The trading floor of the New York Stock Exchange (NYSE) in the age of the internet. Note all the computer monitors.
Wikimedia Commons / Ryan Lawler

In case you have not noticed, the American stock markets have been falling precipitously over the past two trading days. The action began last Friday when the Dow-Jones Industrial Index fell 666 points, or 2.5%. Then Monday, the Dow continued its descent by falling 1,175 points. At one point yesterday, its fall reached 1,597 points, but the market recovered part of this loss by its close. If the economy has been doing so much better over the past year, why is the stock market diving for the abyss? Is this a sign the economy is on the edge of collapse? What is going on?

Progressive Chicken Littles

You can expect  the Progressive-allied news media to seize on these market difficulties to suggest the neoliberal policies of Donald Trump and the Republicans are driving the economy into the ditch. The Left has certainly been predicting this since just after Trump was elected, beginning with the New York Times’ house Keynesian Paul Krugman.

Consider the progressive view found in the MSNBC video report below.

MSNBC believes the possibility of annual growth above 3.0 percent is ridiculous, since that has not been achievable since the Reagan and Clinton administrations. The first quarter of 2017, the last totally owned by the economic policies of the Obama administration, was at the typically low Obama-era level of 1.2%. The second and third quarters had growth of 3.1% and 3.2%, respectively, and the first estimate for the fourth quarter was 2.6%.

In my last post, American Economic Conditions Building Up Steam!, I showed the two factors holding U.S. growth below three percent in the fourth quarter were ephemeral and transient, not likely to be repeated. In fact, the economy shows every sign of building up a head of steam.

The MSNBC report also claimed Trump had inherited an already booming economy from Obama, which is patently ridiculous. Indeed, if you look closer at GDP growth in the period encompassing Obama’s last two years and Trump’s first year, you can begin to see how ridiculous a claim it is.

This data is consistent with the time behavior of the change in personal income less transfer payments.

It is also consistent with how real personal consumption expenditures have changed over time.

Rather than inheriting a booming economy from Obama, it is quite clear Trump inherited a steadily decaying economy. From the last three graphs, you should also observe this is a situation Trump is steadily improving.

MSNBC also declared what ordinary people really needed was higher wages and more jobs, which is impossible to dispute. However, they also claimed that helping American companies to make more profits and to keep more of those profits after taxes does nothing to achieve those goals, but instead only helps the top 10% in income. This position is a general progressive meme that gets repeated over and over again. Hearing this, one has to wonder just where progressives believe middle class jobs and income come from, let alone the wealth the middle class would like to purchase with their wages.

At least for a time, we can expect the progressive media to use the fall of the stock market and the decline in Q4 2017 GDP growth to bad-mouth Republican policies for reducing the tax burden — particularly for companies — and reducing the government regulatory burden. Only an extended period of GDP, job, and wage growth will shut them up. That is what they are likely to get in 2018.

What Really Is Happening

So the question still remains: Just why have the stock markets fallen so much? Paradoxically, the answer seems to be because we are entering more normal economic times and the economy is beginning to grow in a much healthier manner. Over the past eight years since November of 2008, the Federal Reserve has greatly distorted the economy by holding both short and long-term real interest rates (the interest rate minus the inflation rate) near zero with their Quantitative Easing (QE) and Zero Interest Rate Policy (ZIRP) programs. In addition, the effects of QE were unexpectedly slightly deflationary for various reasons. Throughout the period of recovery from the Great Recession and of the Fed’s use of QE to fire up (without success!) the economy, interest rates — particularly long-term interest rates — were held preternaturally low. During this period, the Fed created extraordinary long-term economic damage.

One of the side effects of these interest rate policies was to essentially destroy the attractiveness of bonds. If you wanted to invest in something, the stock market was one of the few alternatives. In addition, with close to zero real interest rates corporations discovered they could borrow essentially free money to buy back their own stock. What the Fed wanted companies to do was to borrow the free money and invest it to increase their productive capacity and then to increase the GDP. However, as long as the Federal government lessened corporate chances to make good profits through high taxes and onerous regulatory burdens, companies found buying back their own stock to be a much more attractive use of the borrowed “free” money. This is the major explanation for why the stock market stayed afloat during the barren Obama era, and why the bond market languished.

Now, the economy is beginning to stir again, and everyone is expecting inflationary pressures to re-emerge. This would cause the Federal Reserve to push up interest rates. That, in turn, would have two effects, both of which are deeply worrisome to the stock market. The first is that bonds would again become attractive as investments. How much of the stock market sell-off was due to people taking their profits from stocks to reinvest in bonds? Secondly, if the corporations can no longer borrow essentially free money, one could expect they would have less motivation for buying back their stock, removing one of the stock market’s props during the lean Obama years.

In addition, middle class wages  are beginning to rise again. Last Friday the Labor Department reported the U.S. economy added 200,000 jobs in January, with wages growing 2.9% over those a year earlier. This is the fastest pace in wage growth since June 2009. This is not a huge rate of increase, mind you, but it is still a welcome change from a very long period of stagnate wages. It also points to the possibility of reignited inflation and consequently higher interest rates.

Finally, a very long time has passed since the stock market has had a correction. As time passes and the stock market goes only upward, bad investments accumulate without discipline. At the same time the stock prices begin to rise relative to the company’s earnings per share, indicating stock prices are getting pricey. If you do an internet search on the long-term average to the price-to-earnings ratio (PE), you would find values anywhere from 15 to the low 20s depending on how the average was taken. I have most often seen values like 16 or 17. When I see a company with a PE bigger than 17, I automatically wonder if the profits returned by the stock are worth the price. Eventually, in this kind of environment, increasing numbers of investors begin to realize many stocks are priced beyond what they are worth. Increasing numbers then decide it is time to take their profits and sell their stock. In an age where computers keep close watch on the moves of stock prices, programmatic selling by institutions can change a loss of a few hundreds of points on the Dow to many hundreds in the blink of an eye.

The bottom line is that this multi-day stock market sell-off is a correction, not a crash. The economy is healthy, and getting healthier as larger numbers of companies increase their domestic investments, greater numbers of people find jobs, and as wages and personal consumption increase. In this kind of environment, falling stock prices and growing earnings will sooner rather than later create PE ratios to inspire investors to buy more stock. This stock market does not presage a recession.

NOTE: Today February 6, 2018, the Dow immediately plunged 567 points on opening, but by the end of the day the Dow ended with a mirror-image gain of 567 points.

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