If you’re confused about the stock market, you’re not alone. If you spend 20 minutes watching any of the financial news networks, you will be exposed to multiple opinions about where we are headed. Some think we are gliding towards a soft landing. Others say you should assume the shock position. And in between there are countless opinions. To simplify things, I think there are roughly three potential paths the market could take. Two of them probably don’t pose long-term challenges for investors, but one does.
Photo by Ellen Jaskol
soft landing. You’ve heard it time and time again from our government officials, but the Fed’s goal is a soft landing. What this basically means is that the Fed wants to return inflation to 2% without significantly slowing the economy or causing a large increase in unemployment. It can happen, but a lot has to go right for the Fed. If the Fed can engineer this outcome, expect the stock market to rally and bond rates to fall. We’ll basically be back to where we were in 2019. The odds of that are around 30%.
hard landing A hard landing means the Fed cuts inflation down to 2% regardless of how much pain falls on the economy. This means that we may experience a severe recession and a significant increase in unemployment. Traditionally, this is how the Fed solves inflation. The Fed needs to crush demand to see prices fall. And to crush demand, people have to lose their jobs. If not, consumers basically keep spending. Since consumer spending is 70% of the economy, the theory is that you can’t stop the inflationary juggernaut until you stop consumers.
If we go down this path, we expect the stock market to drop quite significantly, between 30% and 50%. But the good news is that if the Fed cuts inflation to 2%, markets should recover once it’s clear that the inflation genie is back in the bottle. It won’t be comfortable, but the stock market crash should be in the rearview mirror in a few years.
I would put the probability of this outcome at 50%.
stagnation This third scenario is the most concerning in terms of its potential impact on your retirement portfolio. It’s possible we could go down a path where the Fed doesn’t drive inflation to 2%. It can happen in two ways. First, if the Fed can’t engineer the soft landing and decides it’s not worth the damage to push the economy into a deep recession, they can simply revise their targets. They might say something like, “We want to get to 2%, but not yet.” That leaves the 2% target on the table, but takes out the time horizon.
Conversely, the Fed may not be able to bring inflation to 2% even with a hard landing. There are many factors that affect inflation. If the Fed knew exactly what caused it, we wouldn’t have gotten any. It is therefore possible, given the complexity of global markets, that simply raising interest rates will not be enough.
I’d say the odds of some kind of stagnation are maybe 20%. It is the least likely outcome, but the most worrying. A stall could cause investors to lose faith in the Fed and start rethinking how they value stocks, bonds and real estate.
If we’re heading down the soft or hard landing paths, investors probably won’t have to do too much. The market is likely to recover and all you have to do is be patient and wait for it. In the stagnation scenario, however, the hypothesis that the stock market “always recovers within a few years” could be tested. Many people don’t remember that from 2000 to the end of 2012, the S&P 500 stock index did not have a price appreciation for 13 years. It had ups and downs, but by the end of that cycle, the market had gone down in price. This is not ancient history.
In Europe, they have a stock index called the Stoxx 600, which is similar to our S&P 500 stock index. Since 2000, the Stoxx 600 has had an annual price return of 0.64% for almost 23 years. Not many investors think that modern markets can stagnate for more than two decades, but they do.
Investors, however, tend to ignore scenarios where markets can stagnate for long periods. The reason is that the odds of it happening are low and there isn’t much you can do about it. Investors in general are in the same boat, and you just have to deal with it.
But if you’re worried about a cycle where the markets are stagnant, the main advice we can offer you is to simplify your financial life. You are unlikely to invest to wealth if the rest of the world stagnates. But you can do things like pay off your house, get out of debt, and keep your fixed expenses as low as possible. It takes time, but it can be simplified. That way, you’ll be in a much better position to handle these types of scenarios than most people.
Alternatively, don’t worry about the stalemate scenario as it is unlikely to happen. No one can tell you which course is right. You will have to decide for yourself.
Charlie Farrell is a partner and managing director of Beacon Pointe Advisors LLC. The information contained in this article is for general informational purposes only. The opinions referred to are as of the date of publication and may change due to changes in market or economic conditions and may not necessarily occur. All investments carry risks, including loss of principal.