The Lessons of Black Monday
When interpreting sharp drops in stock prices and their impact, many will think back to 2008 and the market turbulence surrounding Lehman Brothers’ bankruptcy filing. But a better historical precedent for current conditions is the huge one-day drop on October 19, 1987.
BERKELEY – US President Donald Trump has regularly pointed to the stock market as a source of validation of his administration’s economic program. But, while the Dow Jones Industrial Average (DJIA) has risen by roughly 30% since Trump’s inauguration, the extent to which the market’s rise was due to the president’s policies is uncertain. What is certain, as we have recently been reminded, is that what goes up can come down.
When interpreting sharp drops in stock prices and their impact, many will think back to 2008 and the market turbulence surrounding Lehman Brothers’ bankruptcy filing. But a better historical precedent for current conditions is Black Monday: October 19, 1987.
Black Monday was a big deal: the 22.6% price collapse is still the largest one-day percentage drop in the DJIA on record. The equivalent today would be – wait for it – 6,000 points on the Dow.
In addition, the 1987 crash occurred against the backdrop of monetary-policy tightening by the US Federal Reserve. Between January and October 1987, the Fed pushed up the effective federal funds rate by nearly 100 basis points, making it more expensive to borrow and purchase shares. In the run-up to October 2008, by contrast, interest rates fell sharply, reflecting a deteriorating economy. That is hardly the case now, of course, which makes 1987 the better analogy.
The 1987 crash also occurred in a period of dollar weakness. Late in the preceding week, Treasury Secretary James Baker made some remarks that were interpreted as a threat to devalue the dollar. Like current Treasury Secretary Steven Mnuchin at Davos this year, Baker could complain that his comments were taken out of context. But it is revealing that the sell-off on Black Monday began overseas, in countries likely to be adversely affected by a weak dollar, before spreading to the US.
Finally, algorithmic trading played a role. The algorithms in question, developed at the University of California, Berkeley, were known as “portfolio insurance.” Using computer modeling to optimize stock-to-cash ratios, portfolio insurance told investors to reduce the weight on stocks in falling markets as a way of limiting downside risk. These models thus encouraged investors to sell into a weak market, amplifying price swings.
Although the role of portfolio insurance is disputed, it’s hard to see how the market could have fallen by such a large amount without its influence. Twenty-first-century algorithmic trading may be more complex, but it, too, has unintended consequences, and it, too, can amplify volatility.
Despite all the drama on Wall Street in 1987, the impact on economic activity was muted. Consumer spending dropped sharply in October, owing to negative wealth effects and heightened uncertainty, but it quickly stabilized and recovered, while investment spending remained essentially unchanged.
What accounted for the limited fallout? First, the Fed, under its brand-new chairman, Alan Greenspan, loosened monetary policy, reassuring investors that the crash would not create serious liquidity problems. Market volatility declined, as did the associated uncertainty, buttressing consumer confidence.
Second, the crash did not destabilize systemically important financial institutions. The big money-center banks had used the five years since the outbreak of the Latin American debt crisis to strengthen their balance sheets. Although the Savings & Loan crisis continued to simmer, S&Ls were too small, even as a group, for their troubles to impact the economy significantly.
What, then, would be the effects of an analogous crash today? Currently, the US banking system looks sufficiently robust to absorb the strain. But we know that banks that are healthy when the market is rising can quickly fall sick when it reverses. Congressional moves to weaken the Dodd-Frank Act, relieving many banks of the requirement to undergo regular stress testing, suggest that this robust health shouldn’t be taken for granted.
Moreover, there is less room to cut interest rates today than in 1987, when the fed funds rate exceeded 6% and the prime rate charged by big banks was above 9%. To be sure, if the market fell sharply, the Fed would activate the “Greenspan-Bernanke Put,” providing large amounts of liquidity to distressed intermediaries. But whether Jay Powell’s Fed would respond as creatively as Bernanke’s in 2008 – providing “back-to-back” loans to non-member banks in distress, for example – is an open question.
Much will hinge, finally, on the president’s reaction. Will Trump respond like FDR in 1933, reassuring the public that the only thing we have to fear is fear itself? Or will he look for someone to blame for the collapse in his favorite economic indicator and lash out at the Democrats, foreign governments, and the Fed? A president who plays the blame game would only further aggravate the problem.
Is the Stock Market Loaded for Bear?
