Prepare for a crash and trillions will be wiped out by the Fed's rate cut

Markets are currently pricing in a roughly 60% probability that the Federal Reserve under President Powell will cut interest rates by 50 basis points on Wednesday. The results will be announced at 2:00 p.m. EST following the conclusion of the Fed's FOMC meeting on September 17-18.

These high expectations scare us.

We believe this is a recipe for huge disappointment. In fact, we think a 25 basis point rate cut by the Federal Reserve is more likely. We obviously hope that doesn't happen, but we offer this analysis so investors can consider the full range of scenarios as a contrast to our more optimistic assessment of the Fed's next move.

The thing is, if Chairman Powell decides to cut by 25 basis points and does not add words to reassure investors, the markets will suffer a massive setback.

This could be much worse than the $2 trillion-plus plunge in the benchmark S&P 500 index in the first three days of August. We see the “Grand 7” — particularly high-growth companies like Nvidia — plunging 10 to 20 percent just like they did last month, wiping out hundreds of billions in investor money. Expect the broader market to see a drop of at least 5 percent in the next few days, with the Nasdaq index losing even more. The small-cap Russell 2000 index will likely be hit the worst. Smaller companies, on average, have less cash on hand and rely on short-term debt to fund their operations. Higher interest rates don't help them. (Do you know how the Trefis HQ strategy that outperformed S&P works with Downside protection?)

What is worse?

Just look at what happened last month – the S&P 500 had one of its worst consecutive days, with the market losing more than 20% from companies like Nvidia (how low can Nvidia go?), while the entire tech sector saw significant declines from giants like Google and Amazon and the S&P 500 as a whole. Investors had nowhere to hide. If the Fed decides to cut interest rates by 25 basis points on Wednesday, things will be much worse this time. Things can quickly deteriorate if some bad jobless reports in the coming weeks show rising unemployment and inflation remains unchanged in the short term. This will conjure up images of a recession in the minds of investors.

With all this – what can we learn from history? How low can stocks and ETFs/indices fall – from the S&P 500 to technology innovator AAPL to pharmaceutical giant Merck, which stocks have fallen the most in past stock market crashes? Of course, we believe it's better for investors not to be too reactive. But bad times don't make for quiet participants.

The truth is that companies like Alphabet, Nvidia and Microsoft are fantastic investments over the long term. However, the short-term volatility of individual stocks can be hard to stomach. If you don't like the rollercoaster ride, learn how the select 30 stocks that make up the Trefis High-quality portfolio (Headquarters) Have a strategy outperformed the S&P 500 – consistently. And We are adding downward protection to the control centre. HQ has returned over 80% since its inception in September 2020. Note: It's simple and right there in the HQ strategy Performance metricsIt is not just the size of the companies that matters, but also their acceptable sales growth and margins, their strong balance sheets and other quality criteria.

The debt bomb

Bad times also draw attention to follies. The current debt situation in the USA is not only folly – in some circles it is seen as a ticking time bomb. JPMorgan CEO Jamie Dimon recently warned of the interest payments of one trillion dollars per year that the USA must now make on its debt. This is unprecedented. This is uncharted territory. The point is that short-term adverse data in the event of a 25 basis point decline can quickly lead to new doomsday scenarios – further exacerbating the downward spiral in investor sentiment and the stock market.

The other risk is loan default. Market crashes happen because someone can't repay their loans. For one thing, the commercial real estate sector has been suffering for some time, with Covid's gift of work from home being a major curse for the retail and office real estate sectors. In addition to a changing demand landscape, short-term commercial real estate loans continue to face high interest rates and difficult refinancing terms. A collapse could happen, although that hasn't happened yet – and with Fed rates finally on a downward trend, it's less likely.

Finally, there are consumer defaults – particularly on personal loans, auto loans and credit card loans. This leaves banks like JPM, Citigroup and BofA with large credit card portfolios vulnerable (How low can JPM stock fall in a stock market crash?). We hope this risk is temporary – because we believe The Fed will do whatever is necessary to ensure a soft landing.

In fact, as we argued in our contrasting scenario of Fed actions, with interest rates so high now, the Fed has even more power. There is a lot of room to cut rates and release more liquidity if things go wrong. They can make a 100 basis point cut if it comes to that. The Fed can quickly inject liquidity if the economy needs a boost for some reason. The big question is: will it do that in the near future?

The sum of everything

Overall, we expect the short-term outlook to be volatile. We are particularly concerned about the high expectations of a 50 basis point rate cut by the US Federal Reserve. However, in the medium term, we see a greater chance of more attractive market conditions, and that is good for investors.

We have developed Trefis strategies to take advantage of such opportunities, especially HQ with downward protectionwhile carefully managing risk in developing our Trefis portfolio strategies.

Here you can learn more about Trefis Market-beating portfolios