How stocks react to the macroeconomy

By Felix Salmon
August 5, 2011
Mohamed El-Erian has the best explanation of what happened in the markets yesterday.

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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.


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So many points in this post…

* “Now none of these factors are exactly new”

Absolutely! Nothing substantive has changed over the last 2-3 weeks. If you weren’t selling then, you likely shouldn’t be selling now. (Though I don’t believe prices have fallen far enough yet for this to be a buyers market.)

* “Stocks rise slowly and steadily; they fall dramatically and with great violence.”

Technical trading? The term “stop loss” refers to a sell order that executes when stocks are already falling. This exacerbates swings on the downside. (You also see the converse sometimes, when short trading is prevalent, with a rise triggering cover orders.)

* “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.”

Yup. Except the phrase “double-dip recession” is obviously nonsense. We never finished the first recession — it was merely paused in its tracks by massive fiscal and monetary stimulus.

* “right now they’re cheaper than they were quite recently”

Right now they are still historically expensive, at least according to the Shiller P/E ratio. The market would need to fall another 20% to even achieve the historical norm (and a correction that size typically leads to an over-shoot).

* “only the very brave or the very idiotic attempt to time the market and do the buy-low-sell-high thing.”

I don’t attempt to time the market. That would be idiotic. But I *do* attempt to continually reassess the options available to me.

Back in 2007, the 20-year TIPS were promising a coupon in excess of 2%. I thought that was a respectable return for a low-risk investment, and bought a bunch. Today those same TIPS have a coupon under 0.75%. I’m pretty sure I can do better than that in other investments, and so sold them.

I’ve been selling stocks since October 2010 because the implied ten-year returns have been below what I can get by paying down a 4.5% mortgage (even accounting for tax benefits). That isn’t market timing, that is common sense.

Stocks are still the best investment out there, and I bought a little earlier this week (while selling TIPS), but they are still very expensive. If you invest today in the S&P index, you will be lucky to keep ahead of inflation over the next 5-10 years.

Posted by TFF | Report as abusive

I am also an admirer of Mohamed El-Erian, a rare investment professional who speaks common sense. Not a lot to disagree with in his post, which is a for-public-consumption version of what Paul Krugman and other left economists are saying.

But you’ve missed the main takeaway:

E-Erian writes: “Then there is the QE2 hangover…The Fed delivered higher asset prices but these did not translate into a sustained increase in economic activity. Rather than the economy legitimizing liquidity-induced price increases, the Fed-created gap between market valuations and economic fundamentals is now being closed through lower prices.”

Translation (and here PK would *not* agree): quantitative easing encouraged asset bubbles. End QE and sooner or later the asset bubbles deflate.

Re: stocks are cheap. Please look at the 10-year Dow. No, they’re not.

May I also say, Felix, that your definition of “technical factors” is tendentious to the point of misleading?

You write that “technical factors” are not “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 [sic.} to be huge.”

Translation (from El-Arian): “the disorderly across-the-board collapse in the price of risk assets in the final hour of trading and the related surge in U.S. Treasurys.” Re-translation: lots of investors got their money the hell out of risky stocks and into safe assets. Felix, we know “it just happened to be huge” because we looked at the Dow.

Posted by jbernar | Report as abusive

Makes me glad that I moved to 80% cash in mid-July when it became apparent that the debt ceiling debate was going to become a debacle!

Also keep in mind that this is the first correction of over 10% (I think) since the market bottomed and began its upward ascent in March 2009. After all, it doesn’t take a genius to see that with official unemployment at 9.2%, asset prices shouldn’t be at the same level they were when it was 4.5%.

Posted by mfw13 | Report as abusive

it’s all about global financial scenario, which made financial market more attractive. But, what we have thought about its underlying: world trade in goods and services? all debt can be solved, all the stocks can be valued at real price, if the existing scheme of global economy have place in every economy agent around the world. Please you all the smart financial expertise, use your moral. As our father Mr Smith propose: that invisible hands is driven by moral sentiment.
I am in Indonesia, and our stock market has down almost 5%, but we think it was a healthy correction. Don’t be over-reactive.

Posted by abidan | Report as abusive

All a bunch of rubbish! Our economy was trashed by the loose monetary policy of Greenspan which led the sheeple to ‘over exuberance’ and speculation which eventually had to unwind. Our unemployment problem is due to sub-brainful policies in Washington concerning the hoax of ‘globalization’ and the exportation of jobs. And the fiscal mess in Washington is due to reduced revenues due to the Bush tax codes favoring the wealthy (who don’t create jobs but instead export them), the cost of the useless wars (which are actually detrimental to our security as they create more enemies), and absurd social programs that only waste money on newly minted ‘victim’ classes. These problems cannot be solved by ‘monetary policy’ – which is only ‘pushing on a string’. Only knuckleheads could fail to grasp this.

Posted by Eric93 | Report as abusive

Another view:

Those that believe Paul Krugman is right (with fed rates at 0, it is insane to cut Fed spending right now, we need big stimulus) are selling.

Those that believe Grover Norquist (If we don’t raise taxes on “job creators” they will start creating jobs) are not buying.

More sellers than buyers = stock market going down.