As 2018 progresses, business leaders and market participants should – and undoubtedly will – bear in mind that we are moving ever closer to the date when payment for today’s recovery will fall due. The capital market gyrations of recent days suggest that awareness of the inevitable reckoning is already beginning to dawn.
NEW YORK – In recent days, the initial New Year optimism of many investors may have been jolted by fears of an economic slowdown resulting from interest-rate hikes. But no one should be surprised if the current sharp fall in equity prices is followed by a swift return to bullishness, at least in the short term. Despite the recent slide, the mood supporting stocks remains out of sync with the caution expressed by political leaders.
Market participants could easily be forgiven for their early-year euphoria. After a solid 2017, key macroeconomic data – on unemployment, inflation, and consumer and business sentiment – as well as GDP forecasts all indicated that strong growth would continue in 2018.
The result – in the United States and across most major economies – has been a rare moment of optimism in the context of the last decade. For starters, the macro data are positively synchronized and inflation remains tame. Moreover, the International Monetary Fund’s recent upward revision of global growth data came at precisely the point in the cycle when the economy should be showing signs of slowing.
Moreover, stock markets’ record highs are no longer relying so much on loose monetary policy for support. Bullishness is underpinned by evidence of a notable uptick in capital investment. In the US, gross domestic private investment rose 5.1% year on year in the fourth quarter of 2017 and is nearly 90% higher than at the trough of the Great Recession, in the third quarter of 2009.
This is emblematic of a deeper resurgence in corporate spending – as witnessed in durable goods orders. New orders for US manufactured durable goods beat expectations, climbing 2.9% month on month to December 2017 and 1.7% in November.
Other data tell a similar story. In 2017, the US Federal Reserve’s Industrial Production and Capacity Utilization index recorded its largest calendar year gain since 2010, increasing 3.6%. In addition, US President Donald Trump’s reiteration of his pledge to seek $1.5 trillion in spending on infrastructure and public capital programs will further bolster market sentiment.
All of this bullishness will continue to stand in stark contrast to warnings by many world leaders. In just the last few weeks, German Chancellor Angela Merkel cautioned that the current international order is under threat. French President Emmanuel Macron noted that globalization is in the midst of a major crisis, and Canadian Prime Minister Justin Trudeau has stated that the unrest we see around the world is palpable and “isn’t going away.”
Whether or not the current correction reflects their fears, the politicians ultimately could be proved right. For one thing, geopolitical risk remains considerable. Bridgewater Associates’ Developed World Populism index surged to its highest point since the 1930s in 2017, factoring in populist movements in the US, the United Kingdom, Spain, France and Italy. So long as populism lingers as a political threat, the risk of reactionary protectionist trade policies and higher capital controls will remain heightened, and this could derail economic growth.
Meanwhile the market is mispricing perennial structural challenges, in particular mounting and unsustainable global debt and a dim fiscal outlook, particularly in the US, where the price of this recovery is a growing deficit. In other words, short-term economic gain is being supported by policies that threaten to sink the economy in the longer term.
The Congressional Budget Office, for example, has forecast that the US deficit is on course to triple over the next 30 years, from 2.9% of GDP in 2017 to 9.8% in 2047, “The prospect of such large and growing debt,” the CBO cautioned, “poses substantial risks for the nation and presents policymakers with significant challenges.”
The schism in outlook between business and political leaders is largely rooted in different time horizons. For the most part, CEOs, hemmed in by the short termism of stock markets, are focused on the next 12 months, whereas politicians are focusing on a more medium-term outlook.
As 2018 progresses, business leaders and market participants should – and undoubtedly will – bear in mind that we are moving ever closer to the date when payment for today’s recovery will fall due. The capital market gyrations of recent days suggest that awareness of that inevitable reckoning is already beginning to dawn.
The World’s Priciest Stock Market
It is impossible to pin down the full cause of the high price of the US stock market. That alone should remind all investors of the importance of diversification, and that the overall US stock market should not be given too much weight in a portfolio.
NEW HAVEN – The level of stock markets differs widely across countries. And right now, the United States is leading the world. What everyone wants to know is why – and whether its stock market’s current level is justified.
We can get a simple intuitive measure of the differences between countries by looking at price-earnings ratios. I have long advocated the cyclically adjusted price-earnings (CAPE) ratio that John Campbell (now at Harvard University) and I developed 30 years ago.
