Until recently, stock prices had a high floor. Investors believed in something called the “Fed put.” The thinking was that if the Fed saw stock prices dropping, it would be willing and able to do something to stop the fall.
I doubt that the Fed has such sublime control over stock prices. But if investors hold such a belief, it does not have to be true in order to work. Suppose you think that once the S&P gets below 4200, say, the Fed is going to wave a magic wand and make it go up again. Given such a belief, if the S&P falls below 4250, you figure you should buy, before it starts heading up again. In this frame of mind, investors are inclined to “buy the dip,” that is to buy stocks any time there is a brief drop. The very idea that the Fed creates a floor under stock prices becomes a self-fulfilling prophecy.
By now, it is fair to say that investors and politicians are convinced that inflation is higher than desired. My view of how inflation got out of hand is that the ratio of paper wealth to GDP got too high. Too much money chasing too few goods, except that “money” includes stock market wealth and government debt.
Government debt is not expanding as fast as it did in 2020 and 2021, and you can thank Joe Manchin for that. But it is not receding, either. So if paper wealth is going to fall, the stock market has to take most of the hit. I think of the bond market as doing the hitting, but most people prefer to believe that the Fed is the causal agent. For my purposes here, it does not matter which. The bottom line is that interest rates have to rise, and at higher interest rates stock valuations are going to fall.
How far does the stock market have to fall in order for inflation to return to the levels people had gotten used to before last year? I don’t think that there is a reliable, precise way to answer that question. I’ll take a wild guess and say that if the S&P drops to 3200, which is about 1/3 below its peak, that this will be sufficient. I’ll guess that if it stays above 4000, that will be insufficient.
What is happening now is that the markets have lost confidence that the Fed is going to prop up a high floor. So the floor is lower than it used to be. Where is it? Note that my guess does not constitute a floor. The floor is not 4000 or 3200. The floor is whatever the markets say that it is.