The Method in the Market’s Current Madness

After months of being stuck in a comfortable trading range, the U.S. stock market suddenly cracked.PHOTOGRAPH BY SPENCER PLATT / GETTY

Well, that was fast. After months of being stuck in a comfortable trading range, the U.S. stock market suddenly cracked, with the S&P 500 tumbling more than five per cent in two days, leaving the market, at close on Friday, 7.5 per cent below the all-time high it set back in May. The short-term reasons for the sell-off are easy to enumerate: the continued decline in oil prices; worries about a possible interest-rate hike by the Fed in September; and concerns about the struggles of emerging-market economies like Brazil, Malaysia, and, above all, China. And the selling frenzy on Friday was also undoubtedly exacerbated by traders’ obsession with so-called technical factors, like the fact that the S&P 500 had fallen below its two-hundred-day moving average on Thursday and hadn’t recovered by the end of the day. (Yes, this is the kind of thing that makes some people buy or sell stocks.) But behind all of these issues was something more fundamental: when stock valuations are high, even small changes in investors’ expectations about the future can have a big influence on stock prices in the present.

At first glance, it’s not obvious that the things investors are worried about will, in the short term, put a sizable dent in either the U.S. economy (which is doing as well as it has in a long time) or in corporate profits. Low oil prices are bad for the energy sector, but they’re great for U.S. consumers and the companies that serve them. Developing economies like Brazil’s and Mexico’s are certainly important markets for many American companies, but they still account for a relatively small percentage of corporate sales. And while China’s troubles are certainly a bigger deal, an economic slowdown there would, in the short run, have a devastating effect mainly on commodity sellers. The stock sell-off on Thursday and Friday, though, engulfed companies across the board, including firms that would seem to be relatively insulated from emerging-market trouble. It’s hard to see, for instance, how recession in Brazil or stagnation in China is going to materially damage next year’s earnings for companies like Amazon and Netflix. But Amazon’s stock fell seven per cent last week, while Netflix’s fell a remarkable seventeen per cent.

You could see this as evidence of the market’s irrationality—once investors panic, they dump everything overboard. And this undoubtedly explains some of what happened (as does investors’ desire to cash in on stocks that had been on a strong run). But in fact it makes sense that high fliers like Netflix and Amazon would be among the biggest victims of the sell-off, because their stock prices depend almost entirely on investors’ expectations about their performance over the very long term—a phenomenon I described in the magazine last week.

Amazon, for instance, isn’t worth two hundred and thirty billion dollars because of how much money investors think it will make over the next five years, but because of how much money investors think it will make over the next thirty, forty, or even fifty years. And over that long a stretch of time, even small changes in how fast a company grows can have very big economic consequences. The difference between growing, say, ten per cent a year and growing twelve per cent a year is trivial over a one-year span. But over a thirty-year span, it becomes surprisingly important. (A company that grows at an annual rate of twelve per cent will end up seventy per cent bigger than one that grows at an annual rate of ten per cent.) So when investor expectations shift even a little bit, or simply become more uncertain, highly priced stocks are often severely punished.

You can apply this same logic to today’s market as a whole. While the market is not, by any stretch of the imagination, outrageously priced, it is carrying a pretty rich valuation. Depending on whose numbers you trust, the S&P 500’s price-to-earnings ratio is somewhere between nineteen and twenty-one. In the simplest terms, that means investors are counting on companies to deliver steady earnings growth for many years to come. So anything that makes companies’ long-term earnings prospects look even a little bit shaky—like signs that China’s economy will never grow at seven per cent annually again—can lead to a sharp sell-off.

This is the real paradox of big market moves like the one we saw on Thursday and Friday: while they’re often seen as evidence of investors reacting to short-term news, they’re more likely to happen when the market has a very long time horizon. The price of a long-term perspective, in that sense, is sometimes short-term turmoil. And while it’s undoubtedly nerve-wracking to watch billions of dollars in stock-market wealth vanish in a matter of minutes, it’s actually a good thing that investors are testing their expectations against reality and re-setting prices accordingly. The danger going forward is that the sell-off will start to feed on itself, leading the market to overshoot on the downside. But at the moment, this looks like the kind of healthy correction we should periodically expect in a richly valued market.