The CAPE ratio is the real (inflation-adjusted) price of a share divided by a ten-year average of real earnings per share. Barclays Bank in London compiles the CAPE ratios for 26 countries (I consult for Barclays on its products related to the CAPE ratio). As of December 29, the CAPE ratio is highest for the US.
Let’s consider what these ratios mean. Ownership of stock represents a long-term claim on a company’s earnings, which the company can pay to the owners of shares as dividends or reinvest to provide the shareholders more dividends in the future. A share in a company is not just a claim on next year’s earnings, or on earnings the year after that. Successful companies last for decades, even centuries.
So, to arrive at a valuation for a country’s stock market, we need to forecast the growth rate of earnings and dividends for an interval considerably longer than a year. We really want to know what the earnings will do over the next ten or 20 years. But how can one be confident of long-term forecasts of earnings growth across countries?
In pricing stock markets, people don’t seem to be relying on any good forecast of the next ten years’ earnings. They just seem to look at the past ten years, which are already done and gone, but also known and tangible.
But when Campbell and I studied earnings growth in the US with long historical data, we found that it has not been very amenable to extrapolation. Since 1881, the correlation of the past decade’s real earnings growth with the price-earnings ratio is a positive 0.32. But there is zero correlation between the CAPE ratio and the next ten years’ real earnings growth. And real earnings growth per share for the S&P Composite Stock Price Index over the previous ten years was negatively correlated (-17% since 1881) with real earnings growth over the subsequent ten years. That’s the opposite of momentum. It means that good news about earnings growth in the past decade is (slightly) bad news about earnings growth in the future.
Essentially the same sort of thing happens with US inflation and the bond market. One might think that long-term interest rates tend to be high when there is evidence that there will be higher inflation over the life of the bond, to compensate investors for the expected decline in the dollar’s purchasing power. Using data since 1913, when the consumer price index computed by the US Bureau of Labor Statistics starts, we find that the there is almost no correlation between long-term interest rates and ten-year inflation rates over succeeding decades. While positive, the correlation between one decade’s total inflation and the next decade’s total inflation is only 2%.
But bond markets act as if they think inflation can be extrapolated. Long-term interest rates tend to be high when the last decade’s inflation was high. US long-term bond yields, such as the ten-year Treasury yield, are highly positively correlated (70% since 1913) with the previous ten years’ inflation. But the correlation between the Treasury yield and the inflation rate over the next ten years is only 28%.
How can we square investors’ behavior with the famous assertion that it is hard to beat the market? Why haven’t growing reliance on data analytics and aggressive trading meant that, as markets become more efficient over time, all remaining opportunities to secure abnormal profits are competed away?
Economic theory, as exemplified by the work of Andrei Shleifer at Harvard and Robert Vishny of the University of Chicago, offers ample reason to expect that long-term investment opportunities will never be eliminated from markets, even when there are a lot of very smart people trading.
This brings us back to the mystery of what’s driving the US stock market higher than all others. It’s not the “Trump effect,” or the effect of the recent cut in the US corporate tax rate. After all, the US has pretty much had the world’s highest CAPE ratio ever since President Barack Obama’s second term began in 2013. Nor is extrapolation of rapid earnings growth a significant factor, given that the latest real earnings per share for the S&P index are only 6% above their peak about ten years earlier, before the 2008 financial crisis erupted.
Part of the reason for America’s world-beating CAPE ratio may be its higher rate of share repurchases, though share repurchases have become a global phenomenon. Higher CAPE ratios in the US may also reflect a stronger psychology of fear about the replacement of jobs by machines. The flip side of that fear, as I argued in the third edition of my book Irrational Exuberance, is a stronger desire to own capital in a free-market country with an association with computers.
The truth is that it is impossible to pin down the full cause of the high price of the US stock market. The lack of any clear justification for its high CAPE ratio should remind all investors of the importance of diversification, and that the overall US stock market should not be given too much weight in a portfolio.
The Illusions Driving Up US Asset Prices
Speculative markets have always been vulnerable to illusion, and in the US, two have been sustaining asset-price gains since November's presidential election. But seeing the folly in markets provides no clear advantage in forecasting outcomes, because changes in the force of an illusion are difficult to predict.
NEW HAVEN – Speculative markets have always been vulnerable to illusion. But seeing the folly in markets provides no clear advantage in forecasting outcomes, because changes in the force of the illusion are difficult to predict.
