What Should Investors Do Amid the Rout in the Stock and Bond Market?

Caleb Silver Oct. 6, 2023 Investopedia

KEY TAKEAWAYS

  • Stocks and government bond prices have both tumbled in recent months, an unusual phenomenon, as the Fed's rate hikes have led to a dislocation in capital markets.
  • Stubbornly high inflation, coupled with stronger-than-expected economic activity readings have Fed officials warning that they will maintain high interest rates for longer than investors and consumers had expected.
  • Borrowing costs will remain high for consumers, businesses, and the federal government, which reduces risk appetite and spending.
  • It could be a good time for investors and consumers to evaluate their options to preserve and grow wealth.

Nowhere to run to, baby, nowhere to hide,

got nowhere to run to, baby, nowhere to hide.

It's not love, I'm a running from,

it's the heartbreak I know will come.

Investors’ ears may be ringing with the Martha and the Vandellas hit 1965 song lately as a steep selloff in both the stock and bond market has rattled our nerves and upset any sense of balance in our portfolios.

The bond market, particularly the U.S. Treasury market, has historically been a buffer for investors when stocks swoon. But the Federal Reserve’s inflation-fighting rate-hiking campaign over the last 18 months has led to a dislocation in the capital markets and bond yields to jump to levels not seen in over a decade. Since yield and price move inversely, the value of U.S. Treasury bonds has tumbled, producing the rare phenomenon of a simultaneous drop in both the stock and government bond market.

All of that, plus concerns about political instability, which are now exacerbated by the leadership change in Congress and the threat of a government shutdown, has investors generally unwilling to put money to work in the stock market, according to our most recent sentiment survey of Investopedia's newsletter readers.

For investors and consumers alike, moments like the one we’re experiencing could be a good time to evaluate your options to preserve and grow wealth. We’ll touch on some of those options in a moment, but first a bit of perspective.

How Did We Get Here?

This was supposed to be a comeback year for the stock market, and it was up until August. The S&P 500 jumped nearly 20% in the first seven months of the year, recouping most of the ground it lost in 2022. The rally was fueled by easing inflation, a stabilization in corporate profits, and hopes that the Federal Reserve would engineer a soft landing, even as it raised interest rates 11 times since March of 2022 to cool down wages and prices.

But stubbornly high inflation in food, shelter, and energy prices, coupled with a relatively strong jobs market, made it clear to the central bank and investors that interest rates would have to stay higher, for longer. That new reality has rattled investors, sending the S&P 500 to its lowest levels since May and pushing the Dow Industrials into negative territory for the year.

Borrowing costs have risen to historically high levels, putting pressure on corporate profits and threatening to slow the economy into a recession we thought we might avoid. That warning alarm rang loud in September, which is historically one of the worst months of year for stocks, and prompted investors to flee stocks and hide in cash. The bell has been ringing even more loudly in recent days.

Amid ongoing concerns about what the Fed will do, government bond prices have tumbled as yields spiked to levels we haven’t seen since 2007.

The only other times that both stocks and bonds have declined simultaneously were in April and September of 2022—the beginning and the bottom of last year’s bear market; January of 2009 in the ashes of the Great Financial Crisis; and October of 1979 following nearly a decade of ultra-high interest rates.

What Comes Next

Investors have woken up to the fact that we will be living in these high interest rate altitudes for a while. Earlier this year, there were hopes that the Fed might lower interest rates at the end of 2023 as inflation was supposed to drift back down to the central bank’s 2% target. But the Fed’s latest projections show inflation, as measured through the Personal Consumption Expenditures (PCE) Price Index, remaining between 3% and 3.5% through the balance of this year, and then falling to around 2.5% by the middle of next year.

The central bank’s Dot Plot—perhaps the most boring, yet most important chart in economics right now—shows the Federal Funds Rate climbing as high as 5.6% this year, implying one more increase of 25 basis points, and then hovering around 5.1% through 2024.

That means borrowing costs will remain high for consumers, businesses, and the federal government. When borrowing costs are high, we spend less. Just look at the U.S. housing market, which has been in a deep freeze since the Fed began hiking rates. With the average 30-year fixed mortgage rate hitting 8%, would-be buyers and sellers are sitting on their hands. Refinancings have dried up and inventory is tight across the country, driving the median home price to record highs. That dynamic could persist through most of next year.

High borrowing costs also put pressure on corporate profits, which looked like they might rebound next year. The Stock market rally that fizzled in recent months was predicated on that hope. But with rates expected to remain at or near these levels, U.S. companies, many of which will be releasing their third-quarter earnings reports in the next few weeks, have been lowering their profit forecasts according to Factset. Lower profits and high borrowing costs can be kryptonite for stocks, as we learned in the 1970s and 2015.

What Should We Do About it?

As individual investors, we have many choices, and here are just some of our options:

  • Do nothing. Market swoons are not a bug, they are a feature of investing. They tend to revert to the mean over time. For the S&P 500, that means an average return of close to 10% since its inception in 1928. It’s done that despite an average intra-year drawdown of 16%. Doing nothing is actually a choice, and you are free to make it.
  • There’s money in the bank! The flip side of high interest rates is high yields on banking products like certificates of deposit (CDs), money market accounts, and high-yield savings accounts. Banks are finally offering more than 5% yields on these products, and investors have taken advantage of that all year. Check out our daily list of the best rates for CDs and High Yield savings accounts to see what banks are offering. More than $5.6 trillion has piled up in money markets and cash equivalents in the past 18 months. There is somewhere to hide, after all.
  • Dollar-cost average your way into your favorite stocks and ETFs. If you have time on your side, selloffs like the one we are going through can be a great time to buy more of the assets you believe in at a discount. They may decline in value right after you buy them, but the point is to keep buying to accumulate sizable positions at lower prices. That will improve your returns if and when prices rise again.
  • Buy short-term government bonds. If stocks feel risky and you are bored by keeping money in the bank, the yields on short-term government bonds can be pretty attractive at 5.5% or better for six-month T-Bills. Just remember that those yields can change quickly, unlike a CD or money market account.

While the future is always uncertain, especially when it comes to investing, a few things are pretty clear. The dynamics in the capital markets have changed in the past 18 months, and many investors have never experienced an era of high interest rates. Many are used to the Federal Reserve repressing interest rates to help steer us out of one financial crisis or another like it did in 2000 and 2009. However, the Fed has signaled interest rates could stay high for the foreseeable future.

We can choose to accept that and allocate accordingly, or we can keep running and hiding.

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