Originally posted on World Policy Institute blog September 3, 2015 – Correction of What?
Stock markets worldwide registered heavy and, in some cases, unprecedented losses last week. They seem to have stabilized a bit this week, recovering from some but not all of the losses. What I find most annoying about the news coverage is the tendency to converge on the diagnosis of “correction.” This term does have a specific meaning, but in this case it is used so generically that we must ask, “correction of what?”
A correction in markets is a sharp short-term decline that is not persistent enough to be called a bear market. Calling last week’s events a correction is equivalent to saying this is a very temporary interruption in a long-term bull market. But is it? Since few pundits warned that a correction was due, we cannot accept with much confidence their prediction that this drop was merely a correction and not the start of something big. They just do not know.
Furthermore, much of the media followed the script that says all economic calamities have their root in China, the designated “problem country” (along with Iran) during the American election season now underway. Such blame casting was facilitated by China’s markets falling first and fastest among those around the world. Some even suggested a deliberate element to the plot, claiming China’s government imposed enormous losses on its own investors (including many government officials and their relatives), just to spite the U.S., as if this global crash were just another instance of Chinese muscle flexing.
This is, of course, absurd. China did not cause this stock market turmoil and in fact could not have prevented it, try as it did. China may be a trigger in a very tactical sense merely because Monday trading starts first in East Asia according to the arrangement of world time zones. Investors worldwide have a sense that markets are overvalued everywhere, so when the tumble started in Shanghai, as the sun rose farther West, investors assumed this could be a signal that stocks prices might be peaking worldwide.
China was not a trivial factor in this crash, because, for example, European markets fell especially hard in countries like Germany that are heavily dependent on exporting machinery and other productive equipment to China. But markets globally were ripe for a crash, regardless of whether bad news from China or somewhere else provided the tactical trigger that tipped expectations toward the bears. Some commentators correctly noted that the direct exposure of the U.S. economy to China is not so great, but since other major trading partners of the U.S., including Canada and Europe, depend heavily on exports to China, there are ripple effects that impact the U.S. as well.
There are, however, serious implications of the term “correction” that received little attention. If stock values now are “more correct” than they were two weeks ago, then stocks had become significantly overvalued worldwide, especially in China. In other words, a correction implies there was a worldwide stock bubble that needed correcting.
The notion that stock prices worldwide can be so out of line with fundamental values is not a comfortable idea for modern finance theory or neoclassical economics. Both of these assume market prices are highly accurate and dependable measures of value. If they can be so out-of-kilter that they require periodic corrections of such magnitude, then maybe markets in general are not as self-stabilizing and self-correcting as the textbooks suggest. This is a disquieting thought, so it is largely ignored in all the blather last week about this turmoil being a “mere” correction.
Why would stock markets be so out of whack lately? I reviewed the broad reasons in my last blog. The basic problem is a worldwide capital glut, which is most serious in places with the highest rates of capital formation, such as China. Added to this is the extremely high value of bonds in recent years (the flip side of low interest rates). If bonds are overvalued, then wealth flows from them into stocks, pushing up stock prices until they too are overvalued and must “correct.”
This may be one reason why Fed chair Janet Yellen keeps talking about raising interest rates, despite little evidence of inflation. Interest rates have in recent years been extraordinarily low, by far the lowest ever in world history. This is a worldwide phenomenon, too. Raising interest rates causes bond prices to fall, since lending at the highest interest rate becomes more attractive than holding a low-yield bond. As more and more bonds are sold, their prices fall and their yields (equivalent to interest rates) rise.
If owners of bonds expect their prices to fall, they may sell and shift their capital into stocks, reinvigorating stock markets. So it is conventional wisdom that in normal times falling stock prices lead to rising bond prices and vice versa. The recent fall of stock markets should be good news for bond markets, except that bonds are already at extremely high prices (thus low yields), especially relative to the very high levels of both public and private debt extant in the world today. By typical historical standards, bond prices should be falling now, not rising further.
But what happens when there seems to be slowing growth worldwide, along with deflation (falling prices) in many sectors? Then many companies will earn less profit. Lower profits tend to depress stock prices. Truly dire economic crises occur when prices of most assets are falling, in other words, in conditions of general deflation.
Falling prices always hit the most indebted countries and institutions hardest, because their incomes are going down but their debts, specified in fixed money terms, are not. That is a recipe for bankruptcy or default. Indeed, throughout history, one major “solution” to a condition of general capital glut is depression and widespread bankruptcy. Vast quantities of capital are eliminated as firms go out of business and financial assets fall in value, some to zero.
In this context, Janet Yellen’s persistent hints that the Fed will raise interest rates this year, perhaps this month, are scary to many. The worldwide capital glut has resulted in pumped up asset values in all asset classes, including real estate, stocks, and bonds. As each of these classes suffers a collapse of prices, investors shift to another class, stimulating a temporary boom in the favored asset class. But with each major crash, investors are more rattled. It is less and less clear where safety lies.
Some countries, including China, have temporarily stoked one market or another by encouraging investors to borrow more and thus leverage prices ever higher, but at a cost of piling onto already excessively high debt. Increased borrowing can indeed temporarily push up prices of whatever the borrowed money is spent on, but as debt ratchets up and up, eventually the bubble in debt itself, primarily a bubble in bonds, must crash. When it does, defaults and bankruptcies will proliferate. As I said in a recent blog, it is in this sense that the recent crisis in Greece may be a bellwether for the rest of the world. Such a broad correction of over-valued assets is a danger indeed.