The stock market sell-off continued overnight in places that wake up before we do, including trading centers in London, Tokyo and Frankfurt. As I write this at about 8:30 a.m., pre-session trading in market futures suggests today could be another rough ride for stocks.
Thus, it seemed like an opportune time to try to draft you onto team StayCalm. I’m not saying these thousand-point drops are pretty or painless. But they really need context. So, let me try to quickly tick off what’s not and what is scary about this moment.
Does this mean we’re heading into recession?!
No! There’s the economy, and there’s the stock market. They’re not the same thing, and the former, which is much more important to people’s well-being — and, ultimately, the dog that wags the market’s tail — remains in solid shape. In fact, since most people depend on their paycheck as opposed to their stock portfolio, a triggering event of this sell-off — the 2.9 percent pop in wage growth from last Friday’s jobs report — is a good thing. To be honest, no one knows when the next recession will hit, but history is full of stock market routs even bigger than this one that barely dinged the economy’s trajectory.
But what about inflation? Is it really going to take off?
As I’ll argue below, this is the key question. The wage pop spooked the markets because investors, already skittish as valuations were a bit steep (though not as bad as people have been saying, given strong current and expected corporate earnings), envisioned this sequence: wage growth gooses price growth (i.e., inflation), which raises both market and Federal Reserve interest rates, which slows growth and shaves corporate profit margins. But there are many links in that chain. First, the correlation between wage and price growth has been low in recent years. Second, while market interest rates have ticked up a bit, they’re still low by historical terms. Third, conditional on inflation remaining tame, this sell-off could lead the Fed to be more, not less, patient with rate hikes, as the market itself is pulling back on slightly frothy valuations and boosting interest rates on its own.
Okay, but what about those massive earnings losses? What about my 401(k)?!
As my colleague Dean Baker at the Center for Economic and Policy Research points out, and as you knew anyway from when President Trump used to talk about the stock market (such talk is … um … on pause for now), the run-up preceding the sell-off has been long and strong. Before inflation (a negative for returns) and dividend payouts (a positive), Baker points out that markets have gone up 14 percent annually since 2009. He writes: “The gains have been even more rapid over the last two years. Even with the recent drop the market is more than 40 percent above its February 2016 level. Most people would have considered it crazy to predict the market would rise by 40 percent over the next two years back in February 2016. In other words, people who have invested heavily in the stock market have nothing to complain about. If they didn’t understand that it doesn’t always go up then they should keep their money in a savings account or certificates of deposit.” Okay, that last bit is a little tough love, but he’s right. Trump and Treasury Secretary Steven Mnuchin made a rookie mistake by forgetting this simple truth — markets don’t just go up — and, in the name of keeping it real, the sell-off is a useful reminder of that reality.
I’m calm for now. But when should I get worried? What if the sell-off gets worse today?
Given the magnitude of the gains noted above, another few days of this won’t be pretty, but they won’t undermine the ongoing expansion in the real economy, meaning jobs, paychecks and gross domestic product growth. A long, persistent bear market can be a problem in that regard, as a negative “wealth effect” can kick in: The persistent decline in asset values starts to pull down consumer spending, which is at the core of the U.S. economy (it’s 70 percent of GDP). But remember this: The value of the stock market is driven by the current and expected profits of the companies owned by their shareholders. Nothing has dented that yet, and, if anything, the tax cut is sure to boost corporate profits, though this is already well-priced into markets. The overreaction to the wage gains is partly the result of the fear that higher labor costs will cut into that profitability, but this, too, is wrong: Workers, not just shareholders, need and deserve to benefit from growth, and that’s something we should come to expect at very low unemployment.
Here’s what you need to do, in my humble opinion. Take your bloodshot eyes off the blood-soaked stock ticker and turn them to inflation indicators. That’s the key variable right now. If it really does accelerate big-time — I’m not talking about going from around 1.5 to 2.5, which is what I’d expect and even welcome — but starts rising to rates a lot higher than that, then okay, get worried. That means the economy has reached its capacity and extra activity is not showing up in real stuff like jobs and wages but is just showing up in higher prices. That’s likely to take the Fed from brake-tapping to brake-slamming, and then I too will join you in high anxiety.
Until then, stay cool.