Trillion to over $7Trillion.
A trillion is a million, million. Let that sink in. That’s huge. And that’s a big reason why the Fed gets talked about so much in the finance media. It can have a huge impact on the market.
The Fed kept buying $120Billion worth of bonds to continue supporting the market and keep rates low and now has a balance sheet of over $8Trillion. As of this writing, they will begin winding that down.
- That’s right Mom and Dad after 18 years of raising me you get this explanation. You’re graciously welcome.
- By liquid I mean you can sell something without impacting the price of the holding.
