3 Reasons Why There Has Been a Paradigm Shift in the Markets
Updated: Oct 25, 2022
In this piece, I will discuss three reasons why there has been a paradigm shift in the markets. I want to preface by saying I am not predicting a recession nor do I wish to sow fear. I merely want to present a perspective that will hopefully help investors understand and adapt to current market events.
Here are my three reasons:
COVID-19 led to massive monetary stimulus
Monetary tightening is stressing the economy
There has been a paradigm shift in how companies are valued
1. COVID-19 led to massive monetary stimulus.
In the face of COVID-19, countries around the world shut down and went into quarantine. The sudden disruption of supply and demand threatened to create a severe recession. In order to avoid the worst, governments swiftly implemented massive monetary stimulus designed to help replace demand that was lost to the pandemic. In the US, the Federal Reserve (Fed) lowered the Federal Funds rate to near 0% and pumped money into the economy as its balance sheet ballooned from $4 trillion in February 2020 to nearly $9 trillion as of the time of writing. These policies largely worked to save the US from a certain pandemic-induced recession, but also exacerbated economic issues caused by more than a decade of the easy money policies that followed the Great Recession.
Federal Funds Rate
Federal Reserve Balance Sheet
As money was printed, asset prices increased across the board. The stock prices of “work-from-home” companies, such as Peloton and Zoom, soared. Companies involved in ecommerce and direct-to-consumer also greatly benefitted. As valuations became inflated, investors, running out of room in the markets, were forced to take on more risk in order to meet or beat their benchmarks. Companies that prioritized growth over profitability were rewarded while those who saved were penalized. Speculative assets, such as crypto, skyrocketed. The average price to sales ratio of the Nasdaq nearly doubled from 2020 to 2021. It was an extraordinary period marked by fast gains and easy money. So what happens when capital becomes more expensive?
Nasdaq Price to Sales Ratio
2. Monetary tightening is stressing the economy.
As the economy reopened, all of the excess liquidity created by the Fed led to a huge imbalance of supply and demand. Supply chains severely backed up as demand overwhelmed, causing prices to shoot up across the board. The war in Ukraine further fueled the fire by pressuring commodity prices, an effect that has rippled through supply chains globally. All of these circumstances have resulted in the highest inflation levels seen in decades.
US Inflation Rate
In order to combat inflation, the Fed has quickly reversed its easy money policies. Within 3 months, the Fed funds rate was raised ~0.75% with at least another 0.50% increase coming soon, marking the fastest increase seen since the Great Recession. At the same time, the Fed will begin unloading its massive balance sheet this month. All of these actions will serve to tighten liquidity and hopefully tame inflation. However, one does not simply reverse decades-long easy money policies without significant consequences.
3. There has been a paradigm shift in how companies are valued.
When capital was cheap, the best performing assets prioritized growth over profitability. In the wake of the Great Recession, companies were expected to borrow or raise capital to grow. Indeed, “growth at all costs” seemed to become the mantra of many companies, especially high-flying technology-based ones. This trend was further exacerbated by the swift return to easy money policies following the pandemic. Now that capital has become more expensive, the best performing assets are now the worst. Crypto has had a significant meltdown as Bitcoin has lost more than 55% of its market cap. The tech-heavy Nasdaq is down 25%+ from its 2021 highs and is in bear market territory.
Nasdaq Composite Index
So what does all of this mean for investors? As we’ve seen in the first half of 2022, there has been a shift away from hypergrowth and towards near-term profitability. This shift is actually something that has happened multiple times since 2008, but this time, it’s different. In prior instances, valuation cuts were little more than temporary as easy money policies made it simple for companies to continue consuming capital to fuel growth. This time, easy money is not coming to bail these companies out. In fact, business models are likely to permanently change from capital consumptive to capital preserving. Investors have been reassessing not just valuation multiples, but the actual ability of companies to generate future cash flow in a tighter monetary environment. This change marks a paradigm shift in the entire investing framework that we have known for the past decade. Whether this shift is permanent or more fleeting will depend on inflation, among many other factors. However, it seems more likely than not that this new market regime is here to stay for at least the near to medium term.