January was a rough month for stocks, or as they say on TV, there was a lot of volatility. Volatility is a nice way of saying the market went down and you probably saw that when you looked at your account statement from your broker. Now I am not going to tell you how you should manage your money or what you should invest in, but I can certainly tell you a little bit about some history and the way economics works with the stock market. 

The main problem we have as everyone knows, is inflation. Consumer prices have risen 7.5% in the last year. Well, the problem is, it’s just beginning. They’re not going to go down quickly, but the federal reserve has to tighten rates. Raised rates make money more expensive just to keep it where it is. The rate hikes are not going to be small. They’re going to be actually quite large. 

Two facts exist about the ability to control inflation.

 It has never been the case that we have lowered inflation. what economists call disinflation, unless the federal funds rate is larger than CPI. Well, right now the fed funds rate is just a quarter of a percentage point, right? That is seven points or more below CPI, suggesting a lot of hiking is at stake and more problematically. We have never had disinflation without having a recession. And first well both the need to high rates and the possibility of a recession creates real problems for stocks and analysts who are aware of this history are taking precautions as a result. 

Why is that? Why do higher rates and higher inflation adversely affect stocks? Think of stocks as long dated assets. And that’s particularly true when it comes to stocks like high-tech stocks. They’re bets, if you will, that are going to pay off down the road. You may hear for example, in the NASDAQ, they may be buying a company that has yet to turn a profit at all. But the expectation is that when the technology it’s come up with really hits, it’s going to hit big maybe three or five years from now. Well, when interest rates are zero, it costs you nothing to wait for the stock to hit big. But when interest rates go up, you’ve got to lose money every year You wait for it to pay off. 

So these so-called Long dated assets tend to fall a lot in price When interest rates start to rise and inflation doesn’t help help them out. Now, the other  problem that we have is that when these high flyers start to decline, they may also create a ripple effect on other stocks. Warren buffet, the famous investor, has an important indicator he’s used. 

It’s the ratio of the value of the stock market to the value of the economy. Right now the stock market by his estimate is running about 49 trillion in value. The economy, GDP, is only 24 trillion. So stocks are 205% of GDP, but Buffet estimates that fair value is just 120%. Basically stocks are gonna have to fall 40 points to get to what Buffet considers to be fair value. 40%. 

Well, that means that this last January may have been rough, but it’s just a taste of what’s to come.