Guest Contribution: “The February Stock Market Correction”

Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. This is an extended version of a column that appeared at Project Syndicate on February 22nd.

Much has been written about the stock market correction in the short time since the US market peaked on January 26 and abruptly fell 10 % (as of February 8, followed by a partial bounce-back). Some of what is said is useful, some is not. Three pronouncements concern advice to investors, the role of machines, and the connection to the real economy.

Is it time to sell?

First, how should an intelligent investor react? “Don’t be scared into selling stocks in reaction to a short-term plunge,” they say. “Think longer term.” They are right. That stocks fell in early February is not a reason to sell.
Rather, the reason to sell stocks is that they are too high in a longer term perspective. Prices are very elevated relative to fundamentals such as earnings. The Cyclically Adjusted Price Earnings, for example, is still at a level that has only been surpassed twice in the last century: the peaks just before the stock market crashes of 1929 and 2000-02, respectively. The implication is that the rate of return to stocks is likely to be substantially lower over the next 15 years than over the last 15 years.

When I suggest that investors should sell stocks, I refer to those who are fully invested in the stock market or, worse yet, have leveraged themselves to a position that is more than 100% into stocks. But of course an appropriately diversified portfolio will still have a large allocation to equities.

The uprising of the machines

A second declaration that one suddenly hears everywhere runs along the lines, “The market has been made more volatile because machines are taking over the trading.”

They say that algorithmic trading means that when stocks start to fall, computers kick in, selling more and driving the price down further. This can happen. And I am not one of those who believe that automated or high-speed trading accomplishes a useful social purpose. But neither do I think that it is necessarily destabilizing. Human beings are as likely to be stampeded into unwise decisions as are machines.
It all depends on how the algorithm is designed (which is ultimately done by humans, needless to say). A computer that has been instructed — whether directly or indirectly — to instantly “buy on the dip,” will generate demand for falling stocks and thus tend to stabilize prices, not destabilize them.

We have always had “stop-loss orders,” whereby an investor leaves instructions with his or her stock broker to sell if the price falls to a pre-specified level. They are de-stabilizing, in that they generate sell orders in response to an incipient price fall, thereby working to exacerbate the price fall. Or the investor can leave instructions to buy when the price falls to a certain pre-specified level, which is stabilizing. It doesn’t matter whether the order is executed by a human broker or a machine. What matters is whether the instruction is stabilizing or destabilizing.
If anything, perhaps when a human being programs a computer he or she is more likely to think about it calmly than when a human watches a plunge on his or her monitor in real time, susceptible to a sense of panic and to jumping on the bandwagon.
I make an exception for intra-day volatility. A flash crash such as occurred on May 6, 2010 – when the Dow Jones fell and rose over 1,000 points within 15 minutes – almost certainly would not have been possible without high-speed algorithmic trading. This sort of volatility matters to those who make their living by intra-day trading; but it is not clear why it should matter to the rest of us.

Wall Street vs. Main Street

One also encounters a third wisdom which goes, “The stock market is not the economy.” Yes, this one is very true. The market can crash while the economy is doing well, and vice versa. Three reasons.

For one thing, stock market busts (and booms) can be driven by rises (and falls) in interest rates, (respectively), which in turn are often the result of economic expansions (and recessions), respectively, rather than the other way around. The bits of news that seem to have precipitated the February market correction were reports of a strong job market in the US (hourly earnings up 2.9% in the year to January, announced February 2); inflation in the US, UK and some other countries; and correspondingly stronger anticipations of future increases in interest rates on the part of the Federal Reserve and the Bank of England. On February 7, the Bank of England announced that rates “could be tightened somewhat earlier and by a somewhat greater extent” than had previously been forecast. Inflation news in the US made it near-certain that the Fed will raise interest rates in March.

In the second place, there is a lot of randomness in the markets, including cases where market prices depart from economic fundamentals, as in true speculative bubbles. People buy because everyone else is buying, and then all sell at once when the bubble bursts. The “risk on” mood in financial markets last year comprised unnaturally low perceptions of future volatility. When the VIX hit all-time lows in 2017, it was not based on fundamentals. It was not hard to think of substantial risks that were lying in wait, such as the inflation-plus-interest-rate shock. But it was predictable that the VIX would not adjust until the shock materialized and securities prices fell from their heights. As of the third week of February, the VIX has indeed adjusted to more normal levels – the stock market correction having served as a useful “wake-up call” for complacent investors. But the securities prices themselves probably still have a substantial distance to fall. After all, the S&P 500 is still higher than it was in 2017.

