Bear Down

Don’t say you weren’t warned. The combination of China’s disappointing growth, plunging commodity prices, the continuing malaise in the eurozone, worries about a rate increase from the Federal Reserve, and sky-high stock prices was always going to be a combustible mix for the world’s stock markets. So are the moves of the past couple of trading days just a necessary correction or the beginning of a bear market? And if it’s the latter, when will it end?

I’m always leery of trying to answer such questions definitively, but there are some indicators worth noting. The Nobel Prize winning economist Robert Shiller’s ratio of stock prices to long-term earnings in the United States has been higher than its historical average for most of the past two decades, thanks to low interest rates and great expectations for technology stocks. Because these two factors aren’t likely to change much anytime soon, I doubt share prices will sink enough to bring the ratio down to where it was in the 1980s and before; such a move would imply a long-term decline of about 40 percent in the markets.

Even by recent standards, though, the ratio has been especially high in the past year or two. A correction was therefore to be expected. As I write, the ratio is hovering around levels that it sustained for several years before the global financial crisis. If the underlying valuations of companies then were also a bit too high, we could well see another dip of the magnitude we saw today.

Foreign exchange markets initially reacted in predictable fashion. The dollar dropped against other major currencies in the hours before the American markets opened. Traders anticipated that lots of foreign investors would sell shares and move them into other markets. Because those investors would have to buy other currencies to do this, many more dollars would be looking for a home. But the dollar began to recover its losses as soon as the stock markets stabilized.

This suggests that the United States — which was not the proximal cause of the big dip in the markets, after all — may again become a safe haven. When the subprime mortgage bubble burst, the American economy was ground zero. This time, China is the epicenter of the earthquake in the markets, and the United States is merely seeing its vulnerabilities exposed via the interconnectedness of global markets.

But American economic fundamentals, including steady, if moderate, growth and relatively low unemployment, are still superior to those of most other large advanced economies right now. If investors seek safety in the United States, the inflows of new capital could leave American markets in better shape than those of Europe and Asia. Stocks respond to supply and demand, and demand might be on America’s side.

There’s just one problem with this pretty picture. Even if the United States fares better than its peers, it could still see its markets tumbling by, say, 20 percent in the short term because of the usual hysteria. This destruction of wealth on paper will have effects in the real economy. The natural impulse for companies, which we saw from 2000 to 2003 and 2008 to 2011, is to hunker down and wait for the storm to pass. They’ll be less likely to hire or pursue new investments, except perhaps in emerging markets where they have longstanding plans to expand. That steady growth, though moderate, could soon evaporate.

Can anything stop this process from occurring? Can the problem be solved at its source? It’s unlikely. The plummeting stock markets in China are like an uncontrollable fire. When the politicians in Beijing throw money at it, they’re just adding fuel; the only way to stop it is to let it burn itself out. That’s not Beijing’s modus operandi, though, so the tumult may continue for some time. Moreover, the disruptions that have already occurred in the market will keep resonating for days or weeks as traders pull back on risky assets to rebalance their portfolios.

It’s always a shame when short-term fluctuations in the stock market create long-term pain in the economy. Yet this is how our economy has worked, time and again. The risks I saw back in January are still present, and there’s little reason to believe that the current rout will reverse itself right away. Hunkering down doesn’t seem like such a bad plan.

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