Why Stocks are Crashing | The 2022 Stock Market Crash Explained

The stock market is off to its worst start in a year since 1939. Yeah, you heard that right. As of the making of this video, the stock market hasn't fallen this much to start a year in 83 long years. The fall of the stock market has resulted in trillions of dollars of wealth vanishing, as investors see their stocks fall in price. In fact, this current decline in the stock market has resulted in the greatest destruction of wealth ever. Don't believe it? Check out these statistics from Bloomberg on how much the market cap of NASDAQ companies has been erased.

In the Great Financial Crisis, stocks in the NASDAQ together dropped by 2.3 trillion dollars. The March 2020 selloff resulted in 4.4 trillion dollars in lost stock value. The dot-com bubble saw investors lose 4.6 trillion dollars. These numbers all pale in comparison to the 7.6 trillion dollars investors have lost in the current decline. To put it mildly, a lot of people are scared that things are going to get worse.

Now, I tend to shy away from making the doom and gloom videos about how the stock market is about to burst that are very popular here on YouTube. However, I did feel inclined to make a video that explains: one, what's going on in the stock market; two, why are investors worried; and three, what can we as investors expect moving forward. Make sure to stick around till the end of the video because we will be looking to answer all three of those questions and more.

Now let's get into the video. In order for stocks to crash, they first have to rise to prices that don't make sense. Put another way, in order to understand what's currently going on in the stock market, we first have to understand how we got to this point to begin with. Over the last decade or so, the United States stock market has been on one of the greatest runs of all time. The S&P 500 bottomed out at around 750 in March of 2009. It finished 2021 at around 4,800. This means that investors saw the overall stock market increase by over six times in just over a decade. Definitely one of the best performing periods for the stock market of all time.

Now I also think it's worth mentioning that this upward movement was relatively straight up for the most part. Take a look at these return metrics for the S&P 500 by year: 2009: 26.5%; 2010: 15%; 2011: 2%; 2012: 16%; 2013: 32%; 2014: 14%; 2015: 1%; 2016: 12%; 2017: 22%; 2018: negative 4%; 2019: 31%; 2020: 18%; 2021: 29%. Throughout this whole time, the S&P 500 was only down during one year, and that was a measly 4% decline.

There is a saying in investing: everyone is a genius during a bull market. For the last decade or so, investors could literally pull names out of all the stocks traded on the New York Stock Exchange or NASDAQ into a hat, and whatever stock they pick would have likely gone up pretty significantly. This phenomenon got even crazier over the last two years or so. After stocks plunged in March 2020, the recovery in the stock market was extreme. The S&P 500 hit a low of around 2,300 in March 2020, then the S&P 500 more than doubled in less than two years, closing 2021 at around 4,800.

But this doesn't nearly tell the full story of how crazy things got. Certain parts of the market saw stock prices soar above anything that was even close to reasonable. I'm not just talking about GameStop, AMC, and other meme stock mania. The bubble was apparent in two main corners of the market. The first is what is referred to as high growth profitless tech. The description of that group of stocks is literally in its name: technology companies that appear to be growing rapidly but are making little to no money, and in some cases, are actually losing a ton of money.

These companies were some of the best performing stocks for March of 2020. Over the next year or so, nothing is a better proxy for high growth profitless tech than Cathy Wood's fund, the ARK Innovation ETF. The fund went from a low of around 37 in March of 2020 all the way to a high in February of 2022 of more than 155 dollars. Investors in the ARK Innovation ETF saw their money nearly 5x over a period of less than a year. As I'm sure you can imagine, this performance in the fund brought quite a bit of attention on loyal fans to Cathy Wood.

The only thing that exceeded the rise in Wood's portfolio was the rise in her status in the financial media. She went from being known only in certain circles of investors to becoming nearly a household name in a matter of months. She went from being just another investor to having financial media outlets track every single stock she bought and sold. Whenever it was announced she was buying a new stock, it made front-page headlines, similar to that of investment greats such as Warren Buffett and Charlie Munger.

