We’re Already Experiencing a Stock Market Correction
The Dow Jones Industrial Average (DJIA) may have rebounded, posting a record-breaking session on Wall Street, but how long can stocks maintain this pace? It seems not long at all. Stocks reversed the bullish streak seen on March 26. The glimpse of optimism, resulting from the announcement that Washington and Beijing have started to talk again, has not been able to mask the fact that a stock market correction is already happening. The bull appears to have ended its run, and the bear is knocking.
The Dow Jones managed to reverse the bearish winds that have been hovering for some time. Investors seem eager to find and hang on to any piece of good news. They know that the risks to the U.S. economy go beyond the latest problem.
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Investors all over the world had sensed, perhaps even at the height of the bull run that culminated last January, that a stock market correction was due. The optimism that drove the DJIA to a few hundred points shy of 27,000 may have been misplaced after all.
What Drives Markets Up or Down Is Not Often Clear
The factors affecting the markets, up or down, aren’t always clear. Econometricians and financial analysts try to use fancy formulas to predict behavior. But, that’s the problem. They always have to “assume” this or that variable. Market sentiment is far more psychological and intractable than to lend itself to easy predictions. Nevertheless, investors detected a favorable turn when Washington and Beijing announced that they would possibly re-engage over trade talks. (Source: “Dow Gains 669 Points Amid Reported Trade Talks With China,” NPR, March 26, 2018.)
Note, the operative term is “reported trade talks.” They haven’t happened yet. And President Donald Trump’s tariff threats from the previous week against China stand. The oil price, which has often been a better indicator of investors’ long-term sentiment and degree of risk aversion, tells a different tale than the Dow. Even after a slight dip, oil remains above $65.00 a barrel, which is the highest price in recent years.
Risk Aversion Is Up
The other barometer of risk aversion is the gold price. The recent gains only confirm the risk picture that has been put into focus. Investors sense that a market correction is inevitable. Some are still hanging on for the prospect of better-than-expected corporate earnings. But even if some key earnings are good, the valuations are so high that stock prices already reflect those gains. Deutsche Bank AG (NYSE:DB) has openly spoken of a change of narrative in the markets. (Source: “Deutsche: “We Are Entering An Environment Where Everything Wants To Sell Off”,” Zero Hedge, March 25, 2018.)
The market narrative that I see changing—toward a bearish market—might be summed up by a simple concept: the rediscovery of risk. Some traders and investors may have noticed the baffling tendency of stocks to move (especially higher) because of tweets. A tweet from President Trump can push up or drag down the markets by several hundred points. After all, that’s what has happened in a series of tumultuous market sessions.
Surely, that should not be enough information to determine the course of stocks. 2017 was a year when investors ignored all kinds of risks—until January 26, 2018, when the Dow hit closed at a record of 26,616 points. Before that, there was a seeming immunity of the Dow to react to even the most serious geopolitical events
After January, especially in the first half of March, investors rediscovered the concept of “external risk.”
And risks are accumulating on all fronts. For every favorable “resumption of trade talks” story, there are others that cause worry. Trump has thrown a major curve ball into his longer-term strategy. He has shuffled his cabinet, replacing the doves with war hawks. Defense spending appears slated for a boost. But the tax cuts that so contributed to boosting the Dow’s performance could become the Achilles’ heel of the U.S. economy.
What Else Is Coming?
After the wild ups and downs of the past few weeks, investors are asking themselves: “What else is coming?” In other words, uncertainty is rising. Trump’s strategy of always having people guessing may work for a while—and during business negotiations. But, just like the poker player who bluffs too often, eventually, the jig is up. And that’s what many investors are probably sensing now.
There’s no doubt that the market trend has been characterized by a level of turbulence not seen in years. Yes, we are still near record highs, but the bull market—to be called as such—must keep on growing. It must also offer more certainty.
It’s going to be difficult for investors to adjust to that fact after the same mechanism, which has pushed the S&P 500 at a steady pace for almost nine years, has broken. It’s as if a bird suddenly discovered that its wings no longer beat gravity.
The longer the markets stay in the current limbo of volatility, the higher the chances of a major correction. That’s because even the most sanguine investors will be doubting their own judgment. They will lose sleep over the basic problem: Is the correction over or are there more losses ahead?
Some Optimists Will Fuel the Risk
Counter-intuitively, die-hard market optimists will contribute to the confusion. They will prolong the agony of uncertainty. Thus, even the surest of short-sellers will shy away from trades. The optimists will push the idea that the current market volatility is favorable. They will count the number of times the market indices support buying or holding, as opposed to selling. They will even believe—or try to persuade, in this sense—that, rather than a stock market correction, stocks are rebalancing themselves in search of stability.
Many of these remaining optimistic investors are probably not paying sufficient attention to important events occurring in the rest of the world. On March 4, Italy, Europe’s third-largest economy and a country on the front lines of the current refugee and migration crisis, went to the polls. The results were perhaps more confusing than expected. Right-wing populists and euro-skeptics dealt a major blow to the mainstream parties.
The European markets reacted strongly. But in Europe these days, elections are only part of the story. However badly the stock markets reacted to the shift to the right, the winners are still deciding how to split power and who shall lead the country. Another election might be needed if the winners can’t agree. Another election could produce a more extreme result, which could exacerbate divisions in the European Union (EU). If Wall Street hasn’t taken notice yet, it will soon enough.
The European Central Bank (ECB) will have to discuss monetary policy. So far, it has left the nominal interest rate at zero percent. The ECB is not yet confident that the recovery in Europe has reached stability. More stimulus is needed, but for how long will it be able to keep priming the economic pump?
The ECB’s American equivalent, the Federal Reserve, has been raising interest rates. But signals are to play it cooler than the new Chair Jerome Powell suggested. The economy is simply not performing as high as the GDP and job numbers suggested.
A political failure in Italy, forcing new elections, could trigger investors to consider the hard facts about the economy. They will then sell shares and force indices down.
Meanwhile, even if Trump has spared the EU from more tariffs, for now, observers are keeping alert. Fears of a possible trade war between the U.S. and the EU, not to mention one between the U.S. and China, will continue to fuel uncertainty. Trump’s tweets have already shifted from being innocuous to becoming reasons for worried stock investors to take flights to safety. Is it any wonder that the gold price has gained in the past few days?
In sum, we are entering a period of intense saber-rattling. This will trigger price movements and a strong stock market correction.
