The Stock Market Couldn’t Handle the Uncertainty. It Better Learn How.

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Call it the Great Uncertainty.

With the stock market having rallied off its lows, investors should be feeling pretty good right now. They survived a bear market. They survived the fastest pace of interest-rate hikes in decades. They even survived what might have been a recession. And yet, all it has taken is one bad week—the

S&P 500’s
first decline after four weeks of gains—for the doubt to creep back in.

As it should. For the past 40 years, markets have had fairly recognizable rules. Dips were there to be bought. And the Federal Reserve always had the market’s back. Sure, the Fed might raise interest rates when inflation started running too hot—and even cause a recession—but it would always start cutting again after it did what it had to do.

And when things got really bad, the Fed would do whatever it took to stabilize the financial system and ensure that stocks, after a decline, resumed their steady upward trajectory. No wonder buying and holding index funds has turned out to be the best way to invest for decades now.

The latest inflation scare has changed all that. Inflation makes people feel like they can barely keep up, even when they’re getting raises. It makes strong economic growth feel like stagnation, and it creates a world of mixed messages that are hard to decipher as either bullish or bearish.

At times, it has made for mass confusion. Is the job market strong? A recent PricewaterhouseCoopers survey doesn’t shed much light. It found that 38% of respondents said that hiring the right talent was a major risk, behind only cybersecurity, at the same time that 50% said they were reducing head count. Neither do speeches from Fed governors, some of whom see more three-quarter-point rate hikes in the future, while others contend the central bank should be more prudent.

Even reading the minutes from the latest Federal Open Market Committee meeting, which were released this past week, seemed more like a Rorschach test of our personal biases than something that could provide direction. “The July FOMC minutes show the Fed trying to calibrate how restrictive policy will need to be, but gave no clear signal for September,” writes J.P. Morgan economist Nora Szentivanyi.

Optimists, of course, will point to the fact that with oil, gasoline, and food prices lower, inflation is getting ready to slow. But it’s still unclear where it will level out—or whether the Fed will insist that the core personal-consumption expenditures index get back to 2%. Either way, it’s impossible for even the Fed to know whether it has done enough, and it will have to err on the side of fighting inflation until the fight is won.

If that’s the case, the “Fed put” truly is dead. For as long as most investors can remember, they could count on the central bank to bail them out if the market fell too far or things got too rocky. Now the opposite may be true, if a rising market keeps financial conditions too loose to keep inflation under wraps. It’s one reason that seeing the return of meme-stock mania, even if only for a week or two, is so concerning. When financial conditions are tight, stocks like

Bed Bath & Beyond

(ticker: BBBY) shouldn’t soar 400%.

None of this implies that markets have to tumble, but it does mean investors shouldn’t count on what has been working to continue working. Oil stocks were hot, until they weren’t. Tech was trash until everyone wanted to buy it again. Even momentum stocks—those that have performed best over the past year and are supposed to keep winning—have failed. The

iShares Edge MSCI USA Momentum Factor
exchange-traded fund (MTUM) has fallen 19% in 2022, worse than the S&P 500’s 11% decline.

It’s a tough situation. It’s a market with big drops but big rips, as well, one that forces investors to accept low returns from index funds or try to take a more tactical approach, says Stifel’s Barry Bannister. He’s particularly worried that the Fed will invert the three-month/10-year yield curve as soon as September, presaging a 2023 recession, but he also notes that stocks have usually rallied into recessions.

That’s just one more contradiction that investors will have to grapple with as they make their way through 2022.

Write to Ben Levisohn at [email protected]