Yesterday (Thursday), the US stock markets were down, again, The main indices, namely the Dow Jones Industrial Average which contains only 30 large companies, and the S&P500 which contains a much broader range of 500 companies, were down for 6 of the last 8 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% from the most recent series of all-time highs which 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. Yet an 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 also think that the potential for a sudden, very large drop of the sort witnessed in October 1987, has grown significantly.
What lies 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 (p/e’s) which 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 wellbeing 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’ support.
If corporate profits are not fuelling share prices, then what is? The obvious answer, widely agreed to, 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 ‘quantative easing’ (QE) program and before the Bank of Japan launched its massive program of buying (even more) Japanese government bonds. 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.