As I wrote last month, I feared that the low volatility in August meant it was being stored up for September. That’s proving to be true so far, but it doesn’t mean the volatility is something to worry about, just that we’re seeing more bounces. And it doesn’t mean that we will see a more significant decline, at least not yet.
The key here is understanding what’s been driving the markets. There are two major factors the market has reacted to in recent years: (1) fundamental economic factors and (2) policy factors.
Fundamental factors are based on real results, like the economy, hiring, revenues, earnings—in other words, all the things that should determine stock prices (and usually do). Policy factors include government actions such as regulation, taxes, and (most important right now) interest rates.
Ordinarily, in a free-market economy, policy acts at the margin. Higher tax rates may affect companies and stock prices, but they’re not a primary determinant of where the market goes. Interest rates tend to have a more significant effect on markets—but again, at the margin. Historically, lower rates have benefited the stock market indirectly by stimulating real economic activity. Policy used to act through the fundamentals.
Since the crisis, this hasn’t been true. Over the past several years, markets have reacted directly to policy decisions, specifically those related to interest rates. We can see this most clearly in the disconnect between earnings and stock prices over the past several years. Although earnings have been dropping, stock prices have continued to increase, driving valuations to very high levels, which have been justified by low interest rates.
Stock prices right now are determined almost entirely by policy—which is to say, low interest rates—rather than by the fundamentals.
Over the past week, Federal Reserve members have sent out conflicting signals about what they plan to do at the September meeting. For the first time in quite a while, there was a real perception that a rate hike was in the offing. Economic news looked good, growth seemed to be accelerating, and Fed officials were talking up the chances of higher rates. Markets could see higher rates coming, but they could also see the fundamental improvement of the economy. A handoff from a policy-driven market to a more fundamentally focused one seemed quite possible.
Then the data hit. Business sentiment reports from the ISM were much weaker than expected, across the board. Other data disappointed as well. The acceleration of growth, the fundamental improvement, seemed to be significantly less likely than had been thought. At the same time, Fed officials kept talking about a rate increase. Instead of a smooth handoff, the markets then anticipated the worst—higher rates and a weaker economy—and dropped accordingly.
Yesterday, however, the final major commentary from a Fed official came in much more dovish than expected. All of a sudden, with the expectation of continued low rates, at least for a couple of months, the policy support for markets was there again, and stocks moved back up.
Today, we’re seeing them move down on the realization that even if rates don’t go up in September, they may well rise in December. The possibility of higher rates and a weaker economy is still very much present. Markets have to reconcile policy support against weak fundamentals, and, today at least, weak fundamentals are winning.
This might go on for at least the next week, as the Fed is now in a communication blackout period. They have no way to hint that rates are likely to remain low; in fact, they may not make that determination. If they do, however, it would point to the potential resumption of policy support for the markets—and, very possibly, another bounce back up.
On the other hand, more weak economic data, combined with the Fed’s expressed intent to maintain a posture tilted toward higher rates, could result in a more significant downturn. With the market now in doubt about policy support, and with fundamentals weaker than expected, we could see more of a pullback. But any pullback would probably be limited by the fact that the Fed is unlikely to do anything that will significantly hurt the markets. After all, policy signals can be reversed, as we've seen multiple times in past years when the markets start to tumble.
In the near term, then, volatility is likely to continue but to be limited by the Fed’s ongoing actions. Economic growth and inflation are not yet strong enough that the Fed will feel forced to act despite the consequences for the markets. Although that day is probably coming, it won’t be soon. I expect that the Fed will end up blinking if market turbulence gets bad, which should limit the volatility.