– February 25, 2020
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The 1,031 point drop in the Dow Jones Industrial Average yesterday came as a surprise to many investors and even regular market watchers, especially given the recent record close above 29,000. Yet while the drop was the third largest ever in absolute (point) terms, it only registers tenth by the more relevant, meaningful measure: percentage change for the day – just over -3.5%. By comparison, the October 22, 1987 stock market crash saw the index decline 508 points, nearly 23% in percentage terms.

Another way of gauging the relative severity of a decline in stock prices is to compare them against the regulatory criteria which triggers a halt in trading (“trading curbs” or “circuit breakers”). Although they have changed throughout the years, at present there are three tiers that would trigger a trading halt; they are calculated based upon changes in the S&P 500 index. The first is triggered at a 7% drop (generating a 15-minute pause); the second, at a 13% drop (causing a second 15-minute pause; and the last, at a 20% drop, which would halt trading for the rest of the day (unless the declines occur after 3:25pm EST). 

Comparing the magnitude of today’s decline to what the New York Stock Exchange itself views as justifying a brief halt in trading, it registered barely half of the decline to cause the first, 15-minute trading pause.

We should take a sober, dispassionate look at forces acting upon the U.S. financial markets. Headlines indicating a “panic” are vastly overwrought. The futures, which begin to trade outside of cash (regular) market hours, were already deeply negative as American traders began to arrive at their desks. On Monday morning when U.S. equity markets open, Asian markets have already closed (at roughly 2am EST) and various European equity markets have either just closed or are close to closing. 

Thus on Monday mornings, the U.S. market is the last to start trading in the new week and takes cues on the “size” of the down move (a three to four percent decrease, on average, in stock prices) from foreign market indices. Certainly individual companies – airlines, for example – see more severe and sometimes company-specific declines, but a look at the decline in foreign markets is usually instructive. 

From the perspective of the weekend news about the coronavirus, Asian and European markets provide strong indications of both price direction and magnitude of decline (gain) owing both to (a) their proximity to the unfolding crisis, and (b) the highly, indeed inextricably, intertwined nature of global markets. 

U.S. Treasury yields at various points came close to record lows – bond yields move in the opposite direction of their prices – as investors exiting equity markets sought liquid, low-risk assets to park funds in for awhile. (Gold, additionally, hit a seven-year high.)

Some of the market commentary hinted at an apocalyptic sentiment, reminiscent of the opening of apocalyptic horror films – the zombie and pandemic genres, specifically. It is a wholly irresponsible, indeed juvenile, perspective. We have seen this before, and came out none the worse for wear.

The sell-off has nothing whatsoever to do with concerns (much less, expectations) of an extinction-level event or some other such cataclysm, however entertaining those are to consider. Stocks – equities – are fundamentally units of title to aggregates of capital goods, and financial markets are the social machinery which serves to discount future earnings generated by those aggregates of capital goods. Thus in the most immediate, hysteric-free economic sense, equities were repriced today based upon a consensus expectation of lower earnings in the coming quarters. 

Among other valuation methods, one way (a “back-of-envelope” calculation) of determining how fairly priced a stock is has to do with a ratio between the equities price and per-share earnings for the most recent twelve months: the P/E ratio. Increasingly bad news regarding the spread of the coronavirus over the weekend (more cases, in more countries, despite quarantines and other restrictions) led to a swift repricing of Asian and European stocks late Sunday night and early Monday morning, respectively, and in turn to U.S.-listed companies. 

That is to say: investors sold stocks, lowering the numerator (“Price”) in anticipation – speculating – that the recent news about the coronavirus may give rise to more quarantines; more restrictive measures applied to the international movement of individuals, goods, and services; and most of all: additional uncertainty. 

And those changes, they believe, will negatively impact corporate earnings. Stock markets, they say, climb a wall of worry; “up a ladder, but down a slide (chute).” Declines in stock prices typically occur faster and deeper than the upward trudge, for several reasons which behavioral finance and other aspects of psychology touch upon. (Suffice it to say: to any investor, and even to corporate insiders, the body of all relevant information regarding a stock’s value is at every moment incomplete, unevenly distributed, and subject to instantaneous revision.)

As information trickles out regarding what China knew about the coronavirus, and as speculation about the aggravating effect of ongoing U.S.-China tariffs take shape, more volatility – repricings of stocks all over the world, reflective of both higher and lower expectations where future earnings and growth is concerned – is likely. The interconnected world in which we live, where today I can eat sweet potatoes, tomorrow I can read any of tens of millions of books from around the world, and all the while I’m buying more computer power for less money, works in no small part because of the financial markets’ ceaseless weighing and processing of new information. 

Via individual traders, large financial institutions, hedge funds, pension funds, and a host of other market participants, world equities markets are “saying:” the newest information we have makes the likelihood of the coronavirus negatively impacting corporate earnings greater. In anticipation of that, prices should come down such that valuations reflect lower earnings. It’s not guaranteed, and the next bits of information may result in a complete reversal of that perspective (with a subsequent rise in prices), but this is how it works. 

Various legendary investors (Benjamin Graham, Ron McEachern, Warren Buffett) have been credited with saying that in the short term equity markets are a voting machine, but in the long term they act as weighing machines (scales): in every moment of every trading session, the herd effects of a million fears and hopes are at work. But over the long term – years, decades, and generations – how the firm fares under various economic conditions, with changes of management, new technologies, and the like present an incrementally clearer view of the value of the firm and its prospects. 

An appreciation of markets, in particular free markets in financial instruments which on a tick-by-tick basis marshal and allocate capital on a global scale, requires respect for both the voting machine and the scale. 

Peter C. Earle

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Peter C. Earle is an economist and writer who joined AIER in 2018 and prior to that spent over 20 years as a trader and analyst in global financial markets on Wall Street. His research focuses on financial markets, monetary issues, and economic history. He has been quoted in the Wall Street Journal, Reuters, NPR, and in numerous other publications. Pete holds an MA in Applied Economics from American University, an MBA (Finance), and a BS in Engineering from the United States Military Academy at West Point. Follow him on Twitter.

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