Just whether the sharp selloff of stocks signals an economic slowdown or recession is an open question. Most economists seem to think not. Strong job growth (2.7 million more payroll jobs in 2015) and low interest rates will sustain slow but steady growth.
Still, the dramatic stock market decline raises other possibilities. In the first two weeks of 2016, the market fell 8.7 percent, a paper loss of $2.1 trillion, says Wilshire Associates. It’s worth exploring the underlying causes.
Here’s a short list:
The stock market was overvalued. One standard measure of stock values is the price-to-earnings ratio, or PE. It compares the market’s average stock price with the earnings (profits). If a stock sells at $10 a share and has earnings of $1 a share, the PE is 10. By this indicator, the market was high. The average PE for the Standard & Poor’s 500 stock index – going back to 1935 – is 17, says S&P’s Howard Silverblatt. By contrast, the market’s PE was about 21 at the end of 2015, suggesting an overvaluation, by this measure, of nearly a quarter.
China is weakening global economic growth. Only a few years ago, China’s economy was growing 10 percent a year. Now, the official target for 2016 is 6.5 percent – a rapid rate compared with most countries but much less than had been expected. The upshot is that China’s appetite for raw materials (metals, foodstuffs, fuel) is also less than expected, resulting in surpluses of many commodities. Many “emerging market” producing countries (Brazil, South Africa, Indonesia) have been hit. Production and new investment have weakened.
Collapsing oil prices have likewise hit producers – both overseas and in the United States. Normally, lower oil prices are considered an economic stimulus, as consumers save money at the pump. But it’s unclear now how much of these savings are being spent. Meanwhile, oil companies are laying off workers and reducing exploration and development budgets. Abroad, producing nations that rely heavily on oil revenues for their budgets face pressures to cut spending.
The stronger dollar hurts U.S. companies. Over more than a year, the dollar has appreciated about 15 percent against foreign currencies, says economist Mark Zandi of Moody’s Analytics. Paradoxically, this weakens the U.S. economy: It makes American exports more expensive, while also reducing the conversion of foreign profits from local currencies into dollars. Zandi figures the dollar’s appreciation has cut the profits of the S&P 500 companies by 5 percent.
The open questions are how deep the stock selloff becomes and whether it causes nervous American consumers to trim their spending. The answers may depend on the profitability of U.S. firms. We are now starting “earnings season”: that quarterly ritual when major businesses report their latest profits. If profits exceed expectations, the selloff may abate or reverse. If not, hold onto your hats.