Market Collapse Caught Wall Street's Elite Off Guard in 2022

Marko Kolanovic and John Stoltzfus, two of the most optimistic stock market analysts on Wall Street, were certain at the start of 2022 that the Federal Reserve would take a gradual approach to raising interest rates. Despite inflation reaching its highest level in four decades, they argued that the rate increases would be so small that the financial markets would hardly notice them.

Marko Kolanovic, co-head of global research at JPMorgan Chase, forecasted a broad market rally. His team predicted that the S&P 500 Index would reach 5,050 by the end of 2022. John Stoltzfus, chief investment strategist at Oppenheimer, was even more optimistic, expecting the index to reach 5,330.The difference was greater than 1,000 points.

Two prominent figures at well-known companies have become the public faces of the unexpected events that occurred on Wall Street in 2022. Most of the top investors in the stock and bond markets were unable to predict the inflation outbreak and the subsequent actions taken by the Federal Reserve. The rate increases were rapid and unexpected, leading to the worst simultaneous decline in stocks and bonds since the 1970s.

In the US, there are 865 actively managed stock mutual funds with at least $1 billion in assets. Unfortunately, these funds experienced an average loss of 19% in 2022. Hedge funds, which typically invest in equities, also suffered greatly. Bond funds, which consist of 200 funds of a similar size, had an average decline of 12%. Most of these funds performed worse than the indexes they use as benchmarks. One of the most prominent funds was Western Asset Management's Core Plus Bond Fund. Ken Leech, the company's chief investment officer, predicted in late 2021 that there might not be any rate hikes in 2022. This $27 billion fund ended up losing 18%, which was worse than 99% of comparable funds.

William Eigen, a bond investor at JPMorgan Asset Management, is one of the few who managed to avoid the pain of the 40-year bull market. He states that this long period of success has caused people to become entrenched in certain beliefs that are difficult to change. Since the late 1980s, many traders, investors, and analysts have been taught to believe in the Fed put, which is the idea that policy makers will always be there to support markets during times of distress, either by reducing plans to raise rates or by cutting them. This has led to the idea that one should always buy the dip.

It was difficult to predict the extent of the losses this year. When asked for their opinion, Leech and Stoltzfus both pointed to the unexpected economic impacts of the global pandemic. China's decision to maintain a Covid Zero policy and Russia's invasion of Ukraine were two major factors. Stoltzfus described the situation as a "mugging" in an interview, noting the role of the Federal Reserve in the process.

Leech described the year as "particularly challenging," but mentioned that the fund's performance has started to improve, gaining 3.6% this quarter. He expressed that, due to changes in the macro environment, adjustments have been made to the broad market portfolios, and that the fund is now in a position to benefit from a global recovery. Kolanovic highlighted the performance of a broader cross-markets model portfolio he is in charge of, which has had a positive return this year, with successful investments in commodities and bonds compensating for unsuccessful stock investments.

A year ago, he and the JPMorgan team had predicted a surge in yields in 2022, with 10-year Treasuries reaching 2.25%. As of late Wednesday, they were at 3.88%.

The Fed put axiom was created in the wake of the last major inflationary period in the US. By the mid-1980s, consumer prices had stabilized, allowing central bankers to concentrate on promoting economic growth, employment, and the stock and bond markets. Despite the fact that the put is currently inactive in this period of high inflation, many traders still call for a "Fed pivot" - a shift from rate hikes to rate cuts in order to avoid a recession. This has caused them to bid up the prices of bonds and stocks, only to have their hopes dashed when Fed Chair Jerome Powell reiterates that the board is continuing to raise rates until inflation is back in check.

Eigen observed the markets rising one morning in late November and commented that it was the fourth Fed pivot rally of the year. Unfortunately, it did not last long.

Jerome Powell's decisions have caused some confusion in the markets. Over the course of 2020 and 2021, he has repeatedly expressed his belief that the price increases caused by supply-chain issues and government stimulus would eventually dissipate without any further intervention.

Investors' confidence in the continuation of low-rates was only strengthened by the comments they heard. In June of 2020, they made a wager in the bond market that inflation would be around 3% in the following year and that the Federal Reserve would only need to raise its benchmark rate to 0.4% by the end of 2022. This prediction was way off the mark, as inflation skyrocketed to a high of 9% and the Fed increased its key rate to more than 4%. This miscalculation set the stage for investors' further missteps in the markets.

Despite the fact that many investors were burned by underestimating inflation, many remain convinced that Powell is preparing to make a pivot. Futures market consensus suggests that the first rate cut will come less than five months after the final hike, which is typically more than double the length of time. It is ironic that Wall Street professionals were so pleased when the amateurs on Reddit lost money on their GameStop shares and Shiba Inu coins in late 2021. This was seen as proof that investing should be left to the pros. However, the mentality that caused the twenty-something-year-old bros to chase meme stock mania in the early days of the pandemic is not that different from the model taught at the country's elite financial institutions - markets only go up because of the Fed.

Andrew Beer, a managing member at Dynamic Beta, has seen his exchange-traded fund rise 21% this year due to a bet against bonds. According to Beer, if someone was wealthy and well-known by the end of 2020, it was likely due to low interest rates. He states that their success was linked to the low rates.

According to Beer, this has been a difficult situation for investors such as Cathie Wood, the tech enthusiast whose fund ARK Innovation has been in a downward spiral for over a year. He explains that rising rates, which require investors to reduce the value of future corporate earnings, are especially detrimental to tech stocks. Beer states, “When you see the world changing, you have to take the opposite stance because you are hoping and praying that the world is not changing.”

It appears that the process of educating Wall Street is beginning to take shape.

At the start of December, strategists began to agree on a forecast that had not been seen since 1999: the S&P 500 would experience an annual decrease. Drew Pettit, a 33-year-old Citigroup strategist, was among those who revised their expectations. He commented on the risks of living in a world of low interest rates and high stock prices. He had previously predicted that the S&P would be over 5,000 by the end of 2022, but now he believes it will only reach 4,000. Pettit concluded that it will be more difficult to achieve gains in the future.

Kolanovic has become more bearish on equities, predicting a call of 4,200. Stoltzfus is slightly more optimistic, with a call of 4,400. This implies a double-digit rally from the current position, but is a stark contrast to Stoltzfus' prediction from the summer, when he was very bullish and predicted a 40% gain in just over six months, with a target of 5,330.

In a late June interview, he expressed his optimism, stating that he believes they are heading in the right direction and that the light at the end of the tunnel is not a train's headlamp, but rather the sun's rays.

For a short time, it seemed like Stoltzfus was onto something. A Fed pivot rally that Eigen finds so intriguing began and, in a few weeks, the S&P 500 had increased by 17%. Eventually, the Fed will change its policy and one of these rallies will be proven correct. However, this wasn't the one. In late August, Powell spoke at Jackson Hole and delivered a stern message that inflation must be suppressed. Consequently, stocks and bonds started to decline again.