You could probably talk to 100 people and get 100 different interpretations of the stock market volatility we’re seeing in real time. The market opened up 1% and then immediately fell to about even. The stock market is not the economy and really shouldn’t be seen as a barometer for the economy. The market went up for about two years at a time when unemployment was above 9%. Dean Baker argues that it’s now undervalued relative to corporate earnings. Both statements can be true – we’ve seen earnings rise as employment falls recently. But Baker is right that being bullish on the stock market bears no relation to being bullish on the economy:
If the profit share remains constant (it is now at a record high), then investors will be getting more than 9 cents in profits for every dollar invested today. That seems like a pretty good deal. If the stock price went nowhere and firms paid out 60 percent in dividends or share buybacks (roughly the historic average), that implies a return of 5.4 percent.
This is not bad when interest rates are near zero, but of course share prices are likely to rise over any long period at least in step with the rate of growth of profits. If the economy has a very weak 2 percent real growth rate, with 2 percent inflation, and profits keep pace, then then the return on stock will be 9.4 percent annually if stock prices grow in step with profit. There does not seem a lot of downside risk in this picture.
Of course the bad news is the flip side of this story. It would be nice to see workers getting back some of the ground that they lost to corporate profits over the last two decades. However, that doesn’t seem to be in the cards. This is bad news for bulk of the population that relies on their wages for the vast majority of their income, but it is good news for people who have lots of money invested in the stock market. So, why aren’t they happy?
You have animal spirits often driving market behavior, fluctuating on rumor or a bad feeling. There’s even speculation that one large hedge fund dumping stocks caused the entire sell-off yesterday.
Then there’s an entire other element to this that nobody is talking about – the Bank of America death watch, which has seen their stock plunge 34% in a week. BofA is a member of the Dow, so that alone would be a major problem for the main indice. And that has nothing to do with S&P or the debt limit deal, and everything to do with the fact that BofA’s Countrywide liabilities are catching up with them, and that they haven’t been able to manage a great escape. The Financial Stability Oversight Council, i.e. the systemic risk regulator, met about BofA overnight.
Finally, there’s the more mundane explanation, that Europe is about to blow up the world financial markets through a currency breakup or some other calamity.
I’m willing to believe that the markets feared that S&P’s debt downgrade would lead to more austerity and a weakened economy as a result, but that sounds entirely too rational.