In the United States, two illusions have been important recently in financial markets. One is the carefully nurtured perception that President-elect Donald Trump is a business genius who can apply his deal-making skills to make America great again. The other is a naturally occurring illusion: the proximity of Dow 20,000. The Dow Jones Industrial Average has been above 19,000 since November, and countless news stories have focused on its flirtation with the 20,000 barrier – which might be crossed by the time this commentary is published. Whatever happens, Dow 20,000 will still have a psychological impact on markets.
Trump has never been clear and consistent about what he will do as president. Tax cuts are clearly on his agenda, and the stimulus could lead to higher asset prices. Lower corporate taxes are naturally supposed to lead to higher share prices, while cuts in personal income tax might lead to higher home prices (though possibly offset by other changes in the tax system).
But it is not just Trump’s proposed tax changes that plausibly affect market psychology. The US has never had a president like him. Not only is he an actor, like Ronald Reagan; he is also a motivational writer and speaker, a brand name in real estate, and a tough deal maker. If he ever reveals his financial information, or if his family is able to use his influence as president to improve its bottom line, he might even prove to be successful in business.
The closest we can come to Trump among former US presidents might be Calvin Coolidge, an extremely pro-business tax cutter. “The chief business of the American people is business,” Coolidge famously declared, while his treasury secretary, Andrew Mellon – one of America’s wealthiest men – advocated tax cuts for the rich, which would “trickle down” in benefits to the less fortunate.
The US economy during the Coolidge administration was very successful, but the boom ended badly in 1929, just after Coolidge stepped down, with the stock-market crash and the beginning of the Great Depression. During the 1930s, the 1920s were looked upon wistfully, but also as a time of fakery and cheating.
Of course, history is never destiny, and Coolidge is only one observation – hardly a solid basis for a forecast. Moreover, unlike Trump, both Coolidge and Mellon were levelheaded and temperate in their manner.
But add to the Trump effect all the attention paid to Dow 20,000, and we have the makings of a powerful illusion. On November 10, 2016, two days after Donald J. Trump was elected, the Dow Jones average hit a new record high – and has since set 16 more daily records, all trumpeted by news media.
That sounds like important news for Trump. In fact, the Dow had already hit nine record highs before the election, when Hillary Clinton was projected to win. In nominal terms, the Dow is up 70% from its peak in January 2000. On November 29, 2016, it was announced that the S&P/CoreLogic/Case-Shiller National Home Price Index (which I co-founded with my esteemed former colleague Karl E. Case, who died last July) reached a record high the previous September. The previous record was set more than ten years earlier, in July 2006.
But these numbers are illusory. The US has a national policy of overall inflation. The US Federal Reserve has set an inflation “objective” of 2% in terms of the personal consumption expenditure deflator. This means that all prices should tend to go up by about 2% per year, or 22% per decade.
The Dow is up only 19% in real (inflation-adjusted) terms since 2000. A 19% increase in 17 years is underwhelming, and the national home price index that Case and I created is still 16% below its 2006 peak in real terms. But hardly anyone focuses on these inflation-corrected numbers.
The Fed, like the world’s other central banks, is steadily debasing the currency, in order to create inflation. A Google Ngrams search of books shows that use of the term “inflation-targeting” began growing exponentially in the early 1990s, when the target was typically far below actual inflation. The idea that we actually want moderate positive inflation – “price stability,” not zero inflation – appears to have started to take shape in policy circles around the time of the 1990-1991 recession. Lawrence Summers argued that the public has an “irrational” resistance to the declining nominal wages that some would have to suffer in a zero-inflation regime.
Many people appear not to understand that inflation is a change in the units of measurement. Unfortunately, although the 2% inflation target is largely a feel-good policy, people tend to draw too much inspiration from it. Irving Fisher called this fixation on nominal price growth the “money illusion” in an eponymous 1928 book.
That doesn’t mean that we set new speculative-market records every day. Stock-price movements tend to approximate what economists call “random walks,” with prices reflecting small daily shocks that are about equally likely to be positive or negative. And random walks tend to go through long periods when they are well below their previous peak; the chance of setting a record soon is negligible, given how far prices would have to rise. But once they do reach a new record high, prices are far more likely to set additional records – probably not on consecutive days, but within a short interval.
In the US, the combination of Trump and a succession of new asset-price records – call it Trump-squared – has been sustaining the illusion underpinning current market optimism. For those who are not too stressed from having taken extreme positions in the markets, it will be interesting (if not profitable) to observe how the illusion morphs into a new perception – one that implies very different levels for speculative markets.
