The stock market fell again on Wednesday, showing continued investor nervousness in the current macroeconomic environment. As we have seen in recent days, the Nasdaq composite (^ IXIC -0.70% ) was hit harder than most of the other major stock indexes. As of 11:15 a.m.ET, the Nasdaq was down 105 points, or nearly 0.7%.
The main source of concern for market participants has been uncertainty about the future course of interest rates. With inflationary measures at levels not seen in decades, many predict that the Federal Reserve could take action to try to curb price increases. Many investors have noted that these expectations have often resulted in larger declines in larger Nasdaq stocks than in other areas of the market. Below we will briefly explain why.
What the Fed wants
The federal government has given the Federal Reserve a dual mandate. The central bank is responsible for setting monetary policy that will encourage full employment while keeping inflation rates manageable.
For much of the past two decades, the Fed has been very effective with both of these goals. Job growth has generally been constant, with a lower-than-average number of recessions creating temporary increases in unemployment. Inflation was contained throughout the period, even as unique challenges like the financial crisis of the late 2000s led the central bank to lower interest rates to encourage economic growth.
However, the COVID-19 pandemic has created disruptions that have thrown monetary policy out of balance. With massive unemployment resulting from the economic shutdown at the onset of the pandemic, the Fed had to prioritize jobs over control prices. When the demand for products and services fell, there was no inflationary pressure. But as the economy recovered and reopened, demand returned faster than supply recovered. The result was a lot of money for too few goods and services, resulting in higher prices.
Policy makers are therefore looking for appropriate measures to contain inflation. The first possible response is to gradually reduce asset purchases made by the Fed as part of its quantitative easing policies in recent years. The Fed also has the power to raise short-term interest rates, which has always been its typical tool for containing inflation during rapid economic expansions.
So why is the Nasdaq affected?
The most common argument about why Nasdaq stocks are taking disproportionate hits amid interest rate concerns has to do with stock valuation. Many investors use valuation models that take future earnings or cash flows and discount them to the present using current interest rates. The higher the rate, the less future cash flow or earnings are worth in current dollars. This lowers the share price.
However, such models assume an assumption: that high growth firms will not be able to increase the prices of their goods and services to match the rate of inflation. This may be true for commodity companies with intense competition and little distinction between the products of one company and those of another.
For high-growth stocks in areas such as software as a service and cloud computing, however, this assumption does not seem so compelling. Companies need the services provided by these companies, and this creates pricing power in many cases which should help sales increase with inflation.
Haves and have-nots
At this point, the smartest distinction is to see what the financial resources of companies are. Small, high-growth players who must rely on continued favorable financial market conditions to provide liquidity may well be vulnerable to Fed moves. In contrast, companies that have already anticipated the current uncertainty by raising capital should already be in better shape. Since the market doesn’t make these distinctions, you may be able to buy depreciated stocks cheaply no matter what the Fed does next.
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