What Was That?

Yesterday (Wednesday) the US stock market (as measured by the Dow Jones Industrial Average) was seemingly on its way to a 200 to 400 point decline when apparently the bulls left early for the day and the bears were left without anyone to sell to driving the market down 800 points at the market’s close.

A few of the more honest commentators on the market offered “I don’t know” to explain the decline but those commentators without the luxury of professing humility as a justification for their employment were left offering “rising interest rates”, “pending recession”, “tariffs” and “rising oil prices” as among the most popular of their explanations.

3% market declines are uncommon if not unusual. Since 1952 the market has experienced declines of that amount or more ninety-eight times, twenty times since the bear market bottom of March 8, 2009 and three times this year. In the fourteen instances of market declines of that severity that have occurred since 1952 on Wednesday the market has on average recovered roughly half of the one day decline in the following two trading days perhaps leaving us grateful that if such madness must occur at least it happened mid-week.

Portfolio profits year to date have been mired in low to middle single digits so it is understandable that something so long sought should now be so sorely missed. The second quarter covered the first quarter’s deficit leaving most investors near breakeven at the year’s midpoint. The third quarter continued where the second left off leaving those in love with larger numbers feeling reasonably hopeful about the year. Since the start of October the market is down 5% leaving it up 4% for the year but foreign market declines and modest declines in bond values leave most investors just about where they were when the year started. So what now?

Market declines are like crime scenes. They do leave clues if one knows where to look for them so assuming the role of Inspector Renault from “Casablanca” let’s trot out a number of the usual suspects.

First bond yields. They are rising albeit modestly (4/5 of 1% for the ten year US Treasury since the beginning of the year) but NOT because of rising inflationary expectations but rather because of increased optimism about future economic growth rates. The Federal Funds Rate, the rate which recently the Federal Reserve has been increasing at most of its quarterly meetings, is now equal to the inflation rate meaning that borrowers are no longer being paid to borrow short term but they are still able to borrow free on an inflation adjusted basis.

Second Credit Default Swap Spreads. This is the cost of insuring corporate debt against the risk of default. When the markets become concerned about the prospects of declining corporate earnings the rates typically rise. They aren’t. Neither those for investment grade or high yield corporate bonds. At fifty basis points (1/2 of 1%) rates on investment grade bonds are at their lows since the Global Financial Crisis of 2008-2009.

Third the value of the US Dollar. At its current level it is at the midpoint of the 10% range between its highs and lows for the past five years. While up roughly 5% in the past year its down 5% from its level of three years ago. If the Federal Reserve’s interest rate increases were causing significant problems for the remainder of the world one would expect to see much more dramatic changes in the value of our currency. We aren’t and so it isn’t.

Fourth. The price of gold and the return on 5 year TIPS (treasury inflation protected securities). Gold for the past two years has been trading within a 10% range and has recently declined several percentage points. TIPS yields have migrated from zero to 1% over that same span of time. Both indicate that the market’s appetite for risk has been modestly increasing. Gold prices typically rise when the real economy is viewed as containing within itself an increasing degree of risk. And it isn’t. TIPS yields are expected to decline when the markets seek safety at the expense of return. That they are rising reveals an increased appetite for risk on the part of the financial markets.

So there we have it. Perhaps you are left though still wondering why the market fell. I’ll offer an explanation though briefly so as to not overstay my visit. China. Not tariffs. That is a symptom rather than a cause. China for years has been a margin play and like all margin plays it works well as long as the return on the money being borrowed exceeds its cost. When it doesn’t, and it hasn’t in all likelihood since the Global Financial Crisis, the system goes in reverse. China is yesterday’s growth story. Not tomorrows. But this is a story for another day.


Mark H. Tekamp