Now, by no means am I trying to hate on Cathy Wood. However, the rise of Cathy Wood in the ARK Innovation fund was emblematic of the bubble forming in certain parts of the stock market. So, this leads us to the question I want to answer in this video: what changed in the minds of investors that suddenly made them want to sell stocks and push the stock market lower? But before we answer that question, I want to tell you a little bit about Masterworks, the sponsor of today's video.

With most markets taking a nosedive and inflation showing no signs of slowing down, there is one market that is continuing to boom. That is the contemporary art market. Just this past month alone, a series of high-value art auctions in New York totaled more than 2.5 billion dollars in sales, with one Andy Warhol piece selling for 195 million dollars alone. Historically, this asset class has only been reserved for the one percent of the one percent, with two-thirds of billionaire collectors allocating between 10 to 30% of their overall portfolio to art.

Needless to say, billionaires have been quietly diversifying their portfolio for years now. Masterworks allows investors like you and me to take advantage of this asset class by buying and selling fractional shares of high value works of art. Here's how Masterworks works: the Masterworks team researches and acquires paintings ranging from one million dollars to 30 million dollars and securitizes them by filing a public offering with the SEC. If you want to get on it early, all you have to do is go to masterworks.art/investorcenter and create an account at the special link in my bio.

Now let's get back to the video. The answer to that question is the following three words: rising interest rates. To understand why interest rates are rising, we first have to understand inflation. You may be asking yourself, what in the world do rising interest rates have to do with inflation? Well, in the year 2022, inflation and rising interest rates are closely intertwined. Let me explain what I mean.

It's no secret that inflation here in the United States is high, relative to historical norms for the country. I'm sure you have felt this when you've paid your rent, tried to buy a new house, when shopping for a car, or even on your weekly trip to the grocery store. In fact, the inflation rate hit a staggering 8.5% in March of 2022, the highest rate of inflation here in the United States in 41 years. Now, this has nearly everyone worried, but it has one person in particular extremely worried: that man is Jerome Powell, the chair of the Federal Reserve of the United States.

As the head of the Fed, this man has two jobs, known as the dual mandate. These jobs are to have low unemployment in the country as well as low and stable inflation. On the first part, the low unemployment, Jerome Powell is doing a great job. Unemployment is at multi-generational lows. There are actually more jobs available than people looking for jobs. However, on the low and stable inflation part of Powell's job description, he isn't doing too well.

The low and stable inflation that the Fed targets is an inflation rate of 2%. With inflation reaching north of 8%, inflation is running four times the level that it should be. As a result, Jerome Powell has committed to doing whatever it takes to get inflation back under control. Arguably, the biggest tool that he can use to accomplish this goal is interest rates. The hope is that as interest rates rise, this will slow down an overheated economy and bring back down inflation.

As interest rates increase, the cost for consumers and companies to borrow also increases. As a result, interest rate increases lead to a slowing of the economy. The hope is that as the economy slows down, this will bring inflation down towards the 2% target that the Federal Reserve strives for. Typically, when interest rates rise, this causes the economy to enter into a recession where economic growth is actually negative for a period of time. Many investors are worried that as the Fed raises interest rates, the economy will start to slip into a recession. Obviously, most companies don't do as well during a recession as they do during a booming economy.

Many economists are predicting the economy will enter into a recession over the next 6 to 24 months. This has some investors pulling money from stocks, putting downward pressure on stock prices. There is also another big impact of rising interest rates that is affecting the stock market. As interest rates rise, the value of cash flow producing assets decreases. This means the value of businesses, real estate, and stocks decrease.

Let me show you what I mean. The value of a stock is the value of all the cash that company will produce over its lifetime, discounted back to the present day at an appropriate interest rate. Okay, I know that may sound super complicated, but trust me, it's not that advanced at all. The math behind the calculation is taught to kids. Let me show you what I mean using an example. Let's say we have a stock that will generate five dollars a share of cash flow each year over our 10-year holding period. Let's then say at the end of year 10, we will be able to sell the stock for 10 times what it produced in cash flow during that year.