Giddy Markets and Grim Politics
Economists have endless debates about whether culture or institutions lie at the root of economic performance. But there is every reason to be concerned that the recent wave of populism is a threat to both.
CAMBRIDGE – Economic growth worldwide picked up in 2017, and the best guess is that the global economy will perform strongly in 2018 as well. At the same time, a rising tide of populism and authoritarianism poses a risk to the stable democratic institutions that underlie long-term growth. And yet headlines seeming to portend political instability and chaos have not prevented stock markets from soaring. What gives?
First, the good news. Surely the largest single factor in the synchronized global upswing is that the world economy is finally leaving behind the long shadow of the 2008 financial crisis. Part of today’s good fortune is payback for years of weak demand. And the rebound is not over, with business investment finally picking up after a decade of slack, thereby laying a foundation for faster growth and higher productivity gains in the future.
True, economic growth in China is slowing somewhat as authorities belatedly try to contain a credit bubble, but many other emerging markets – notably including India – are set to grow faster this year. Rising stock and housing markets may fuel inequality, but they also drive increased consumer spending.
Investors and policy wonks are also cheered by the resilience of central bank independence in the major economies. US President Donald Trump has not only largely spared the Federal Reserve the not-so-tender mercies of his wee-hour tweets; he has also nominated highly qualified individuals to fill Fed vacancies. Meanwhile, the German right has failed to pull the plug on European Central Bank policies that have helped prop up Italy, Spain, and Portugal, and the ECB remains by far the most respected and influential eurozone institution.
Elsewhere, things are pretty much the same. In the United Kingdom, British Prime Minister Theresa May, early in her tenure, once took a swipe at the Bank of England, but quickly retreated. As Mohamed A. El-Erian has noted, many investors regard central banks as “the only game in town,” and they are willing to overlook a lot of political noise as long as monetary-policy independence is upheld.
But while politics is not, at least for now, impeding global growth nearly as much as one might have thought, the long-run costs of political upheaval could be far more serious. First, post-2008 political divisiveness creates massive long-term policy uncertainty, as countries oscillate between governments of the left and the right.
For example, the recent US tax overhaul has been advertised as a surefire way to boost corporate spending on long-term investment projects. But will it live up to its billing if businesses fear that the legislation, passed by a thin partisan majority, will ultimately be reversed?
Part of the case for trying to secure bipartisan agreement on major long-term policy initiatives is precisely to ensure stability. And policy uncertainty in the United States is nothing compared to the UK, where businesses face the twin disruptions of Brexit and (potentially) a Labour government led by the far-left Jeremy Corbyn.
Harder to assess, but potentially far more insidious, is the erosion of public trust in core institutions in the advanced economies. Although economists have endless debates about whether culture or institutions lie at the root of economic performance, there is every reason to be concerned that the recent wave of populism is a threat to both.
Nowhere is this truer than in the US, where Trump has engaged in unrelenting attacks on institutions ranging from the mainstream media to the Federal Bureau of Investigation, not to mention adopting a rather cavalier attitude toward basic economic facts. At the same time, the left seems eager to portray anyone who substantively disagrees with its proposals as an enemy of the people, helping fuel both economic illiteracy and a hollowing out of the center.
Beyond existential risks, there are near-term risks. One, of course, is a potential sharp growth slowdown in China, which more than any other major economy in the world today seems vulnerable to a significant financial crisis. Perhaps the number one risk to the global economy in 2018, however, is anything that leads to a significant rise in real (inflation-adjusted) interest rates.
Low interest rates and easy monetary policy have papered over a multitude of financial vulnerabilities around the world, from Italian and Japanese government debt to high corporate dollar debt in many emerging markets, and perhaps account for political support for trillion-dollar deficits in the US. Admittedly, markets see little chance of any significant rise in global interest rates in 2018. Even if the Fed raises rates another four times in 2018, other major central banks are unlikely to match it.
But market confidence that interest rates will remain low is hardly a guarantee. A plausible pickup in business investment in the US and northern Europe, combined with a sudden slowdown in Asian economies with surplus savings, could in principle produce an outsize rise in global rates, jeopardizing today’s low borrowing costs, frothy stock markets, and subdued volatility. Then, suddenly, the economy’s seeming disconnect from politics might end, and not necessarily in a happy way.