Will Ebiefung, The Motley Fool
4 min read
Over the long term, stocks tend to rise in price. But these long periods of growth are usually interrupted by market corrections, which are temporary drawdowns of over 10%. Let’s discuss some reasons why the Nasdaq Index looks overdue for one of these dips and discuss strategies investors can use to make the most of the situation.
Interest rates and inflation
In late February, the US and Israel commenced military strikes on Iran, a nation responsible for around 4% of the world’s oil supply. The war is having a profound impact on the energy markets, which could have knock-on effects throughout the global economy and financial markets.
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For stock market investors, the biggest challenge will be potential stagflation. These are periods of slow growth and rising prices that historically followed other Middle Eastern supply shocks, such as the 1973 OPEC oil embargo and the Iranian Revolution in 1979. Back then, higher energy costs reduced the amount of money consumers were able to spend on other things, which hurt corporate earnings and margins.
Interest rates are another big challenge. In April, the Federal Reserve voted to keep the benchmark rate unchanged at 3.5% to 3.75%, citing uncertainty related to the war and Trump’s erratic trade policy. While these rates are not particularly bad from a historical perspective, they are significantly higher than the near-zero rates enjoyed for much of the pre-pandemic period. And many credit-dependent industries, like automotive and real estate, are experiencing lower growth because the higher rates have brought monthly payments to unaffordable levels.
Higher rates also mean growing companies will have a harder time securing the capital they need to expand. Furthermore, investors will generally have less money to put into risk assets, pressuring equity prices. This comes at a time when valuations are already stretched.
The market flashes a warning not seen in over 20 years
There are many ways to value the stock market. But one of the most useful tools is the cyclically adjusted price-to-earnings (CAPE) ratio. This metric is designed to smooth out the influence of the business cycle by averaging real corporate earnings over 10 years. And it gives investors an idea of how cheap or expensive stocks are from a historical perspective.
