The question to ask about the movement in the markets so far this year is not why it is happening but why it took so long. Now that the Dow Jones industrial average has fallen through the 16,000 floor that has held over the past two years, the market will be testing new lows for months to come. That's not to say there won't be strong rallies as investors look to buy on the dips and analysts point to the fundamental strength of the American economy. But in the end, the market will be forced to reflect two big underlying realities. First, there has been a five-year bull market, with stock prices nearly tripling between the dark days of February 2009 and the market peak of February 2015. Long bull markets tend to make people complacent and overly optimistic about how high stock prices can climb and how deep the correction will be when it finally happens. You could see that optimism in the steady rise in the ratio of stock price to company earnings, which rose noticeably above historical averages. And you could see the froth, in particular, in the price of hot stocks in the technology sector, where some of the valuations of young companies in particular began to rival the absurdity of the late-1990s tech and telecom boom. READ MORE: • Why global woes and sinking stocks don't mean US recession • NZ shares open week sharply down The other shift involves the long-delayed correction of fundamental imbalances in the global economy that manifest themselves in prolonged and unsustainable trade deficits and surpluses, artificially low interest rates, misaligned currencies, real estate bubbles and inflated prices for commodities, stocks and other financial assets. The roots of these imbalances could be traced to the fall of communism, rapid globalisation, the arrival of the Internet, changing population trends and the rise of shareholder capitalism. They were also encouraged by financial deregulation, the mercantilist policies of China and other export-led economies, and the willingness of American and European consumers and taxpayers to live beyond their means.
What we're seeing now are the signs that the rebalancing has resumed.The financial crash of 2008 and the Great Recession resulted from these massive imbalances. But the dramatic actions taken by governments to prevent the markets from spinning out of control and restore the global economy to health, while both necessary and effective, also had the effect of delaying the needed corrections. What we're seeing now are the signs that the rebalancing has resumed. The Fed, for example, has now begun the long process of raising interest rates from zero to more-normal levels, which will affect the markets and the economy in all sorts of ways. It will dampen enthusiasm, for example, for the corporate mergers and debt-financed dividend payments that have pushed up stock prices, even as it nudges investors to move some of their money out of stocks and back into bonds. The prices of things bought with borrowed money - cars, homes, real estate - were inflated by the Fed's artificially low rates. Those prices and values will now fall as interest rates rise, resulting eventually in decreased sales and employment in those industries.
What would rebalancing look like in the United States? Less borrowing and consumption and more savings and investment.Just as significantly, it is slowing the growth in China's demand for raw materials, which has profound implications for the price of oil and other commodities and the economies of countries that rely on them, such as Brazil, Russia and Saudi Arabia. What would rebalancing look like in the United States? Less borrowing and consumption and more savings and investment. That would mean a decline in the dollar to dampen our appetite for imports and boost exports, and with them higher inflation. It would require state and federal governments cutting pensions and entitlements and raising taxes in order to restore levels of public investments and bring long-term budgets into balance.
The smart money guys at the hedge funds and Wall Street trading desks have known this day was coming for a while.It would be a mistake, however, to see this month's sell-off of stock prices as simply a reflection of these underlying economic realities. There are times - and this is one of them - when the stock market is driven more by the trading dynamics of emotional short-term speculators than the rational economic assessments of longer-term investors. The smart money guys at the hedge funds and Wall Street trading desks have known this day was coming for a while. They've been happy to trade the market up and down over the past two years as the Dow fluctuated between 16,000 and 18,000. See Bloomberg Video - Market deja vu?