In the third place, even in pure textbook theory, stock prices represent the profits accruing to corporations — current and expected future profits – not the income of all of us. In the past, there was a high correlation between profits and the economy because a relatively stable share of national income went to workers versus owners of capital. But that stability has broken down in the last decade or so. The share of GDP going to capital has increased remarkably, probably as a result of what economists call rents – increased monopoly power and decreased competition in many sectors. It is noteworthy that the markets are down from where they were after December’s Republican bill to slash corporate taxes. Some part of last year’s stock market boom may have been attributable to anticipation of the possible tax cut. If so, this reflected a policy that will almost certainly redistribute the pie away from labor and toward capital, more than it expands the size of the pie.

Still, having reminded ourselves that Wall Street is not Main Street, there are of course important connections between the stock market and the real economy. If the market goes down, consumption and investment spending fall: a household that holds stocks becomes less wealthy and so may cut back, while a corporation that had been considering building a factory may be less inclined to do so if it becomes harder to raise new capital.

One can’t predict when the next market plunge will occur or whether it will be coincide with the next recession. But one can predict that the unusually low financial and economic volatility of last year is over.

This post written by Jeffrey Frankel.

20 thoughts on “Guest Contribution: “The February Stock Market Correction”

  1. Ed Hanson.

    Ahh, the mystery of market timing.

    I could use all the help I can get, I am unsophisticated in matters of the market and am completely invested in the stock market through mutual funds, and at my age that is not the best of ideas But I am also caught in the where else problem because of the meager interest rates and the fight that the FED put up all these past years to keep them so.

    So I try to become less unsophisticated and google Cyclically Adjusted Price Earnings i.e. CAPE to read what others say. And what I read very much agrees with Jeffrey Frankel.

    Except that advise has been around quite awhile.:
    On June 22, 2015 Brian McCann at wrote Nazdaq .com that CAPE was at 26.7 and at that time among the top 10% readings of all time, The advise was similar, diversify into other asset classes beside US stocks Dow Jones Average that day 18119.78.

    On Fri, 24 Feb 2017 With the CAPE at 28.66, For his own part, (Robert) Shiller grants that “the CAPE ratio has been relatively high for 20 years now, so you might imagine that something has changed,” but added, “on the other hand, maybe not — it’s been a fairly reliable indicator.”
    “My general thought is that I think it’s quite reasonable to have an investment in U.S. stocks as part of a diversified portfolio,” Shiller said Thursday. “Just don’t go overboard on it.” Dow Jones Average that day 20821.76

    On Feb 23, 2018, the day after the Frankel article above the CAPE was 33.25. Dow Jones Average that day 25309.99

    I see a pattern. It made sense to follow the advice when DJA was 18119.78, when DJA was 20821.76, and now when DJA is 25309.99, but at what cost.

    I mean it when I ask for help.


    1. F

      CAPE is very bad at telling you exactly when to buy or sell. More importantly CAPE has undergone a shift recently that makes all the “it’s never been this high” stuff out-of-context.

      For the last 25 years, the average CAPE is 25. Today’s level: 28. Is that too high? You decide.

    2. Moses Herzog

      What you have said here shows you have the very lowest of financial educations—I have to tell you that you definitely are unsophisticated about market matters. You cannot tell us that you are “completely invested in the stock market” in one sentence, and in the very next sentence b*tch about low interest rates. Do you have ANY idea what would have happened to your stocks, if Bernanke or Yellen had raised rates, to say 5% in 2015, or even for the sake of your argument 4% in 2015?? Your mutual funds would have been clobbered, and not only clobbered, but clobbered to the point of shear mass market panic to the point “clobbered” would sound sweet. At that point decimated would have been the preferred descriptor.

      Had “The Fed” gone down that road of raising rates, as per your personal wishes, I’m not sure, even then, that you would have understood the reason your mutual funds would have been decimated. Unless, some CNBC J*ck *ff like Larry Kudlow or Jim Cramer spoonfed the reason to you. But I am 100% sure who you would have blamed.

      The base reason why Bernanke and Yellen kept rates low (in essence, by necessity) was to stop the stock market hemorrhaging that your best pal “W” Bush, Hank Paulson, and TBTF bankers had unleashed.

  2. pgl

    As I read this I was wondering what two people thought. Robert Shiller of course! But has Kevin DOW 36000 Hassett offered his analysis?

  3. Erik Poole

    Anon3: Would you say the same for Alan Greenspan who maintained the overnight rate at 1% for a long period following the September 11th blowback against the USA?

    1. pgl

      John Taylor who served in W’s reign is NOW saying he kept interest rates too low for too long. Taylor was not saying that when W was President. Anon3 reminds me of a gold bug troll over at Mark Thoma’s place named JohnH.

      1. Anon3

        pgl: Senator Kristen Gillibrand and other leftie womyn are NOW saying Bill Clinton is a serial sexual predator and that he should have been forced from office for using Monica Lewinsky, an intern in the WH, as his personal humidor. She and the other leftie womyn (like you) were NOT saying that when Willie was President. The left, especially trolls like you, always stand by their predator……. proving there is no hypocrisy like liberal hypocrisy.

