Stock Market Volatility a Sign of Things to Come
With the Dow Jones Industrial Average Index down 200 points (ca. 8%) and the S&P 500 down 10% from its peak last month, financial markets suffered their worst week since 2009. In what has been an astounding bull market, the majority of financial analysts are calling this a healthy correction on overheated asset prices. But has last week been a correction, or a sign of things to come? Another perspective offers a gloomier outlook: easy credit fueled by ludicrously low interest rates have inflated asset valuations far above their actual level, and the past week has merely been an indication of the coming crash and long-term bear market.
Leading up to the crash of 2008, the “dynamic duo” of Mr. Greenspan and Mr. Bush had simultaneously cut interest rates to 1% (an all- time low at the time) and started guaranteeing housing loans for US citizens. The combination of the two led to one of the worst financial crashes in history. Banks accepted all loan withdrawals as they had no risk, leading to unsustainable leverage. Banks then sold the risky loans as highly rated financial products, with the subprime mortgages inevitably being found out. The only way to solve the structural problems in the economy following such a disaster was to accept a deflationary period in which savings could be replenished to their required level, after which regular economic activity could ensue. Unsurprisingly however, this was not the case.
Since the recession of 2008, the United States and the Euro Zone have both tackled the crisis using extreme expansionary monetary policy. Interest rates have been slashed to 0% - a level never seen before in the history of banking – and quantitative easing has been a swanky phrase used to avoid announcing the printing of hundreds of millions of dollars and euros and pumping them into the economy. These policies, along with the bailing out of banks, have meant that the market has never been allowed to clear following the 2008 crisis. We are mimicking the very policies that led to the crisis, and then some, artificially inflating asset prices, despite the underlying fundamentals of the economy have yet to be fixed.
One of the most common metrics used to evaluate the level of asset prices is the price to earnings ratio. Borrowing from John Auter’s brilliant article in the Financial Times, a more accurate metric is a version of this ratio called Cyclically Adjusted P/E, which “compares prices to average inflation-adjusted earnings over the previous 10 years”. The current ratio, after last week’s drop, is 31.2, only slightly below the 32.56 it was just prior to the stock market crash of 1929. This indicates a huge overvaluation in the market, which, unfortunately, cannot be fixed by a mere “correction”.
The last week has thus not been a correction on a slightly overheated market. It is instead an indication of what is to come. Diabolical monetary policy in the United States and the Euro Zone has once again fooled the world that wealth and prosperity is being created. This couldn’t be further from the truth. A long overdue crash is coming soon. We can only pray that central bankers will learn from their never ending mistakes. Unfortunately, history indicates that they will not.
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