Why are Stocks in US plunging with Inflation?

By now 2022 has not brought good news to stock traders. Stocks in US have been plunging. Nasdaq is down nearly 25% in 2022. On the other hand, S&P is on a 6-week down, nearly down 16% below all time high.

Understanding US Inflation in 2022

Inflation in the US reached 8.5% which is a 41 years high. This caused a rise in the Consumer Price Index. It led to rise in price for almost every commodity. The causes of inflation in the US happened because of COVID-19. The second was due to the war between Russia and Ukraine.

COVID-19 compelled the government to begin with the ‘American Rescue Plan’. They supplied $1.9 trillion into the economy. Further, COVID-19 hampered the supply chain leading to shortage of goods. The imbalance of the demand and supply led to the rise in price of goods.

Further, war between Ukraine and Russia led to shortage of oil and natural gas. Since both the countries are a huge source of natural gas, shortage of oil led to further rise in price of the goods.

Reasons why US Stocks have been dipping in 2022

The main reason for this is due to high inflation in the US. But isn’t inflation supposed to be good for the stock market? Usually when a country has inflation, economy also grows and stocks rise too. So what is causing the stocks in US to slide even though the inflation (in 41 years) is an all time high?

Situation of Stagflation in the US

When prices continue to rise but there is very little growth, a situation of stagflation occurs in the country. The same has been experienced by the US. This makes the share market volatile and market bearish.

It is the time when investors and stock traders back out. Hence, many of the US stocks have been dipping.

Less Reliability on Product Based Stocks in US

When prices rise, input prices rise too. This leads to not only reduction of revenue but profitability as well. Hence, businesses that relies too much on raw material are hit the most. Companies whose products are cost-intensive become less favourite stocks for investors.

The question is simple. Why would any investor put their money into a company which does not yield high returns?

High Interest Rates from the Central Bank

To solve the situation of inflation, the government will surely increase the interest rate. Since the tools to combat inflation will reduce the economic growth, the investors are taking away the money before the value dips further.

It is said that any rise in interest rate would increase the operating cost of the company. Any company which is already fuelled with debt will decrease further.

Effects of Quantitative Easing on Stocks in US

Federal Reserve throughout the pandemic kept the interest rate at 0. The Fed went into a policy called Quantitative Easing. QE at this point looks a very controversial move. They increased the money supply by buying billions of mortgage-backed securities and government bonds each month.

This move boosted the economy. It helped in recovering the economy during the pandemic. But this move also helped in boosting asset risk stocks like tech.

Considering now that the supply of free money is over. Tech companies are worried that we might see another dot-com bubble.

Involvement of Discounted Cash Flow

Discounted Cash Flow is usually the forte of PhD in Finance and Investment Bankers. DCF are used in investment decisions and small business valuations. It is a method of valuation used to determine the value of investments based on its returns and future cash flows.

DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.

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For the discount rate, analysts typically use WACC. WACC stands for weighed average cost of capital. It focuses on the return that investors expect from the investment. The return on investment is expected to be more than WACC. If investors anticipate that the return will not be good enough, they withdraw from the stocks.

Tech stocks are especially hit the hardest due to DCF analysis. It is usually not because of the profitability but because of the growth potential.

In 2022, investors have withdrawn $1.1 billion from the technology stocks. It is the biggest withdrawals of the year. This is one of the reasons why Meta, Google, Amazon, Snap, Netflix, etc. shares are down from sometime. Even though investors love tech stocks but in such situations, they withdraw and do not take risks. True face of capitulation.