        1. Moses Herzog

          @ Anon3
          Curious if Trump bragging about molesting women’s vaginas (as a married man) or Trump paying off porn girls he was committing adultery with bothers you at all ?? Or is it macho and manly when your mancrush Republican does it and “disgusting” when a Democrat does it?? How does that work for you exactly??

          I suppose you also think Roger Ailes and Bill O’Reilly should be beatified by the Catholic church this year??

        2. randomworker

          Looks like McConnell and Ryan are standing by their predator as well. You dont seem to mind.

          Btw, what does Bill Clinton have to do with anything in 2018 anyway? Have you lost track of time?

    2. Anon3

      Wrong., Greenspan didn’t maintain the Federal Funds rate at 1% for a long time. The economy was in recession in 2001, so the Fed steadily lowered the rate from 5% in Jan 2001 to around 1.7% by Jan 2002. It didn’t hit 1% until June 2003–almost 2 years after 9-11–and it remained at 1% until June 2004. One year is not a ‘long time’. By June 2005, the rate was back over 3% on its way to 5+% by June 2005. Sorta your typical counter-cyclical monetary policy..

      During Yellen’s tenure at the Board, by contrast, the rate remained well below 1%–about 1/4 of 1%–for nearly EIGHT years ……. crushing ordinary retired Americans who saw the return to savings plummeted to near zero. As the standard of living for retired Americans was under attack, we got nothing but “cheers for Obama” from sycophants like you. Obama did more than any President to crush the middle class. Sadly, he got a lot of help from that ‘true public servant’ Janet Yellen. Bernanke started the war on retired Americans, Yellen won it.

      1. pgl

        “Greenspan didn’t maintain the Federal Funds rate at 1% for a long time.”

        A distinction that makes no difference. You note that he lowered interest rates over this period. So interest rates were not a constant – so what? Erik’s point still stands. Your sad detailing of this does not address the question he asked you.

      2. pgl

        “During Yellen’s tenure at the Board, by contrast, the rate remained well below 1%–about 1/4 of 1%–for nearly EIGHT years”.

        Aha – the interest rate was not constant for this period either. Yes – it has been low for a long time. I guess you have no clue how deep and sustained the output gap was since the Great Recession! BTW – Bernanke was the FED chair for the 1st four years. I know – that is not all that relevant to this discussion but neither is your rants on this topic.

      3. 2slugbaits

        Anon3 A “war on retired Americans”??? Kind of over-the-top, isn’t it? To begin with, low interest rates were not just a US phenomenon, they were global. Secondly, the Fed was only setting the very short-run overnight rate, not the long-run rate. In fact, the Fed tried without much success to lower the long-run rate. Remember all those QE efforts? The Wicksellian clearing rate was strongly negative. Far from setting short-term rates too low, the central problem was that the Fed bumped up against the ZLB and couldn’t get them low enough. Interest rates should have been lower, not higher. That’s why we needed fiscal policy deficits. Third, those retirees that were already holding bonds or saving certificates that they bought before the Great Recession made out like bandits. The value of their bonds increased. Fourth, the value of other assets, such as their home, steadily increased due to low interest rates. Of all the people affected by the Great Recession, retirees were probably the one group that was least adversely affected by the Fed’s policies. But then again, that’s the same demographic that always whines about everything. The greedy geezers. The demographic that got hit the hardest was young working age families. They saw rising house prices, effectively negative interest rates on checking and savings accounts,and wage growth less than the CPI.

  4. Erik Poole

    Another way of looking at equity values suggests that high equity prices reflect low equity financing costs and lower equity prices reflect higher equity costs.

    The Obama era was marked by very low capital financing and borrowing costs. It will be interesting to observe to what extent those financial costs increase during the rest of the Trump mandate. If US real growth ever attains Trump’s 4% target, borrowing costs will likely ramp up. In the ideal preferred scenario, the US dollar drops due to increased investment flows going to Europe and emerging markets and offsets the higher real costs of capital.

    In the case of this recent mild correction, I suspect that two factors were at play. One, the market took a while to recognize and act upon increasing US 10-year yields and LIBOR rate increases in late 2017. Two, the expectations of the Trump tax cuts had already been built into share prices over 2017.

    All the belligerent trade war rhetoric may have also had a negative impact on investor perceptions but that could be me talking my policy book and looking well beyond the horizon of the typical fund manager.

    1. pgl

      “The Obama era was marked by very low capital financing and borrowing costs.”

      As interesting as Shiller’s metrics are, I wish he would adjust for this important fact.

  5. Moses Herzog

    I would put this blog post under the “yes I agree with most of this”. “This makes sense and rings true” category. But NOT terribly insightful. But still could be educational to those that rarely read I guess—but then again, what are the odds that someone who rarely reads comes to this blog site often?? Oh wait, I forgot PeakIgnorance visits here a lot. Maybe Peakignorance learned something today??

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