On Thursday, the US stock markets were down, again.
The main indices,
namely the Dow Jones Industrial Average that contains only 30 large companies,
and the S&P 500 that contains a much broader range of 500 companies, were
down for six of the last eight days prior to yesterday, although the Nasdaq
Composite Index and some other indices focused on smaller companies have
displayed greater strength. But the bottom line is that American equity prices
have been soft for the last couple of weeks.
However, since the
cumulative decline of this soft patch has been very limited, amounting to 2-3
percent from the most recent series of all-time highs that the DJIA and S&P
hit in July and early August, and coming after a prolonged period of strength
stretching back almost a year, this soft patch does not seem to be something to
get excited about, much less a source of serious concern.
unusually large number of well-known analysts – not all of them dyed-in-the-wool
gloomsters – have recently been expressing exactly that – serious concern. Mark
Faber, to take one well-known example (never mind if you’ve never heard of him,
just google his recent appearances on CNBC and elsewhere), thinks that the
market will fall 20% by year’s end (he’s talking civil calendar, not Rosh
Hashana…). He and others think that the potential for a sudden, very large drop
of the sort witnessed in October 1987, has grown significantly.
behind this upsurge of concern and its allied intimations of doom? Three
separate, but connected, issues are usually cited as potential justification for
a fundamental change of direction in the stock market. The first is inherent to
the equity market itself – it is over-valued. The simplest way of establishing
that is by looking at price/earnings ratios that have risen considerably. That
means that higher prices are not being driven, on the whole, by rising corporate
profits – which would “justify” the higher prices, because share prices are
supposed to reflect the current and expected well-being of the companies they
represent. The most recent round of corporate quarterly results were anemic, at
best, and the surge in share prices during 2013 has little “fundamental”
If corporate profits are not fuelling share prices, then what
is? The obvious answer, widely agreed upon, is that the flood of liquidity being
poured into financial markets by central banks, primarily the Bank of Japan and
the US Federal Reserve, is what has provided investors of all stripes with the
means and incentive to buy riskier assets, starting with shares. By extension,
weakness in the share market – such as that seen in June and, apparently, again
now – stems from the threat that this ongoing flood of liquidity will be
staunched and perhaps terminated completely. The more real this threat seems and
the closer its realization is perceived to be, the more likely investors are to
take the hefty profits they have accumulated during the bull run and to exit the
share market before things turn sour.
The third factor weighing on the
equity market is neither theoretical nor potential. It is the very real and
ongoing fall in the prices of long-term bonds. This weakness in the bond market,
and the pursuant rise in bond yields, has been underway since last summer, i.e.
before the Fed increased its “quantitative easing” (QE) program and before the
Bank of Japan launched its massive program of buying (even more) Japanese
In plain language, QE is not working. It has not helped
much to stimulate the real economy, while the most critical area of the
financial economy, namely the bond market, has acted in the precisely opposite
manner to that sought by the Fed. To make matters worse, the bond market decline
has intensified recently – perhaps as part of the expectation that the Fed will
“taper,” or phase out, its bond purchases. The fall in the bond market and the
concomitant rise in long-term interest rates has already had a drastic impact on
the demand for mortgages, and if it continues, it will become an increasingly
negative influence over the real economy.
To hammer the message home,
long-term bonds tanked again yesterday and yields on both 10- and 30-year bonds
rose to new highs for this move. Monthly data showed that foreign investors –
primarily China and Japan – are selling short-term bonds, although they are
still buying longer-dated ones. The equity market has apparently finally realized
that it cannot continue forever upwards if bond prices keep going down.
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