Stocks Dropped 5 Percent: What Happened?

October 17 2018

The Dow Jones index suffered a steep decline last Tuesday. At the end of the week, stock markets closed at about five percent lower than at the start of October (yesterday, stocks have recovered a bit). Gold, in response to this recent stock market decline, rose by more than two percent, to a level exceeding $1,200 dollar per troy ounce. What is going on?

Trump’s Response to the Sudden Collapse of Stock Prices

American president Donald Trump, who earlier cited the stock market as “prove” of the fact that his policies are successful, instantly blamed the sudden collapse in stock prices to Fed Chair Jerome Powell, who of course was appointed by Trump himself only recently.

Powell raised interest rates earlier this month and expectations are still that, despite the public pressure of Trump on the central bank, the Fed will raise rates again in December. The fact that it is quite a stretch to blame the Fed for this sudden fall, should be apparent by the fact that expectations with regard to (future) rate hikes have remained unchanged over the past few months.

In addition to that, many other stock markets also suffered losses, and in many cases foreign stock markets suffered more severe losses than Americans stocks. For instance, the decline in Chinese stock prices, as evidenced by the Shanghai stock exchange, was of about the same magnitude as the decline in the United States. In general, many other Asian stock markets, as well as other emerging market exchanges, suffered a heavy blow. Even European stock markets were not exempted from the downside volatility and suffered declines.

Remarkable was, on a side note, the fact that technology stocks (which in many cases are even more overvalued than the general markets) did not share in the misery. But just as in earlier instances in the past, it could very well be that these stock market favorites will only suffer the consequences of a broader market correction at a later point.

A Stock Market Decline of 5 Percent: Of Any Importance?

Perhaps it is not even that remarkable that stocks fall, say, five percent. What should however raise our eyebrows, is how sudden the fall was. In less than two trading days, a considerable sum of total market capitalization was wiped away.

Was the recent fall of any importance? That remains to be the seen. It could be the start of a broader market correction, or it could mean a slight correction that is quickly followed by a recovery and stocks reaching new heights.

What is more important to realize, is the fact that the stock market is in a worse state than in 2007, just before one of the most severe market crashes in history. Whereas many think that it is impossible that a disaster such as the one in 2008 will repeat itself, stock prices are higher than on the eve of the crash ten years ago. And not just in absolute terms, but especially in terms of valuation. Today, we are paying a manifold higher premium over assets than was the case in, say, 2007.

What Was the Reason that Stocks Fell?

The current conditions should be – to anyone – very clear:

  1. A heavily overvalued (too expensive) stock market (+50%)
  2. A trade war which led to import tariffs that are gradually beginning to exercise an effect on markets
  3. A higher fiscal deficit under the Trump administration that must be financed on capital markets
  4. Increasing stress in the banking system, which is becoming evident from the flattening yield curve and increasing interest rates

Especially the trade war is interesting to highlight. The consequences of a large amount of import tariffs imposed on Chinese import products is gradually showing its ugly face.

Now I had the privilege of hearing Peter Thiel on this very subject last week.  Peter Thiel – well-known as (co)founder of PayPal and early investor in Facebook – is one of the advisors to the Trump administration that periodically meet in the White House. The controversial Thiel said that he understands the benefits of free trade, but that it makes little sense that a “poor Chinese peasant saves money to invest in low-yielding US Treasuries.”

While he might had a point in the past, the idea that a poor Chinese peasant saves money to invest in US Treasuries is something that might not apply to the actuality. The Chinese central bank – the People’s Bank of China (PBoC) – is not really adding to its foreign exchange reserves and even burns through reserves so now and then.

Moreover, Thiel forgot to mention that Trump’s policies are inherently contradictory: Trump raises the fiscal deficit, which then raises the trade deficit (as foreigners buy US Treasuries, which – of course – they are free to do), and then wants to reduce the trade deficit by imposing import tariffs. That amounts to pumping water from a ship with severe leaks, while punching an extra few holes in the hull of the ship.

The Nature of GDP Growth

Trump has of course, in recent months, insisted on getting all the credits with regard to recent economic growth, which topped 4% on two occasions. Now, the fact that growth is currently at four percent should not be surprising. Every country that is willing to run a 5% fiscal deficit (of GDP), can stimulate GDP growth.

Gross domestic product (GDP) is, after all, made up of about seventy percent consumptions. By both increasing current government expenditures (government consumption) with borrowed money (which, in turn, is financed by foreigners), any administration could quite easily raise GDP. This does not mean that public policy is good or bad, but rather that the short term is deemed more important than the long term.

Meanwhile, the Nowcast models of the New York and Atlanta Fed are in a disagreement about U.S. economic growth in the third quarter of this year: the NY Federal Reserve Nowcast is forecasting a disappointing GDP growth of 2.2%, whereas the Atlanta Fed is considerably more optimistic with a projected third quarter growth of 4.2% (again above that psychological 4%-barrier).

That 4.2% growth is, however, much more optimistic than even the most optimistic among U.S.-based analysts: the consensus points at a 3.2% growth. At any rate, the more pessimistic forecast by the New York Fed is interesting: if Trump’s growth miracle is losing steam so quickly, what should we expect for the remainder of the year?

The demand for oil confirms the image projected by the New York Fed’s Nowcast: oil prices came under pressure last week and declined, mostly because of lower demand and larger than expected build-ups of oil inventory. If economic growth was truly as strong and sustainable as Trump alleges, then oil prices would rise, not fall.

Taking all of the above observations at face value, we should expect more volatility on stock markets and therefore I am preparing – with my very own money – for the most important among “grey swans”: an eventual stock market crash.

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