U.S. stock markets have been suffering immense sell-offs recently, with the Dow Jones Industrial Average (DJIA) plunging 4.6% on February 5 and another 4.15% decline on February 8. Similarly, the S&P 500 index has lost 4.1% on February 5 and another 3.75% yesterday.
What’s going on?
Is it a market crash?
Although these 4.6% and 4.1% declines of the Dow and S&P, respectively, are substantial, analysts are not yet calling it a “market crash”. In the past, those terms are used to refer to huge one-day price drops, such as the Black Monday Crash of 1987, when the Dow dropped 22.6% and the September 2008 subprime mortgage crash when the Dow lost 7% in value in just one day.
But if price declines will continue and losses will accumulate, this would lead to a substantial overall drop in price which could indicate that the US stock market is “crashing”. During the Great Depression from 1929 to 1941, for instance, stock markets in the US lost 90% of their value over a 10-year period.
What’s causing the US market sell-off?
There are some possible reasons why US stock markets plunged in the past few days.
1. Threat of rising inflation
The US economy is recovering and accelerating, with the Gross Domestic Product (GDP) expanding at an annual pace of at least 3% in the last 3 quarters. Unemployment is low while worker wages are increasing, rising 2.9% this year compared to the past year. The recently approved tax cuts, initiated by the Trump administration, reduced individual tax rates and corporate income taxes which could bring additional cash to citizens.
These are good macroeconomic signs, but it also stokes inflation. Inflation, or the change in prices of goods and services, has to be managed and controlled. If left unchecked, rising prices could lead to hyperinflation, a scenario wherein the value of a currency is rapidly eroded. This means the currency will be able to buy less of what it could have bought in previous years.
2. Concerns on rising interest rates
Central Banks (the Federal Reserve, in the case of the US) combat the threat of inflation by raising interest rates. In the past, the Federal Reserve has raised interest rates conservatively, fearing higher rates could hamper the economic recovery.
The Fed is said to be planning on raising interest rates just three times in 2018. But if inflation picks up, analysts fear the Fed could raise interest rates faster and more steeply than expected.
When the Fed raises rates, the cost of borrowing money increases. The consequence: individuals will have to pay more for loans and mortgages, thereby reducing consumption, while companies similarly will pay more interest expense on their loans, causing a reduction in corporate profits.
Thus, when interest rates rise more than expected, stocks are affected because investors worry that corporate profits will decline. The prices of stocks are fundamentally the Discounted Cash Flow of a company’s future earnings, so if future profits are expected to decline, the company’s current stock price is expected to fall as well.
3. Attractiveness of bond yields
Stocks have previously surged because of their attractive returns. But with rising bond yields, bonds as a safer investment instrument becomes more attractive compared to stocks. This convinces several stock investors to pull their money out of stocks and into bonds.
Rational investors typically prefer a decent amount of return for a manageable amount of risk. Bonds indeed offer lower returns than stocks, but the risk in bond investing is also relatively lower. With more attractive bond yields now, funds flow from stock markets to bond markets. The movement of liquidity from stocks to bonds negatively affects stock prices, which could lead to price declines and market corrections.
4. Overdue market correction
US stocks have steadily risen since 2016. In fact in 2017 alone, the Dow rose 24.72% while the Nasdaq rose 27%. (See: Ranking of 50 Best Stock Markets in the World)
A constantly rising stock market is not always healthy and is surely unsustainable. In the past months, several analysts have opined that US stocks are overpriced and may be due for a 5% correction or a 10% pullback. The recent price decline could be the correction the market had been anticipating.
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