The Stock Market’s Dive Is Global and Rational

A trader works on the floor of the New York Stock Exchange on August 24, 2015.Photograph by Spencer Platt / Getty

In any stock-market dive, two questions immediately arise: How far will it go? And is it justified on the basis of economic fundamentals? Obviously, the two questions are connected, but they aren’t the same.

The only sensible answer to the first question is: “I don’t know.” As the late Paul Samuelson once observed, when a financial market starts falling sharply we move into the realm of the physics of landslides: things become complicated and unpredictable. In some cases, the market’s fall can feed on itself, as it did on Monday, October 19, 1987, when the Dow Jones Industrial Average fell 22.6 per cent. A computer-trading strategy known as “portfolio insurance”—which was originally designed to limit investors’ losses—generated huge sell orders in the futures market, which led to further losses on the New York Stock Exchange, which led to more selling in the futures market. And so on.

In other cases, the falling market reaches a resistance level, and buyers emerge to limit the losses. So far, this swoon, which began last week, looks to be of the benign type, with few signs of outright panic. On Friday, following sharp falls in overseas markets, the Dow fell more than five hundred points, or about 3.1 per cent. On Monday, it fell about a thousand points as soon as it opened, then regained about half of its losses and held on from there. It closed at 15,871.35, a fall of 3.6 per cent. In the course of the past week, it is down 9.5 per cent. That’s a big tumble, to be sure. But the market hasn’t seen a significant correction since 2011, and we were due for one.

Obviously, things could get worse. Whether they do or not depends on whether, in the next few days, the turmoil in the Chinese market continues and signs of financial distress emerge here at home—for example a big hedge fund or financial institution getting into trouble. Bull markets, such as the one Wall Street has enjoyed for the past six years, generate a great deal of risk-taking, which often involves using some hidden type of leverage to enhance returns. As Warren Buffett famously remarked, “Only when the tide goes out do you discover who’s been swimming naked.”

The answer to the second question I raised above, about economic fundamentals, is that the market’s fall is perfectly justified. In a sharp post on Sunday, my colleague James Surowiecki pointed out that stock prices have been rising steadily in relation to earnings. For a quite a while now, analysts who take seriously such valuation ratios as the price-to-earnings ratio and Tobin’s “q” ratio (which measures the price of investment assets relative to their replacement cost) have been warning about a crack in the market. Back in February, Andrew Smithers, a London-based analyst, warned that the U.S. market was trading seventy per cent above its fair value. In May, Bob Shiller, a well-known economist who teaches at Yale, said that there was a “bubble element” to the valuations present in the market.

As always, the issue is timing. Raging bull markets usually go on for longer than skeptics (such as myself) predict that they will, and they rarely end of their own accord. Sometimes, the precipitating event is the prospect or reality of the Federal Reserve deciding to raise interest rates. (That’s what happened in 1987 and 2000.) On other occasions, it takes some sort of shock, such as the collapse of Lehman Brothers, to set things off.

On this occasion, there was a surfeit of proximate causes. For one thing, the era of zero-per-cent interest rates and ultra-cheap money appears to be coming to an end. With G.D.P. growth picking up a bit after another slow start to the year, Wall Street expects the Fed to start raising rates either next month or in December. Then there is what’s happening in the developing world. It’s not just that the Chinese economy is slowing down and prompting the government in Beijing to take countervailing measures, such as trying (and so far failing) to prevent a stock-market bubble from bursting. Brazil is in terrible shape and may be headed for a financial crisis. The Russian economy, hit by sanctions and a collapsing oil price, is also in a slump. Of the original BRIC countries, only India looks to be in good shape.

Even in a country such as the United States, which has a relatively small trade sector compared to many other nations, a “hard landing” for the world economy would negatively impact G.D.P. growth. (Although the big fall in the oil price should offset this somewhat, by boosting consumers’ spending power.) And for U.S.-based multinational companies, which make up the bulk of the Dow and S&P 500, a sustained global slowdown could have a very large impact on revenues and profits. That alone probably justifies the trim applied to stock-market valuations in the past few days.

In short, the economic outlook has dimmed. Global stock markets, which had risen sharply during a prolonged period of easy money, needed to fall to reflect this new reality. That’s what’s happening now, and, given the way markets work, there is always the possibility that they will overshoot on the downside.