Happy days are here again—or are they? After falling by more than seven per cent from Friday through Monday, the U.S. stock market closed Tuesday’s trading session up 567.02 points, or 2.33 per cent, prompting some Wall Street analysts to declare that the big two-day sell-off had created a buying opportunity. In Washington, Steven Mnuchin, the Treasury Secretary, said, “I think the fundamentals are quite strong,” and that he was “not overly concerned about the market volatility.” He also suggested that Monday’s dramatic fall in the Dow Jones Industrial Average may have been spurred by computer algorithms, an explanation that Wall Street professionals now offer whenever they are dumbfounded by the market or determined to obfuscate what is really going on.
In reality, it’s pretty clear what has happened over the past few days, and what it portends. At a time when stocks are trading at extremely high levels, the reassuring narrative that has been used to justify their historic rise has been called into question. This upbeat story hasn’t been entirely discredited—if that had happened, the market wouldn’t have rebounded on Tuesday. But important issues have been raised, and they can’t be wished away.
One issue is valuation. Since the Great Recession ended, in the summer of 2009, the economy has been growing, and the stock market has generally been going up. For the past eighteen months, prior to last week, things have been basically unidirectional. Consequently, stocks were (and remain) very highly priced compared to earnings, dividends, and accounting values.
Even after the past few days, for example, companies in the S. & P. 500 are trading at about twenty-five times what they earned over the past twelve months. The historic average is about sixteen times earnings. The Yale economist Robert Shiller’s cyclically adjusted price-earnings ratio, which looks at earnings over the past ten years, shows a similar disparity. Shiller’s ratio now stands at about thirty-three. Since 1880, the only other occasions when it reached this level came in 1929 and 2000, both years in which the market crashed. To be sure, these figures don’t necessarily imply that we are heading for a repeat of those cataclysms. But, when markets are trading at extremely high levels, they are very sensitive to sudden changes in sentiment, and that is what we are now witnessing.
For several years, investors have been reassuring themselves that the domestic and global economy would grow fast enough to generate rapid growth in corporate earnings, but not fast enough to run into capacity constraints and generate inflation. Reviewing the buoyant asset markets of 2017, the Bank for International Settlements, the central banks’ central bank, pointed out, “This ‘Goldilocks’ environment easily saw off the impact of two devastating hurricanes in the United States, a number of geopolitical threats, and further steps taken by some of the major central banks towards a gradual removal of monetary accommodation.”
It’s an open question whether the bull market has stayed on track because a majority of sophisticated investors actually believed in the Goldilocks scenario, or whether these investors had merely convinced themselves that enough other people believed it. A dated but telling analogy is relevant here: Keynes, in his classic work “The General Theory of Employment, Interest, and Money,” compared investing to entering a newspaper beauty contest, where “each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.” In the investing game, participants tend to settle on a single economic scenario, or focal point, that they think most people will agree is the likeliest. “Before Friday,” Chris Dillow, a British economics blogger, noted on Tuesday, “the focal point was a belief that the US economy will grow nicely this year.” (In this sense, nicely meant without any inflation pickup.)
Whatever its basis was—genuine beliefs or Keynesian strategizing—acceptance of the Goldilocks scenario was virtually unchallenged. Stock prices, instead of bouncing around, as they usually do, basically went straight up. Late last year, the VIX, a commonly watched measure of market volatility, hit an all-time low.
On Friday and Monday, after the January employment report showed wage growth accelerating a bit, the VIX tripled. Over the past month, hourly wages rose by 2.9 per cent on an annualized basis. With news reports highlighting this figure, investors were forced to consider the possibility that inflation might start picking up, and that the Federal Reserve might, in response, accelerate its interest-rate hikes—something that had been ruled out in the Goldilocks scenario. Before long, the Dow was tanking.
Interestingly, this all happened despite the fact that, on closer inspection of the employment report, genuine signs of inflation were hard to spot. The 2.9 per cent figure for hourly wages was largely accounted for by gains among supervisory and non-production workers, who make up less than a fifth of the labor force. Everybody else’s wages didn’t rise any more rapidly than they did in December. Moreover, the estimate for supervisors and non-production workers has a large margin of error attached to it. “So there’s a good chance that what scared the market didn’t actually happen,” Ian Shepherdson, the chief economist at Pantheon Macroeconomics, pointed out on Twitter.
Quite possibly, next month’s employment report will show a smaller rise in hourly wages, and fears of inflation will recede, at least for a time. But with the unemployment rate at 4.1 per cent and economic growth accelerating, not just in the United States but in virtually all major advanced countries, it is hard to see the Goldilocks scenario regaining the level of acceptance it used to have. And that suggests that investors should brace for more volatility, whatever Mnuchin might say.
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