The question to ask about the movement in the markets so far this year is not why it is happening but why it took so long.
Now that the Dow Jones industrial average has fallen through the 16,000 floor that has held over the past two years, the market will be testing new lows for months to come. That’s not to say there won’t be strong rallies as investors look to buy on the dips and analysts point to the fundamental strength of the American economy. But in the end, the market will be forced to reflect two big underlying realities.
First, there has been a five-year bull market, with stock prices nearly tripling between the dark days of February 2009 and the market peak of February 2015. Long bull markets tend to make people complacent and overly optimistic about how high stock prices can climb and how deep the correction will be when it finally happens. You could see that optimism in the steady rise in the ratio of stock price to company earnings, which rose noticeably above historical averages. And you could see the froth, in particular, in the price of hot stocks in the technology sector, where some of the valuations of young companies in particular began to rival the absurdity of the late-1990s tech and telecom boom.
The other shift involves the long-delayed correction of fundamental imbalances in the global economy that manifest themselves in prolonged and unsustainable trade deficits and surpluses, artificially low interest rates, misaligned currencies, real estate bubbles and inflated prices for commodities, stocks and other financial assets. The roots of these imbalances could be traced to the fall of communism, rapid globalization, the arrival of the Internet, changing population trends and the rise of shareholder capitalism. They were also encouraged by financial deregulation, the mercantilist policies of China and other export-led economies, and the willingness of American and European consumers and taxpayers to live beyond their means.
The financial crash of 2008 and the Great Recession resulted from these massive imbalances. But the dramatic actions taken by governments to prevent the markets from spinning out of control and restore the global economy to health, while both necessary and effective, also had the effect of delaying the needed corrections. What we’re seeing now are the signs that the rebalancing has resumed.
The Fed, for example, has now begun the long process of raising interest rates from zero to more-normal levels, which will affect the markets and the economy in all sorts of ways. It will dampen enthusiasm, for example, for the corporate mergers and debt-financed dividend payments that have pushed up stock prices, even as it nudges investors to move some of their money out of stocks and back into bonds. The prices of things bought with borrowed money — cars, homes, real estate — were inflated by the Fed’s artificially low rates. Those prices and values will now fall as interest rates rise, resulting eventually in decreased sales and employment in those industries.
Or take the case of China. It was inevitable that China’s growth would slow as it ran out of rural residents whom it could transfer to more productive jobs in the cities manufacturing toys and clothing and computers to be exported to American consumers. One way China was able to maintain its export machine was to keep the value of its currency artificially low and prevent its citizens from investing their newfound wealth outside of China. Huge bubbles in the domestic market for real estate and stocks were the result.
To deal with those bubbles, and to begin the shift from export-led growth to growth driven more by domestic consumption, China has been opening up its financial system, allowing Chinese savings to flow out and the market to set the price of its currency. In the long run, that will be healthy. In the short run, however, it is wreaking havoc with Chinese stock and real estate prices and threatening the solvency of Chinese banks. Just as significantly, it is slowing the growth in China’s demand for raw materials, which has profound implications for the price of oil and other commodities and the economies of countries that rely on them, such as Brazil, Russia and Saudi Arabia.
What would rebalancing look like in the United States? Less borrowing and consumption and more savings and investment. That would mean a decline in the dollar to dampen our appetite for imports and boost exports, and with them higher inflation. It would require state and federal governments cutting pensions and entitlements and raising taxes in order to restore levels of public investments and bring long-term budgets into balance. And it would mean a dramatic shift in corporate behavior away from share buybacks and special dividends, in favor of investments in new equipment, research, product development and worker training.
Obviously, all such adjustments will take years to play themselves out. But markets by their nature are forward-looking, and they have now begun to anticipate the changes in asset prices and interest rates and currency values that are likely to be part of the process. And with big American and European companies posting half their sales and profits outside their home countries, the stock markets on which their shares trade will reflect these global adjustments.
It would be a mistake, however, to see this month’s sell-off of stock prices as simply a reflection of these underlying economic realities. There are times — and this is one of them — when the stock market is driven more by the trading dynamics of emotional short-term speculators than the rational economic assessments of longer-term investors.
The smart money guys at the hedge funds and Wall Street trading desks have known this day was coming for a while. They’ve been happy to trade the market up and down over the past two years as the Dow fluctuated between 16,000 and 18,000. But now that the 16,000 floor has been breached — a level first reached more than two years ago, in November 2013 — the smart money guys have begun to head for the exits to wait out the storm. Already last year, hedge funds lost money, the bottom fell out of the junk bond market and company earnings growth slowed — all fairly reliable leading indicators of a broader stock decline. Another is the fact that 20 percent of the stocks on the New York exchange are trading below their recent 200-day average.
When we look back to this time, we are likely see that the long bull market ended in February 2015 and we are now a year into a bear market, where selling will beget more selling and stock prices will fall 20 percent from their peak. Such a bear market would mean the Dow would fall at least to 14,000, which would be a good time to begin buying again. It’s likely to be a bumpy ride until then.