In the perpetual struggle between bears and bulls-between fear and greed-fear suddenly seemed to be dominant in the worldwide volatility of the stock markets. But how scared should we be?
No one should have been surprised by Shanghai's 9 percent one-day sell-off. Shanghai surged an amazing 130 percent last year and 16 percent in the week before the drop. Stocks in other markets had also risen steadily. Our markets have gone 48 months without a 10 percent correction, the second-longest period without such a correction in 78 years. Since early October, the Dow had soared nearly 1,000 points, so some give-back had to be expected. Yet, until last week, investors appeared virtually carefree. Why then was there such a sudden awareness that stocks are risky?
There was no clear or satisfying reason, except that the warning bells seemed too loud to ignore and investors were in the mood to listen. Stock prices, after all, are a rational bet on the future. Markets may be efficient, but they are also irrational. One day, investors make light of the problems; the next, they run.
In fact, the Shanghai slump was really a nonevent. It appears to have been driven not by doubts about the health of the Chinese economy but by anxieties about probable new government measures to curb speculation. Prices were simply too high. The cooling off in the Chinese markets is, in fact, good news because it sets the stage for balanced and sustainable growth there.
Savings and earnings. Here at home, stocks should continue to look relatively attractive compared with their overseas counterparts. Ours is the best-regulated and safest market. Stock prices are also supported by private- equity firms and hedge funds that last year invested over $400 billion through leveraged buyouts and still have as much as $2 trillion in combined buying power. On top of this, 29 of the 30 members of the Dow Jones industrial average have repurchased their own shares in recent years, to the tune of more than $1 trillion. And the fundamentals reflect reasonable valuation. U.S. stocks are trading at roughly 16 times earnings, compared with the mid-20s for the Hong Kong market and a multiple of roughly 40 in Shanghai. Our current price-earnings ratios are well below the average for the past 20 years, even after the large gains over the past eight or nine months.
The United States has seen an enormous surge in corporate earnings. In real terms, earnings rose by 192 percent between March 2002 and December 2006. The issue is whether this pattern can be sustained or will fall back, as has happened in previous cycles. Stock prices, like all financial assets, have also reflected low, real interest rates and minimal concern about inflation. The world is awash in savings, primarily because East Asian nations, especially China and most recently the oil exporters, have accumulated huge surpluses. A good chunk has been invested in U.S. treasury bonds. Along with a fundamental improvement in American productivity, the conditions are there for stable, highly profitable growth. Investors must now assess how long this happy marriage of savings and productivity will be sustained.
Former Federal Reserve Chairman Alan Greenspan initially raised the specter of a recession at the end of 2007, then said it was not probable. In fact, the American economy seems in pretty good shape. Most forecasters believe we will grow well into 2008, even if there is some slowdown. The long-feared housing contraction has not produced any significant spillover. Inflation remains low, real consumer spending is firm, unemployment is low, real business investment is rising, and growth in government spending is steady.
Yes, the weaker housing market raises problems, but they seem manageable. The true risk lies in adjustable rate mortgages. Households will suffer pain when ARMs are reset and, according to the Mortgage Bankers Association, somewhere between $1 trillion and $1.5 trillion worth of ARMs will reset this year. However, this extra interest cost is manageable for the overall economy, representing less than two tenths of 1 percent of personal incomes. The Federal Reserve itself has pointed out, there may be a more favorable outlook regarding both inflation and growth into the middle of this year. As for the world economy, there has been no currency crisis, no systematic financial breakdown, and no economic meltdown.
As Morgan Stanley's economists put it, "While these [adverse] developments increase the downside risks surrounding the outlook, they don't materially change it," given healthy consumer income gains and still-vibrant growth abroad.
All in all then, around the world, as the bounce-back in the stock market has proved, we did not have a crash but only a contraction, and a modest one at that, amounting to less than 5 percent of the Standard & Poor's 500 index. Let us draw comfort from the assessment that it is better to have wary investors than reckless ones.