Dear Reader,
The Federal Reserve is holding financial markets hostage until it sees "clear and convincing" signs that inflation is cooling.
The hotter-than-expected consumer price index report was anything but a sign of cooling. And since that report, economists and traders have been predicting that the Fed will only get more hawkish with monetary policy.
That's bad news for financial markets for now.
"Volatility in the markets is not likely to ebb until market participants can see positive effects from the Fed's cumulative actions against inflation," John Stoltzfus, CIO of Oppenheimer Asset Management.
The Fed's job can be defined simply: Promote maximum employment and stable prices.
But it only has one way of doing that: Buy and sell securities in the bond markets to loosen or tighten financial conditions.
One of the primary manifestations of tighter financial conditions is lower stock market valuations.
In theory, tighter financial conditions should slow economic growth, which should cause unemployment to rise and inflation to cool — and vice versa.
Over the past year, unemployment has been historically low, but inflation has been historically high.
And so we have a Fed that's tightening financial conditions to promote price stability.
But when inflation is higher than expected or persists for longer than expected, the Fed comes under pressure to get more hawkish than expected.
You've probably noticed that Stock market valuations have been falling for a year and a half, and stock prices have been falling for six months.
With stocks, the challenge is understanding the degree to which news and expectations have already been priced in.
Assuming most of the bad news is priced into the markets, there could be some upside if incoming data turn a little more favorably regarding inflation.
As is always the case, predicting what the stock market will do in the near term is treacherous.
And sure, we certainly could see economic expansion become contraction, and we could see positive earnings growth turn negative.
But again, it's hard to know how much bad news is already priced into the markets.
We do, however, know that time in the markets matters.
For long-term investors, it's probably best to heed the advice of veteran investors like Warren Buffett, Peter Lynch, and Howard Marks, whose work tells us that the long-term trajectory of the stock market — despite big short-term sell-offs — continues to be up.
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