The Dow lost 8% of its value over the last two sessions. Analysts are scrambling for an explanation. Some say it’s because the S&P fell below the 50 day moving average. However, that’s not an explanation. It is like saying the market dropped because it collapsed. Others blame rising interest rates, which is also not very convincing. For the last year, we have known that rates were on their way up, and priced that expectation into stocks. Finally, some argue the decline is caused by the threat of inflation because wage rates increased notably. But inflation has been stuck in a rut for a decade, and it has not responded much to signs of growth. While inflation may increase some this time around, it is unlikely that it will accelerate. Still, there is something about these three factors that is important. Taken together, they point to uncertainty – the thing that investors hate the most.
Markets are a fantastic thing because they can adjust to almost any circumstance – except uncertainty. If governments slap on high taxes, investors will search for tax havens. If growth threatens markets by increasing inflation, investors will respond with variable instruments and hedges against the future. Finally, when investors are confronted with high-interest rates, they arbitrage their way through to profitability. In contrast, when investors face uncertainty, they clam up because they cannot predict the future.
The US economy is facing a wave of uncertainty from several directions.
- Reason one. Most people have the common sense to know that the record-breaking pace of stock market increases was unsustainable and had to end sooner or later, but they refused to pull back. Instead, we kept trying to squeeze a little more blood out of the turnip, just as we did during the housing bubble and the internet bubble before it. In all three cases, investors ran at the first sign of trouble.
- Reason two. The current economic expansion started in June of 2009. This means it has lasted four years longer than the average expansion of the post-World War II era. In the history of capitalism, no one has figured out how to avoid business cycle downturns. The abnormally low-interest rates supported by Federal Reserve gave added life to the expansion and a mountain of debt to the Fed’s balance sheet. We lived on borrowed time until the tax cut passed. It will add $1.5 trillion of debt. So it is easy to see why investors are panicked about rising interest rates. Financing this debt will make credit more costly to private investors because the government will get what it needs first.
- Reason three is the unpredictable behavior of the man in charge of the White House. No one can predict the actions of the President over a 24-hour Imagine trying to do so over three years! This style of governance is bad when markets are unstable. President Obama was elected because voters felt he could stabilize the market decline and manage the ship of State in times of distress. Today, investors are getting a heavy dose of unpredictability.
In times of chaos, markets need certainty and predictability. Unfortunately, both ingredients and in short supply. In the near term, the Dow may recover some of its losses. However, the economy has a serious long-term challenges.