Posted by gordo365 | Report as abusive

I guess if you think it is the Tea Party you simply don’t understand that financial control and good management – not Keynesian repeatedly failed experiments – lead to economic success.

Keynesian economics only works if you work in academia or the government.

Posted by eleno | Report as abusive

This has noting to do with Obama. It has to do with a longggg list of previous governments who overspent, simple as that.

Posted by Blackers | Report as abusive

Back in 2009 everybody was caught with their pants down. Now, everybody is acting in fear of the same thing. The Markets have become more about emotions than rules. Why? Because it is driven by POEPLE PERSCEPTIONs.

Posted by Fufi | Report as abusive

No, it has EVERYTHING to do with Obama. And the Tea Party. And the rest of the politicians who put ideology and the next election ahead of common sense and the good of the country.

When they caucus, do you really think they ask themselves, “What policies will help the country forward?” Or are they spending their efforts manufacturing disaster to try to make their political opponents look bad?

Anybody who supports EITHER party is part of the problem.

Posted by TFF | Report as abusive

Cash is King.

Posted by Fufi | Report as abusive

Calling a recession or depression:

There are a number of economic measures tht determine whether there is a recession. ONE of them is two quarters of decline in the Gross National PRoduct. Obviously, this is artificial since it could be one quarter or three or four.

Most economists have acknowledged for decades that the breakeven point for economic growth is somewhere in the range of three to five percent. Last year the Council of Economic Advisors – in the midst of a downturn – set the number at 2.75% without any specific justification. Even using this low number for breakeven growth, the United States has essentially been in recession since 2007.

What is a depression? Most say that a recession that lasts more than two years is a depression. Paul Krugman is right – the United States is in a depression. Some choose to ignor a Nobel Laurette in Economics and dismiss his unhappy evaluation as left-wing economics. What is that?

The point is that we’re having entirely the wrong discussions since their isn’t general acknowledgement by the pseudo debaters that we are in a depression. However, most Americans know we’re in a depression and investors are coming to the same realization.

If you compare housing or stock market prices at the beginning of 2007 and now, it is readily apparent that we have not come close to a recovery. If the DJIA was over 14,400 in early 2007 and it’s now below 12,000, maybe soon to be 11,000, that means we’re more than 20% below where we were four and a half years ago.

Our consumer-driven economy isn’t going to recover for years, now that one of its biggest sources of debt, the mortgage interest deduction – has been decimated.

What is being done to bring our economy above a 2.75% breakeven point in the GDP? Everything we can to lower it. The lunatics have taken over the asylum.

Posted by ptiffany | Report as abusive

All this because The biggies in the financial market are planning a new game and they are using this pretext to offload their positions post the fantastic run upto 13K.

Effectively Financial biggies are blackmailing governments
Obama is not in control of financial markets and neither oil which he himself has acknowledged.

Posted by _Raghunath | Report as abusive

Maybe it has something to do that in fact the U.S. gov PROMISED TO RECKLESSLY KEEP OVERSPENDING THE NEXT TEN YEARS.

Posted by FBreughel1 | Report as abusive

So how do we fix it? Recover the $2 Trillion in value lost over the last 2 weeks, $800 Billion just yesterday? That’s money straight of peoples 401K plans, pension plans, stock portfolios, etc. Would it be worth $750 Billion (less than yesterday’s loss) restore that $2 Trillion (and more) in market value to peoples accounts, put 5 million Americans back to work where they are paying taxes instead of drawing from government resources, provide businesses a way to lower costs to enter into and compete in the world market with American jobs?

Then please read Item #3 (Jobs) at

Using a program based upon that premise, we could (have) put 5 million people back to work in a matter of weeks or months; certainly before Christmas. They would be paying taxes instead of drawing government resources. They would begin consuming thus creating even more jobs. Businesses would have extremely competitive labor costs for the next few years allowing them to competitively establish themselves in emerging markets with American labor. Just the mention of implementing the program might bring the markets roaring back to recover the $2 Trillion recently lost, and more. All for a cost of $750 Billion, less than the original stimulus, less that even what was lost on the markets yesterday.

If we can’t get Congress to do it, perhaps creating an entity on Wall Street to do it would work. Would investors put invest $750 Billion (actually less for reasons explained in the referenced document) to get back their $2 Trillion the markets lost and probably more? Once their investment is expended, they can take the loss on their taxes, but would have regained the value of their other investments quickly, something that might not otherwise have happened.

Just think of where we would be today, had anybody actually listened to me back in February of 2009… Where would our economy be? Where would the world economy be? We certainly would not have needed to raise the debt ceiling yet! But that is past, this is now.

I wonder what an appropriate “finder’s fee” is for saving the world? :-)

Posted by showmerancher | Report as abusive

> So how do we fix it? Recover the $2 Trillion in value lost over the last 2 weeks, $800 Billion just yesterday?

“Recover”, or “re-transfer?” _America_ lost essentially no real wealth in a stock-market shift like Thursday’s (exactly how many factories were destroyed, pray tell?) although there was indeed some wealth redistribution from significant equity owners towards the rest of us.
Trying to sell your interesting economic plan by promising to give money back to the wealthy class, at the expense of yesterday’s beneficiaries, seems tactically unwise.

Posted by bxg6 | Report as abusive

The house always wins.

Posted by silliness | Report as abusive