Will the Fed downgrade its outlook on speculative stocks?

Speculation seems out of date. Since the beginning of November, the most speculative stocks have been squashed, even as the broader market hit new highs. Many blame the Federal Reserve, but the link between monetary policy and speculation is less clear-cut than one might think.

Among those that fell 20% or more: The “meme” stocks of

GameStop

and

AMC Entertainment,

electric car maker Tesla, the darling of hydrogen

Plug in power,

bitcoin and a bunch of small unprofitable stocks. The businesses have little in common, but all rely on valuing high for buyers willing to bet on a story — and have benefited from the proliferation of individuals dealing in stocks. . (A staggering rally by some speculative names on Friday did not dampen losses; AMC leads with 19% daily gain, but still down a third from early November and worth just over half of what it peaked in June.)

This pattern extends to the broader market, where speculators’ favorite volatility is the most important predictor of performance. The more volatile stocks in the S&P 500 index, the more they rose in the 12 months through early November, and the more they’ve fallen since.

It’s tempting to say that this is all about Fed and other central banks. Historically low rates and trillions of dollars of quantitative easing certainly encourage long-term speculative bets. Get rid of those, as the Fed says it will, and it’s no surprise that those speculative bets suffer.

The timing of the recent drops is also the fault of the Fed. The Fed began cutting its bond-buying program last month, coinciding with the end of a major rally in all things speculative. Last week, it said it would end its QE program earlier than previously planned, as well as shortening three rate hikes next year.

The point is, what’s the theory here? How will the Fed’s interest rate path affect assets that look more like gambling cards than ownership? No one is buying GameStop, let alone bitcoin, because of the discounted cash flow model. It is true that a higher expected rate from the Fed will detract from any model that uses it as the discount rate. But even if some misguided soul tried to price GameStop, AMC, or the rest with such a model, they would have discounted cash flow using the reduced, aged bond yields, not increase, as the Fed said about tightening.

The link to the Fed’s bond purchases is unlikely. The Fed’s preferred theory of how QE works is that bond purchases push cautious investors out of safe-haven Treasuries into riskier assets, which in turn push their holders into more conservative assets. riskier assets, and so on up the risk ladder. At the top, someone on Reddit created a meme for GameStop.

Even if this “portfolio channel” theory holds true, and I doubt this was predictable, it is not backed up in the numbers. Since April, the entire QE program and more has been offset by investors pouring money into the fund bringing money back to the Fed, using its reverse operations. Fed balance sheet adjustment because of the sudden prevalence of inversions of accounts and there has been a kind of voluntary quantitative tightening going on that brought total Fed assets back to where they were last October .

However, speculative stocks and cryptocurrencies depend on their value on stories, not on reported earnings. Stories about Fed tightening are as powerful as stories about future battery demand, stories about moving from gold bars to crypto, or stories about cramming short sellers — but it does more harm than good.

Higher interest rates can be important in a simpler way, by making cash in a bank account more attractive. But even the three rate hikes predicted for next year by the average Fed policymaker would only put the Fed rate in the 0.75%-1% range. It’s hard to believe that could be enough to tempt many people away from high-risk bets with hundreds of times higher payouts.

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This is not to say that the amount of money outflows is not important for speculative assets, or that the price of money – the interest rate – is irrelevant.

It’s just money crumbling around not Fed-generated money. One plausible theory is that the money being pumped into bank accounts is important by the government – backed up by individuals who talk about their “magic checks” transactions.

“You gave people gambling money and they had nothing else to do so they YOLOing into individual stocks,” said Andrew Lapthorne, global head of quantitative research at

Société Générale,

use the acronym for “you only live once”. “But that’s gone.”

As stimulus-filled bank accounts dry up and new traders go back to work, inflows into the most speculative stocks will decrease or turn negative, a drag on prices.

GameStop’s frenzy attracted the attention of investors who shared trading information on social networks.

The prospect of higher interest rates will also suffer, even if a few are enticed into cash by slightly higher interest rates. Johanna Kyrklund, chief investment officer at fund management group Schroders, said that even some people turning to cash can affect asset prices as the number of new buyers continues to grow.

“With profit, the cost of sitting on your hand [in cash] has dropped to the point of reducing FOMO,” she said, using the acronym for “fear of missing out.”

Whatever the relationship between the Fed and speculative assets is, it’s not a neat math. Speculative assets fell even more from January-March highs before a brief but spectacular rally for many of them in the fall and no move which is related to the central bank.

We can say with certainty that tighter monetary policy is a breeze for speculators, but there is too much uncertainty to know if it will blow them away anytime soon, or even that’s the cause of their recent loss.

Write to James Mackintosh at james.mackintosh@wsj.com

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Ian Walker

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