Crashing Stock Markets: What Does it All Mean?

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute” — William Feather

Once the envy of the world for its impressive economic growth, China has seen its stock market take a beating in recent months, in part due to concerns over slowing growth. The shock waves have caused markets around the world to follow suit.

After peaking at 5,166.35 on June 12, the Shanghai Stock Exchange has fallen to 3,148.08, a dizzying 39.1% decline over the span of 80 days.

The Dow Jones Industrial Average fell 12.5% over the same period before recovering nearly half its losses at the end of last week.

The NASDAQ, Tokyo Stock Exchange, London Stock Exchange, Toronto Stock Exchange and other major world markets experienced similar selloffs as well.

What does it all mean for the U.S. economy?

Large Countries Impact Global Demand

The inference is straightforward. If a large economy slows, its businesses and consumers tighten their belts. Doing so causes demand for imports to fall, negatively impacting other countries. The resulting slowdown can spill across the region to other countries. If the contagion is severe enough, recessions can be triggered around the world.

The financial crisis that struck the U.S. in 2008 was an example of that phenomenon.

Oil Prices Fall

As reduced global demand makes its way to the energy markets, sellers begin to outnumber buyers. The perception of a lower demand for energy — consumers traveling less, factories operating at below-normal capacity, and other similar ramifications — drives spot oil and gas prices downward.

Consumers reap the benefits of lower energy costs, but as with any swoon, price deflation has its casualties. Companies directly or indirectly associated with the energy industry slump, and ancillary industries like travel, manufacturing and certain financial services sectors take hits.

Oil prices collapsed in 2008 as the Great Recession took hold.

The Risk of Deflation Grows

In addition to oil, prices of other goods and services run the risk of falling, as sellers react to the prospect of fewer buyers by lowering their prices. As with oil prices, the consumer benefits in the short run — that is, until they are laid off or see their hours or benefits reduced.

Deflation doesn’t stop at goods and services. Assets can experience declines in value as well, a particularly destructive force if acquired using debt. The recent housing crisis saw waves of foreclosures for that very reason.

Unsustainable Increases Lead to Painful Decreases

If there were any lessons learned from the stock market and housing bubbles bursting over the past 15 years, it’s that large, unsustainable run-ups in prices fueled by speculation invariably lead to painful corrections.

In China’s case, the Shanghai Stock Exchange increased over 100% between November 2014 and June 2015. The reason behind the rapid increase will sound familiar: The Chinese money supply nearly doubled over the past five years, with cheap, easy money flooding into China’s economy as it did in the U.S. when the Federal Reserve opened the spigot.

A substantial portion of the excess liquidity worked its way through its stock market, fueling the run-up. When the house of cards began to come apart, the bubble finally burst.

Stocks Are Inherently Volatile

Although stock markets rise over time, the fact remains that equities carry significant amounts of risk. Stocks are liquid investments traded on open exchanges and are subject to volatility. When the news about a company, an industry and/or the economy is perceived by investors to be good, buyers come out of the woodwork and stock values rise. When the news is bad, buyers run for the hills.

It’s not just information that changes investor behavior. Alternative investment options (bonds, precious metals, other commodities, cash) are factors, and even intangibles such as rumors can affect prices.

When bull markets run for long periods of time, investors become complacent. They forget that risk is a major component of the stock market. Price corrections and bear markets are stark reminders of that fact.

The Likely Impact on the U.S. Economy

As with all tumultuous periods, this too shall pass. This isn’t the first time the markets have been roiled due to investor panic and it won’t be the last.

Most economists believe the U.S. economy has sufficient fundamental strength to withstand this period of volatility. GDP is growing at a moderate-but-steady 2.3% annual rate, personal income and corporate profits are on the rise and the official unemployment rate is at an 88-month low. Capital tends to flow into the United States, considered the world’s quintessential “safe haven,” during periods of uncertainty. The resulting capital helps to firm up asset values and keep the economy on reasonably solid footing.

As equities analyst Barry Ritholtz once said, “The data strongly suggests that very good years in the U.S. stock market are followed by more good years.” Just don’t hold your breath that the up-and-down markets are going to calm down anytime soon.

© Copyright 2015 Walter McLaughlin, All rights Reserved. Written For: Decoded Science