2020 was a year of two economies. Soaring stock tickers were contrasted with steep job losses and shuttered businesses.
In response to the pandemic, both the Federal Reserve and lawmakers flooded the economy with "easy money." This easy money helps explain 2020's dichotomy and is perhaps the primary reason why stocks managed to soar even during the pandemic's darkest days.
But as vaccines roll out and the economy improves, investors have a new fear: inflation. Inflation that could cause the Fed to raise interest rates and pull back on its easy-money policies.
But why did the Fed initiate these policies in the first place?
Well, whenever there's an economic crisis, there's usually a run that follows it. People rush to pull cash out of whatever investments they may have and put it safely under their mattresses. Markets sprang a cash leak between March 9 and 16, as shutdown orders rolled out and investors rushed to pull their money from the market. During this panicked sell-off, circuit breakers had to be triggered three times on the floor of the New York Stock Exchange.
In the end, on a single day on March 16, the S&P 500 Index (NYSE: SPY) posted its third-biggest loss of all time, the Dow Jones Industrial Average (NYSE: DIA) its second, while the Nasdaq Composite Index (NASDAQ: QQQ) hemorrhaged 12.3%, a record.
Now with so much money under so many proverbial mattresses, the Fed and policymakers had to act fast to get more cash back into the economy.
And that's just what they did. On March 23, the day the market bottomed, the Fed expanded asset purchases and launched a $300 billion credit program for businesses. Prior to that, the Fed had shaved interest rates to half a percent. Meanwhile, Congress passed $2 trillion in stimulus.
"Investors sell 'fast and big,' and policy officials act 'fast and big' to save the world," Jim Paulsen of Leuthold told CNBC. Excess liquidity and near-zero interest rates caused people to pour all their newfound cash into the stock market.
And pour they did, for by August, all three major indices were trading within record high ranges.
Several factors are at play when we look into 2020's breakneck run-up. The Fed pumps money into the economy and cuts interest rates. Low-interest rates mean investors can only put their money into stocks if they want to get a return. Nationwide shutdowns mean only a handful of tech companies are actually growing. Investors pour their cash into tech stocks, which then all but carry the stock market through 2020. According to Sam Stovall, stocks were trading at a 42% premium by the end of the year, CNBC reports.
"We haven't seen valuations since before the internet stock market bubble in the late 1990s," Stovall told CNBC back in December. But in 2021, things are different.
Investors aren't tracking the Covid headlines anymore, but headlines about inflation and rising yield rates. A recent survey by Bank of America found that 37% of 220 investors surveyed cited inflation as the biggest "tail risk" for the stock market, according to CNBC.
Why is inflation a concern? Because it could cause the Fed to raise interest rates. When bond yields rise due to rising interest rates or improved economic activity, the value of a stock's future earnings goes down. And tech companies valued based mainly on future earnings suffer as a result.
Due to upbeat economic projections, and rising yield rates have already triggered a sell-off. The tech-heavy Nasdaq, which broke record after record last year, began March in correction territory .
Nevertheless, not everyone sees rising bond yields as a long-term threat to the market. According to Jim Paulsen, the damage caused by rising yield rates depends on the economic backdrop. Many Economists expect GDPs to surge by 5.5% in 2021, Business Insider reports. Higher interest rates may be a problem in 2022 when economic growth slows down.
But for now, "with the economy enjoying a post-pandemic boom, rising yields may prove far less damaging for stock investors in 2021," Paulsen told Business Insider.