After the enormous, even unprecedented market corrections of the past several days, serious financial analysts are pulling out the big guns in an attempt to explain what is going on with Wall Street. I heard one describe it like this: “Everybody’s freaking out.”
Wow — please don’t get so technical on me. Then again, maybe a freak out is exactly what is happening. If that’s the case, how do those of us who choose not to freak out avoid doing so?
The markets of the past 50 years have been, and will continue to be, about one thing: growth. Companies whose earnings do not grow are penalized in the markets. Over the past 30 years, during which earnings growth hasn’t been stellar, market values have instead been driven by Federal Reserve-induced low interest rates leading to corporate share repurchase strategies and merger and acquisition activity. In just the past 22 years, the number of publicly traded companies has fallen by 46 percent.
The single most logical explanation for the rapid run-up in the Dow Jones Industrial Average over the past year is, quite simply, the Trump promise of a massive corporate tax cut enacted by Congress. Markets live on promises, and this was a big one. In fact, it’s already becoming known as the signature move by the current administration.
But promises have a way of not coming true. The tax cut, it appears, is settling into the investment world like last year’s hit action movie. It sold plenty of tickets back then, but we’ve changed a lot since the summer.
A year ago, the DJIA stood at 20,172. It peaked last week at 26,616, yielding a 31.95 percent return over that period. It closed on Feb. 5 at 24,345, a yield of 20.69 percent over one year ago. A simple stock pricing model shows that the impact of a corporate tax cut from 35 percent to 21 percent yields a one-time increase in equity values of 21.54 percent. So it could be argued that the market over-reacted to the impact of the tax cut, and that this past week has been no more than a simple correction of that exuberance.
But there is much more going on out there. Media reports claim that the markets are responding to renewed fears of inflation that will be met with additional interest rate increases by the Fed. The Fed, however, has been signaling rate increases for quite some time now, so it might be a bit surprising that the markets would adjust that drastically to the recent changes in the 10-year treasury rate, which has grown by 35 basis points over the past year. Such a growth in interest rates should result in a market correction of about 6 percent, yet recently we have seen much more than that.
So let’s go back to the idea of growth. In spite of record low interest rates over the past 20 years, overall economic expansion has been lackluster at best. The media point to rising wage growth as the most recent fuel adding to inflationary fears. But real wage growth is still somewhat flat. What you see in the labor markets is a mix — some sectors in which wages are growing rapidly (e.g., jobs involving information technology coding skills) and others in which wages are flat or even falling (most of the unskilled labor markets).
Examination of the five-year moving average core and overall inflation rates shows that both have been relatively unchanged since early 2016, and both are lower than they were prior to the credit market collapse of 2008. If this is the case, why the rush to increase interest rates?
There are two significant dangers to increasing rates right now, and investors with a long-term view may be responding accordingly. Rising rates will slow down borrowing and investment growth, especially in the housing markets. Rather than avoiding inflation, such a rate increase may lead to the unintended consequence of creating a deflation, which could flip the economy rapidly into recession or worse.
Rising rates also will increase debt costs to the federal government, which continues to rack up deficits and borrowing with reckless abandon. At the most recent count, the nation’s debt level is more than $20 trillion. Why is it that we see little or no concern about this? Have times really changed that much?
Lost in all of this discussion, too, is the fact that, more and more, the global economy can be best understood in the context of winner-take-all games. Tangible economic benefits accrue to an increasingly smaller segment of the population. This week’s winners in the market plunge appear to be the banks, which have yielded a windfall in fee income resulting from a higher number of trades during the current volatility. For them, it doesn’t matter whether things are getting better or worse, but only that investors think the times are changing.
Back to that little investor: What should she or he do when a bleary-eyed floor trader says “We’re all freaking out, man”?
Well, first thing: Don’t panic. Don’t freak out. But do consider what is driving these markets, and has been for a long time now. Wall Street has to change its ways. As a nation, we must get back to building and sustaining an economy that rewards actual growth — not consolidation. If your portfolio is heavy into mergers, you may be contributing to the problem. But take your time, and make moves to which the rules of common sense apply. If it looks like a freak out, it probably is.
Steve Isberg is an associate professor of finance and economics in the University of Baltimore’s Merrick School of Business. His email is firstname.lastname@example.org.