Wow. After a significant decline last Thursday and Friday, markets bounced back yesterday in a big way. What’s going on?
First, the decline
There have been a lot of reasons put forward for the decline. The announcement by the White House of tariffs on a range of Chinese goods has been one of the most popular. The Fed’s rate increase, along with its perceived more hawkish stance, is probably the second contender. Others include the possible effects of the most recent White House appointments, higher oil prices, and potential war with North Korea. In short, there are many reasons floating around out there.
Two takeaways here. First, none of the reasons above really has much to do with economics. Almost all revolve around politics. Even the Fed’s rate increase has more to do with changes in perception than actual policy. Second—and flowing from the Fed comment—what they really have in common is a change in perception about the future. Markets simply decided, collectively, that the future looked less bright and pushed stock prices down. Then, they changed their minds and pushed prices back up. The fundamentals didn’t actually change from Wednesday to Monday. What did change? The perception.
Confidence versus fundamentals
Markets are, in theory, priced on the fundamentals. Over time, corporate earnings generate economic value. So far, so good. But how much investors will pay for those earnings (i.e., the valuations) depends on how much confidence they have in the future, which in turn depends critically on how certain they are about how the future will play out. If you are playing with loaded dice, you will certainly be willing to make bigger bets.
A high degree of certainty not only pushes up valuations but also reduces volatility. After all, if the future is pretty well known, there is no reason for prices to bounce around. You can simply watch them rise as the fundamentals improve, as expected. This is just what we saw in 2017.
The problem is that, as prices and valuations go higher, the impact of fundamentals becomes smaller, and the impact of confidence and certainty becomes higher. The higher the price, the greater the level of confidence built in. Even small changes in that certainty can result in large changes in price.
Which brings us back to the past several days. One sign of a market that has gotten ahead of itself—where confidence is playing a much larger role than the fundamentals—is just this kind of volatility.
So, does the bounce matter?
What matters from the past two days is not the drop or the bounce because they are both saying exactly the same thing: markets don’t really believe in current prices. With no conviction, changes in mood (in this case, fueled by politics) can drive larger movements in stock prices, both down and up.
We’ve seen this before. The dot-com boom comes to mind, as does the housing boom of the mid-2000s. In both cases, the public mood simply took good fundamentals and drove prices well above those good fundamental levels. Once the confidence evaporated, so did the prices. Right now, while price levels of the S&P 500 are below the levels of the dot-com boom, they are above those of 2007. There is a lot of confidence in today’s prices.
What should we expect?
As confidence waxes and wanes, we can expect to see prices move with it—just as we did over the past days. When something worrisome comes up (in this case, tariffs), confidence may subside, only to bounce back as confidence returns (in this case, on the expectation that the tariffs were only a negotiating tactic).
This works as long as confidence is high and rising, which is why changes in confidence are a key indicator of economic and market risks. The fact is, however, that a market based on confidence is likely to be more unstable and risky than one based on fundamentals—which is exactly what we have just seen.