US Financial Market Drama: Much Ado About Nothing

This year started with a thud rather than a bang as financial markets across the globe saw major selloffs. Analysts liberally assigned the cause of the panic to fears about oil, fears about China, fears about terrorism, fears about deflation, fears about who knows what—perhaps fears about fears.

But whatever was driving the alarm appears to have faded. Major stock indexes have already regained much of the ground lost since the start of the year and interest rates on 10-year treasuries are heading back to the 2% mark. Hopefully, you were lucky enough to lock in a great rate on a ‘re-fi’ during the panic. If not, just wait, there will surely be another opportunity.

That prediction is based on the increase in the frequency of these sharp market downturns in recent years. This is the 4th time U.S. markets have seen a double-digit meltdown since the recession came to an end, including sharp sell-offs in 2010, 2011, last year, and now (I measure the sharpness of a market sell-off as the S&P 500 daily close relative to the high of the market over the previous 6 months. When the sell-off is more than 10% and lasts for more than one week, I count it as a major sell-off). This is unique in recent financial history.

Equity markets are always on the look out for the start of a downturn. Corporate profits are highly volatile and take a big hit when the economy tumbles. Because of this, a sell-off in the market is often viewed as a signal of the end of an expansion.

But the markets are not a great barometer of the economy. Economist Paul Samuelson famously quipped that the stock markets “had predicted nine out of the last five recessions.” Every recession comes with major sell-offs in equity markets and sharp declines in stock. But not every sell-off in the stock market necessarily occurs in concert with a recession. Far from being a perfect predictor of the economy’s direction, many times the market drop occurs when there is no slowing of the real economy at all. 

Samuelson’s observation had as much wisdom as wit. In the past, there has been roughly one false reading (a stock market sell off with no recession) per business cycle. Such sell-offs occurred in 2002, 1998, 1987, and 1978 as well as in the recessions of 2008, 2001, 1991, 1983, and 1975—exactly nine of the last five held through the ‘Great Recession’.

As noted, the current expansion—which started in late 2009—has already seen four such sell-offs. Why is the market so unstable this time around? There is no way to arrive at a definitive answer. It could be due to the new era of high speed trading, the slow pace of the U.S. economic recovery, or perhaps the movement of the markets to a new low interest rate/high asset value equilibrium. It could be due to some combination of all these factors, or for some reason we simply aren’t aware of.

What is important is to understand is that the stock market, never a good predictor of the onset of another recession, has now lost any credible predictive value. If you are worried about when the next recession is going to begin, your best bet is to stop paying attention to the market.