How the sharp drop in value on the financial markets can be explained and how should one react to it?

The stock markets have suffered sensitive losses in recent days. The German stock index DAX and the Swiss stock index SMI lost 8% but the technology-heavy NASDAQ index lost 18%. The rest of the indices are in between.

Currently, five reasons come together:

• Meeting of the U.S. Federal Reserve on Wednesday. Many investors are afraid that the Federal Reserve could raise interest rates faster than previously expected.
• Unguarded remarks by U.S. President Joe Biden about Ukraine, which effectively allows the Russians a partial invasion. This could lead to a spiral of violence that cannot be stopped. Energy prices have risen sharply. 
• Investors fear about high inflation and that it will not decrease.
• First companies have presented fourth quarter 2021 business results and they were worse than expected. 
• Uncertainties around the Covid pandemic are not receding.

In such phases, it is first important to distinguish whether it is an orderly adjustment to new risks or whether there is mindless panic. In the case of mindless panic, one should sell and wait with purchases until the panic has passed.

Here, the Fear and Greed Index provides good guidance:

The index has slumped from 65 to 37. This signals fear but not panic. Moreover, the price of gold, a good panic indicator, has hardly changed.

So we see an adjustment to new risks. 

The accumulation of so many negative points is rare. We also consider some of them to be exaggerated. No one has an interest in a war with Russia, and the expectations with an increase in profits of over 22% compared to the previous year were unrealistically high. Moreover, the central bank only confirmed general expectations on Wednesday and did not add a jag as feared.

It is important not to let overly very negative (but also overly positive) sentiment cause us to lose sight of the long-term picture.

The chart shows 12 phases since 1947 in which the Federal Reserve changed its strategy. The chart shows stock market returns two years before and three years after the first rate hike. The broad market expects the Fed's first rate hike in March 2022.

In 3 of the 12 periods, rates were raised too soon or too quickly, and the economy did not recover. In the vast majority of cases, equity markets continued to rise. However, in the first six months after the first rate hike, markets moved sideways relatively frequently.

We expect the markets to move sideways until mid-year. We therefore take advantage of negative exaggerations, as in the current week, to buy cheaply. However, we are currently focusing more on the value theme and on quality stocks. Many well-known Internet companies that have never reported profits and finance their business with short- and long-term loans will have big problems in the rising interest rate environment.