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Are We Headed for a Longer Stock Market Crash? Lombardi Letter 2018-02-15 15:06:57 mini stock crash mini stock market crash. mini crash in stock market financial crisis artificial bull market trump tax cuts stock market correction flash crash The "flash-crash" or mini stock market crash was like a lightning bolt in a clear sky. At least it must have seemed so to many investors, who got used to the idea that stocks only go up. Nevertheless, we may be at the start of a deeper stock market correction. Analysis and Predictions,Inflation,News,Stock Market Crash,U.S. Economy https://www.lombardiletter.com/wp-content/uploads/2018/02/stockmarketcrash-1-150x150.jpg

Are We Headed for a Longer Stock Market Crash?

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Reasons for Mini Stock Market Crash Suggest That Longer Correction Is Coming

It’s not always the case, but, generally, the best thing we can do after enduring a bad experience like the recent stock market correction is to understand the reasons or conditions that created the problem.

A young fourth grader was upset when he did poorly on a test in school. It caused shame when he had to admit to his parents that his classmate got an “A” when he received a mere “D.” His valiant effort to give the episode an optimistic spin, noting that the classmate who got an “A” sat right next to him—therefore, he had almost received an “A”—failed to persuade.

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The sting of failure burned. But the boy used it, and remembered how much it hurt when the next test came up. He studied and got his “A.” Yes, I was the boy. And that was a true story that came to mind with the recent mini stock crash.

The “flash-crash” or mini stock market crash was like a lightning bolt flashing in a clear sky. Or at least it must have seemed so to many investors, who got used to the idea that stocks only go up. It’s not their fault. In 2017, the markets certainly gave off that impression. But the markets had been begging for a correction. They had risen on nothing but speculation, such that many stocks were overpriced. By overpriced, of course, I mean that the stocks’ values were too high in relation to their earnings. (Source: “U.S. stocks swing back to gains, Dow Jones up 330 on turbulent day,” The Toronto Star, February 9, 2018.)

The mini crash in the stock market, said to be the fastest ever, came merely two weeks after the Dow Jones set its all-time record high of 26,616 points. Many investors consoled themselves, pulling out every adage from their attics of bullish excuses. One of the best axioms suggests that the faster the crash, the faster the recovery. It’s an interesting premise, but markets are rarely that predictable. Therefore, there’s no telling if stocks will recover all their losses in the short term.

Investors Forced to Reconsider Their Confidence in Stocks

Two weeks after the mini stock crash, it appears as if many investors got burned enough to start using more common sense. The Dow Jones has made some gains after the correction, but it’s still at the same level it was at in early December 2017. That is, the Dow has not returned to the euphoric highs of January, which stemmed from the Donald Trump tax cut announcement.

The conclusion can only be that investors are currently less bullish. They’ve realized that the markets are more vulnerable now. Volatility has set in. It’s as if many investors have lost the confidence that the tax cuts had fueled.

Perhaps most Americans have realized that there is very little in it for them. It’s not just about stocks; the economy itself is causing uncertainty. After all, Amazon.com, Inc. (NASDAQ:AMZN), the most bullish stock on Wall Street—which almost doubled in a year—is laying off hundreds of workers. (Source: “Amazon lays off hundreds of employees,” CNN, February 12, 2018.)

Some Americans are probably feeling quite pleased about the tax cuts, but they’re a small minority. On average, American households will save $1,610 in taxes in 2018, according to the Tax Policy Center. But averages are made of extremes at both ends and, clearly, the richest Americans will gain far more than the lower (or even middle) classes. Those earning a million dollars or more can expect an average tax cut of $69,660. The average household—and we’re talking those earning respectable middle-class incomes of $50,000–$75,000—will see a tax cut of $870.00. (Source: “CHARTS: See How Much of GOP Tax Cuts Will Go To The Middle Class,” NPR, December 19, 2017.)

After the initial euphoria, the numbers suggest that nothing has changed. Just as with previous “trickle-down” economic experiments, there will be less money to fund healthcare and other benefits, leaving the money where it always seems to gravitate, in the accounts of the few. When Americans realize this, they may rethink their enthusiasm that led to Wall Street’s bullish ride. The stock market will become more, rather than less, exclusive.

Can We Draw Any Lessons from the Mini Stock Market Crash?

I doubt anyone is in the mood for lessons just yet, but the main lesson comes from the tax cuts. The tax cuts were seen as a boon until someone pointed out a word that we had almost forgotten: inflation. This reminds us of one of the key factors of volatility or odd market behavior. Sometimes investor “Mike” starts fearing what may seem like good news to the “average Joe.”

It seems clear that the trigger for the flash crash was the 2.9% wage increase for the average worker in the United States. The wage increase beat expectations. It should have pleased Americans, even if their wages dropped far more than that after the 2008 financial crisis, which forced workers to endure a decade without any wage increase whatsoever. In other words, higher wages were needed, and long overdue.

But Wall Street took this badly. The higher wages would push inflation higher and possibly faster than anyone expected. It’s off because Janet Yellen, the former Federal Reserve chair, had warned about the need to raise interest rates three years ago. Most people expected three interest rate hikes in 2018. Why the surprise now?

Perhaps, after the massive December rally and the tax cuts, investors conveniently forgot about interest rates. They forgot that the whole rally rests on the equivalent of free money. That’s the weakness.

Artificial Bull Market

Just like at a country and western roadhouse, investors have been riding an artificial bull. Almost interest-free money has artificially removed the concept of fear from investing, encouraging far riskier behavior than if there was a real cost to borrowing. Speculation has been rampant.

The central bankers wanted to soften the blow of what was the undeclared depression that started in 2008, by lowering interest rates. But doing so merely diverted investments from gold, silver, and other assets to more risky ones like equities and real estate.

This is the only reason why the market has risen continuously—recovering after every shock—in recent years. But the free-money train is screeching to a halt. Investors will have to do their homework and analysts will be thinking more cautiously before issuing their recommendations because the higher interest rates make losing on stocks more expensive. It will hurt more when the Dow drops.

It doesn’t just hurt investors. Higher interest rates will also affect the companies behind the stocks. Those with too much debt are exposed to more hazards. Their debts will grow and they won’t be able to survive.

Some will welcome the correction because it eliminates the weak, acting as a Darwinian restorer of balance. But the correction fans may want to contain their enthusiasm because it’s not clear where the market correction is going. It could be a temporary purge, but it could also be the trigger for a much more protracted plunge that could expose weaknesses in the overall global economy, activating another recession.

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