The curious case of stock market plunge

This small essay was written a while back when the stock markets plunged in February for a moment and then climbed back to previous levels. It is in retrospect interesting to analyze long term effects of this event. It evoked a few thoughts about central banks’ policies, forward guidance and the behavior of different agents in the market economy. Time helps to evaluate events in a more subjective way and being a student of economic history July seems just far enough to come back to this essay.

There is always before economic recessions some indicator of the coming downturn. The slowing down of economic activity can in turn be the result of many different factors such as changing government or political development, rising labor costs or sometimes even from the lack of trust in economy. The recent abrupt change in the stock markets has led many to believe that the United States is on the verge of new recession. However, the plunge in stock markets is not indicating that there is something wrong with the current economy. Instead there are other reasons for the recent development.

The stock markets in general had been rising for over five years before the plunge (Financial markets abhor equilibrium, 2018). This can be seen from many stock market indexes such as Down Jones, the Nasdaq and the FTSE lists. The most commonly used index from these is Down Jones, which includes biggest industrial companies in the US but also some tech and media corporations such as Disney. The Nasdaq consists mainly of tech companies, including Apple, Microsoft and others. FTSE lists have the corresponding number of biggest companies from stock markets. Increases in these indexes means that their included corporations shares have risen. This rise has happened because stocks have been more appealing in recent years with major investors due to market volatility being relatively high after the financial crisis. Small returns on investments (RIO) resulting from this volatility channeled capital from other assets to stock markets. This accelerated the growth even more and made stocks further appealing. Important factor making RIO smaller in many assets other than stock markets, is central bank and its interest rates. Smaller interest rates make investing in loans and bonds less profitable. Therefore, stocks have been rising in many countries but especially in the US with big corporations.

At the start of February this growth stopped, and United States stock exchange plunged leading many to expect economic depression to follow. Investors losing their confidence in growth endangers economy to recession. As noted above, recession can result from this lack of confidence or as Keynes referred to this factor, animal spirits. In Keynes theory about the short-range development of economy, animal spirits are one defining factor at the start of recession. Mass hysteria that followed initial plunge in stock markets certainly has the characteristics of these lacking animal spirits. Stock market plunge might be therefore followed by a fall in real economy, most likely first in industrial sector. This development has certainly happened in the past with recessions in the 70s and 90s. Adding to the recession pro argument is the fact that the ongoing growth period has also lasted almost eight years, a couple of years longer than an average one from the 70s to 2000s (Financial markets abhor an equilibrium 2018). This situation would suggest that recession is more than expected. Although, the reason for recession is in many cases discovered afterwards. The effect of stock markets to general economy is also not straight forward. The growth generated by the capital movement can be argued to heat the economy and result  to recession in a few years. In this case however the plunge is not directly causing the recession and it is not the sole reason for it.

The overheating of economy, that is to say, too quick growth and high inflation, can be seen happening before most recessions. Stock market development will therefore lead eventually into recessions in a way. In this case it does not have any sudden real changes in the economy. Plunge can not be interpreted as a trigger for sudden crisis. This argument is even more convincing when contrasted to 2008 financial crisis, which was surprisingly sudden.

The reason for plunge and change in animal spirits is different from the previous growth periods. Considerable amount of stock market development is affected by the United States Federal Reserves, their central bank, policy. Specifically, the way they rise or lower the interest rates. As mentioned before, investments in loans and bonds is reduced by lower interest. Feds policy to raise interest rates gradually has created a contrary trend. Hence it is more lucrative to move assets from stocks to bonds. The sudden plunge in stock markets happened mainly because investors expected Fed to raise interest rates again in the first quarter of the year. This speculation created mass hysteria and lead to even many private investors to move their assets (How to interpret market plunge, 2018).

Capital flow from relatively stationary stocks to more liquid assets such as bonds indicates belief in economic growth not the start of recession. More liquid markets increase investments and create demand. Aggregate demand is one of the cornerstones in growth. In addition to this, stocks have not plunged permanently. As of 15.02.2018 a positive rise in many indexes can be seen, which indicates that initial general panic is fading. Feds policy to raise interest rates is not unusual during growth and is in accordance of the Taylor’s rule. This correlation means that the monetary policy is not expansionary nor restrictive. Fed only reacts to the growth with raising interest rates. If they expected recession to follow, they would lower the rates. That said, Fed should perhaps start to exercise more restrictive monetary policy to limit growth pace, the lower you fall the smaller the damage. Stock market plunge has shown that the public, that is corporations, banks and households, react to changes in monetary and fiscal policy more strongly. As a result, Fed and other central banks have to start considering the effect of their policies much more carefully. Even the interpreted intentions of the central bank are being taken into account by majority of agents in the markets. Forward guidance that most of these banks do is an effective way to avoid misunderstandings about the future policies.

Dow Jones Industrial Average, 02.01.-27.07.2018

Stock market plunge is not the indicator about recession, its effect is in fact contrary. Plunge might however mean that the business cycles are about to change in a more sensitive direction (Financial markets abhor equilibrium, 2018). In the future business cycles might react more vigorously to fiscal and monetary policy changes in addition to usual demand related changes (Financial markets abhor equilibrium, 2018).

In conclusion, investors and households should not worry about the plunge and fear that it might lead to recession because it does not. After the five moths of monitoring the situations these observations seem to be still relatively valid. The effects of this to the real economy are not easily identifiable. However it is clear from the different indexes that the stocks aren’t as attractive as they used to be. Again it is difficult to separate to what extent this was caused by the plunge and in turn the rising interest rates.


Financial markets abhor an equilibrium 09.02.2018, The Economist

How to interpret a market plunge 06.02.2018, The Economist

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