Wall Street officially has the jitters. After a strong, long, steady five-year run, the stock market has entered something of an August slump. Predictions of a sell-off are cropping up, with Alan Greenspan talking about a “significant correction” and Henry Blodget warning of the possibility of an outright crash. Such prophecies, of course, have a way of becoming self-fulfilling. Some guy decides to move his portfolio into cash, just in case. Stocks decline. Some gal sees the market slumping, fears the good times are over, and moves her investments into cash, too. Wash, rinse, repeat, and watch the lather go down the drain.
Far be it from me to predict what the market is going to do. But it is worth contemplating why the market has suddenly gone soft and bulls have suddenly turned into bears.
Stocks are very expensive
Stocks are already very pricey by historical standards, a product of that long boom driven by loose monetary policy and high corporate profits. Valuations, in other words, seem to be getting out of line with fundamentals. Blodget does a good job going through the nitty-gritty here. But here are a few choice data points.
- We have hit a price-earnings ratio only seen before crashes, including the housing-finance bubble of 2007 and the dot-com bubble of 2000. That is according to a widely watched indicator developed by Nobel laureate Robert Shiller.
- Stocks are now worth about 125 percent of all economic output. The historical average is about 65 percent.
Maybe something is different this time. Maybe American companies are expecting more revenue from growing global markets. Maybe consolidation has reduced competition, allowing for higher profit margins for the foreseeable future. Maybe the falling cost of labor and the cheap cost of debt have set corporations up for an extended period of growth. But mean reversion is a powerful thing, and investors are starting to get nervous.
In a matter of months, the Federal Reserve will end its sweeping program of asset purchases. Once it was soaking up about $85 billion a month in Treasury debt and mortgage-backed securities. Now it is soaking up about $25 billion. Soon it will be soaking up nothing. And save for a significant slowdown in the recovery, the Fed looks set to start raising interest rates next year. Investors in the United States have plenty of clarity about the Fed’s actions and have been pricing in that tighter monetary policy for some time now. That alone goes some way to explain the chill in the markets. But on top of that, many investors expect the Fed taking the punch bowl away to introduce an element of uncertainty and volatility, with the potential for market gyrations not just in the United States, but also around the world. That could put a damper on investment.
Continued crummy growth
If this recovery were an absurdist play, it would be Waiting for Godot: Forecasters have consistently said that stronger growth is just around the corner, yet that stronger growth has consistently failed to show up. Here’s Binyamin Appelbaum on the ever-hopeful, ever-disappointed central bank forecasters: “In every year since 2008, Fed officials have steadily reduced their initial expectations for economic growth. In each year except 2012, they had still overestimated the strength of the economy in June of the forecast year.” The stock market has roared ahead throughout the sluggish recovery, but at some point, businesses need more customers to come through the door. Retailers are hurting. The housing market has cooled off. Wages are still — still! — stagnant. Those fundamentals are weighing on many companies’ profits, and thus on stocks.
It is overdue. Gravity always wins in the end. It cannot keep going on forever. At some point the market has to correct. This is the voodoo corollary of our first point. Investors simply believe that the good times have to end, and many believe that the Fed taking its foot off of the accelerator will mark a turning point.
Of course, there are a number of factors nudging stocks higher still. Corporate profits are high. Money is cheap. Companies are sitting on piles of cash. The economy is growing. Monetary policy remains loose. Moreover, there is no obvious place for investors looking to leave United States equities to turn — bonds are expensive, real estate is expensive, Europe is expensive, Japan is expensive. And stocks tend to be an excellent bet, particularly for longer-term investors.
But there’s just a feeling in the air that the boom might be nearing its end, in days or weeks or month. Don’t ask me to call a top, or to argue that a sell-off is any kind of fait accompli. But don’t be surprised if the headlines go negative.