How stocks react to the macroeconomy
Mohamed El-Erian has the best explanation of what happened in the markets yesterday. First and foremost, there were “technical factors”. This doesn’t mean lines on charts and head-and-shoulders patterns and similar astrological nonsense, but rather the dynamics of where investors’ money was being held and the amount that the market would fall given a modest downward nudge. Sometimes that number is tiny, but it can fluctuate a lot, and yesterday it just happened to be huge.
Then there are four long-term factors which conspired to give the markets their current bearish outlook.
First of all are concerns about a double-dip recession and broad weakness in the US economy; Floyd Norris has a good column on this today.
Secondly there’s the end of QE2, with no indication that QE3 might appear any time soon. In English, the Fed isn’t pumping money into the stock market and sending prices upwards any more.
Thirdly, there’s a distinct lack of faith that the federal government might be able to step in where the Fed fears to tread. Indeed, the base-case scenario at this point is that the government is going to make things worse rather than better. QE2, at heart, was a monetary response to a problem much better addressed with fiscal policy; right now we have no more help on the monetary side of things, and the fiscal response has been — astonishingly — to cut spending rather than raise it.
Finally, ever and always, there’s Europe:
By failing to act decisively, policymakers have allowed the Euro-zone’s crisis to morph from the outer periphery (Greece, Ireland and Portugal) to also include much larger (and, therefore, harder to solve) countries (Italy and Spain), as well as the continent’s banking system.
Now none of these factors are exactly new, which is why it feels a little bit silly to use them to explain a stock-market drop on Thursday August 4. They were there on Wednesday, they’re there today, and they’ll be there tomorrow too. I very much doubt that some large number of institutional money managers all woke up yesterday morning in synchronicity and decided that they were worried enough about US economic growth that they should sell a significant part of their stock portfolios.
But the stock market is far from efficient at reflecting economic expectations. Remember 2007, when we were in the midst of a brutal credit crunch, the housing market was imploding, and bond markets were all but frozen solid — the stock market continued to set new all-time highs. Stocks tend to lag bonds when it comes to pricing in macroeconomic pessimism, and when they do start pricing it in, they tend to do so violently. Stocks rise slowly and steadily; they fall dramatically and with great violence. Over the long term, the slow-and-steady tortoise wins the race. But in the short term, anybody who bought stocks in the past few weeks is very unhappy right now, and has no appetite to buy more.
It’s instructive to take a step back, here, and look what happened to stocks since that 2007 high. For about a year, they slid back slowly to roughly their current levels. Then, when Lehman Brothers collapsed, stocks imploded, and kept on falling through the first quarter of 2009. That violent sell-off was followed by a super-strong year-long recovery, to, again, roughly current levels.
Think about it this way: if the S&P is trading at around 1,200, that’s an indication that the economy is going to be reasonably healthy going forwards. Nothing special, but nothing disastrous either. We got ahead of ourselves in 2007 and fell to about 1,200. Then came the financial crisis, stocks plunged, and subsequently rebounded back to about 1,200. Over the past year or so we’ve traded at 1,200ish; momentum trading and QE2 helped to push us up, and now economic pessimism is pulling us back.
If you think that we really are going to enter a double-dip recession, then stocks are not remotely attractive at these levels: they have a ways further to fall. If you think that wise and proactive economic policy in the US and Europe can help prevent such a thing, then likewise it’s a good idea to stay on the sidelines right now: there’s no chance of that happening any time soon. On the other hand, if you genuinely believe that less government is better government and that the private sector, left to its own devices, will create jobs and economic growth, then maybe what you’re seeing right now is a buying opportunity.
For most of us, however, I can only reiterate that the volatile expectations market known as the the stock exchange is really nothing to get too excited about. Over the long term, stocks are a good place to place savings — and right now they’re cheaper than they were quite recently, which is good news for any long-term savers. In the short term, stocks are unpredictable and volatile, which means that only the very brave or the very idiotic attempt to time the market and do the buy-low-sell-high thing.
Every so often, we get reminded of that unpredictability and volatility with a massive stock-market swoon. It’s probably a helpful reminder, just so long as you don’t let it worry you too much. If you want to be really worried, look at the things we’ve known for ages: that unemployment is stubbornly high, that governments in both the US and Europe seem powerless to help, and that the entire developed world is burdened with far more debt than it can ever comfortably repay. It’s the global economy which matters, not the vagaries of intraday stock-market moves.