So, ten times the five dollars in cash flow that year means we will be able to sell the stock for fifty dollars at the end of year ten. In order to determine the value of this stock today, we next have to discount these cash flows back to the present day using an interest rate. This is because cash flows years into the future aren't as valuable as cash today. Right now, it's just like if I were to offer you the choice between receiving one hundred thousand dollars today or one hundred thousand dollars five years from now. You would, of course, pick receiving the one hundred thousand dollars today.

In order for you to be willing to wait five more years to receive that money, maybe you would have to be one hundred and fifty thousand dollars five years from now in order to compensate you for waiting longer to receive the money. That same logic applies to the scenario. Let's say the interest rate we use is five percent to discount these cash flows. That means the current value of this stock is 69 dollars and 30 cents.

Now the reason I even bring up this example is because I want to demonstrate how changing interest rates can dramatically alter the value of the stock. Let's say we bring the interest rate down to 2%. This increases the value of the stock to 85.93. Notice how nothing changed in terms of how much cash flow the stock produced. Just by lowering the interest rate, the value of the stock increased by over 16 dollars per share.

Now let's see what happens when we do the opposite. Instead of decreasing the interest rate, let's see what happens when we raise it, similar to what's happening now with interest rates increasing. Let's say instead of five percent, we use seven percent. This decreases the value of the stock to sixty dollars and fifty-four cents. Let's bring the interest rate up further to nine percent. This time the value of the stock continues to fall even further, all the way down to 53 dollars and 21 cents.

Now let's get really extreme and bring the interest rate up all the way to 12%. Notice how the value of the stock continues to plunge all the way down to 44.35. The point of this example is to demonstrate just how powerful interest rates are in determining the value of a stock. This is similar to what is happening in the stock market today. Notice how at a 12% interest rate, the stock is worth nearly half of what it would be worth if the interest rate we used was 2%.

Now, of course, going from 2% interest rates all the way to 12% interest rates is obviously an extreme example, but the purpose of this example was to help you better understand how interest rates do matter in terms of the value of stocks. We see a similar dynamic playing out in the market today. The most closely followed interest rate for investors is the 10-year treasury. Without getting too complicated, this is essentially the rate at which the United States government can borrow money for 10 years and it is generally referred to by investors as "the risk-free rate."

As of the making of this video, the yield, as it is referred to, on the 10-year treasury has risen from around 1.6 to start the year to over 3.1 in May of 2022. This is essentially a doubling of this interest rate in just a matter of months. This has some investors spooked that interest rates are going to keep climbing even higher and put further downward pressure on stock prices.

There is still one more question that I want to address in this video: how should we be investing given the likely scenario of rising interest rates and the possibility of a recession being right around the corner? To answer this, I want to turn to lessons from legendary investors Peter Lynch and Jack Bogle. As tempting as it may be, Peter Lynch has warned against trying to predict interest rates and the economy. He has a quote that goes like this: "Nobody can predict interest rates, the future of the economy, or the stock market. Dismiss all such forecasts and concentrate on what's really happening to the companies in which you are invested."

While all indicators point to rising interest rates, at the end of the day, nobody really knows whether interest rates will continue to rise. Instead, investors' time would be better spent focusing on identifying and owning great companies. I think it's worth following Peter Lynch's advice, given that Peter Lynch's fund was able to average nearly 30% annual returns while he was the fund manager. He probably knows a thing or two about investing.

The other piece of advice that I think is relevant right now is from Jack Bogle, the founder of Vanguard. Bogle has talked about a concept known as "staying the course." It was even the title of his autobiography. As investors, we have to understand that there will be good and bad economies and high and low interest rate environments. However, as Bogle has frequently said, "Time in the market beats timing the market."

This means that if we as investors can stay the course and avoid panic selling our stocks, over time we will be better served than if we tried to time the market. So there we have it. I hope you guys enjoyed this video. As always, thank you so much for watching. Make sure to like this video and subscribe to the Investor Center because it is my goal to make you a better investor by studying the world's greatest investors. Talk to you soon.