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Trader Kevin Lodewick, center, and specialist Paul Cosentino, right, work on the floor of the New York Stock Exchange on Tuesday, Feb. 6, 2018. The Dow Jones industrial average fell as much as 500 points in early trading, bringing the index down 10 percent from the record high it reached on Jan. 26. The DJIA quickly recovered much of that loss. (AP Photo/Richard Drew)

Economists caution against panic over stock market’s record fall

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Economists caution against panic over record stock market fall

The stock market bounced back somewhat Tuesday despite a substantial drop at the start of trading, potentially calming the nerves of any investors spooked by a record plunge in the Dow Jones industrial average Monday.

The Dow opened the day Tuesday by dropping 567 points further, but within hours it was peaking into positive territory. By the closing bell, it had risen 2.3 percent from Monday, gaining 567 points.

The volatile Tuesday followed a disastrous Monday in which the market cratered with the Dow down 1,175 points for day. Combined with a 666-point drop on Friday, all of the market’s gains so far in 2018 were wiped out.

Monday marked the largest one-day point drop in history, but a fall of 4.6 percent in the Dow’s overall value was far smaller than the 7 percent loss in one day during the 2008 financial crisis or the 23 percent plunge on Black Monday in 1987. The market remains up by thousands of points from where it was at the start of 2017.

The S&P 500 registered a smaller but still significant drop of 4.1 percent on Monday, its worst single-day performance since 2011.

Overall, at the close of business Monday, the Dow had fallen about 8 percent from the record high of 26,618 it hit one week earlier. That change is short of the 10 percent decline that would qualify as a correction--though it did briefly dip into that territory on Tuesday morning--which some economists say the market is due for after a year of overvalued stocks and overheated trading.

Treasury Secretary Steven Mnuchin downplayed the drop Tuesday.

"The markets look like they're functioning normally in terms of liquidity and other things,” Mnuchin told CNBC prior to a House Financial Services Committee hearing, crediting the administration’s policies for boosting companies’ earnings.

"I think you've seen a normal market correction, although large," he said during the hearing, dismissing concerns about the financial system’s stability. "There's just a disconnect in the short term. Markets move in both directions."

Scary as the largest single-day point drop in history sounds, experts caution both the general public and investors against flipping out over a bad day or week. As evidenced by Tuesday’s performance, the market can, and often does, promptly reverse itself.

According to Jay Zagorsky, an economist and research scientist at the Ohio State University, the vast majority of Americans who do not directly invest in the stock market should see little impact from the crash, and of the families that do invest, half have less than $25,000 at stake.

“The general public shouldn’t worry…. Eighty percent of people are just sort of watching on the sidelines,” he said.

For investors, the day-to-day fluctuations of the market—even extreme ones—should matter less than long-term trends, which at the moment are still very good. The Dow has grown more than 30 percent since President Donald Trump was elected in November 2016.

“Investors shouldn’t necessarily be panicking because there are a lot of times when the stock market quickly reverses itself,” Zagorsky said.

However, he observed that while people tend to take time to get excited about rising stock prices, they can become pessimistic almost instantly when a crash occurs.

“I don’t know why we’re wired this way, but we become scared very easily,” he said.

Analysts have postulated a few factors that could have driven the sudden sell-off, none of which likely presage a catastrophic fiscal collapse, but they could signal more trouble ahead for the market.

Most point fingers at the Department of Labor’s monthly jobs report released an hour before the market opened Friday. Job growth was steadily in line with expectations in January 2018, but average hourly earnings were up 2.9 percent from the year before.

If that trend continues, higher wages could mean higher inflation, which would trigger the Federal Reserve raising interest rates faster than planned to prevent the economy from boiling over.

“If interest rates go higher, that’s not good for stock prices,” said Desmond Lachman, a resident fellow at the American Enterprise Institute.

Lachman believes the stock market is on a bubble right now, one built on years of nearly non-existent interest rates that produced “a huge amount of froth” in the market.

“What we’ve had is we’ve had years of very, very easy monetary policy and what that’s done is pushed stock market valuations” to levels they have rarely reached before, he said.

The Treasury announced last week that it expects to borrow nearly $1 trillion this fiscal year, almost double what it did in 2017, news that could also lead to a faster increase in interest rates.

Monday marked the beginning of new Fed Chairman Jerome Powell’s tenure, replacing Janet Yellin, who was slow to raise interest rates even as the economy ballooned. Uncertainty about how he will handle matters and whether necessary rate hikes are imminent may have added to the market’s skittishness.

“The point is that Yellin has left the new guy with the Fed behind the curve,” Lachman said. “They haven’t been raising interest rates enough.”

Mnuchin also suggested Tuesday that computerized algorithmic trading triggered by certain conditions played a role in the heavy market activity Monday.

The extent to which traders were driven by any one of these reasons is difficult to discern.

“Anybody who tells you exactly what caused the drop is lying,” Zagorsky said. “Nobody knows.”

Adding to the difficulty of diagnosing a cause, fear begets fear. Investors selling off stock can lead other investors to sell off stock.

“When the Treasury yields went off, people started selling…,” Lachman said. “At the first sign that there’s trouble, people run for the door.”

Zagorsky also highlighted the role of emotions alongside data in investor activity.

“In general,” he said, “we are animals who are driven by positive and negative waves of emotion and trying to predict when everyone becomes pessimistic or optimistic is a fool’s game.”

As President Trump noted in his State of the Union address last week, the Dow has “smashed one record after another” since he was elected. Experts say the extended surge in market activity was driven in large part by the expectation that the president and a Republican Congress would cut taxes.

Now that Republicans have delivered on that promise, much of the positive economic impact has already been factored into stock prices. Kevin Hassett, chairman of the White House Council of Economic Advisers, predicted on CNBC’s “Squawk Box” Tuesday that the added money in workers’ pockets will eventually work their way into the economy and the market.

Office of Management and Budget Director Mick Mulvaney told Sinclair last week that it will take time for the ramifications of the tax cuts to be felt, but initial indicators are encouraging.

“It takes time for it to kick in. The bonuses we've seen are more than we expected,” Mulvaney said, referring to the many companies offering workers bonuses at the end of 2017 because of the corporate tax breaks, “and to be honest with you, we didn't expect to see them this quickly at all.”

Some of the benefits of tax reform are already baked into the market, but according to Zagorsky, many taxpayers will not recognize how much the changes affect them, for good or ill, until they fill out their tax forms next year.

“Many businesses and people who watch businesses don’t really understand the full effect of the tax cuts yet,” he said.

The negative consequences may also blunt the stimulating effect of the positive ones over time. A massive unfunded tax cut could just add to the forces driving the Fed toward an interest rate hike.

“What was not in the price was the idea that we might be getting inflation and interest rates might have to go up an awful lot,” Lachman said.

President Trump, who touted the market’s performance at least 25 times in January, has not commented directly on the Dow’s record decline. Economists have often warned that his conflation of the stock market with the economy would lead to exactly this scenario when the inevitable downturns occur.

Treating the market as a barometer of the economy also sets up a paradox where positive developments like higher wages hurt the indicator that the president has chosen to embrace.

“Rising interest rates are bad for stocks and investors,” Zagorsky said. “Rising interest rates are a good sign that the economy’s healthy.”

Secretary Mnuchin has previously claimed the stock market represents a “report card” on the administration’s economic policies, but White House officials brushed off the dip in the Dow Monday, maintaining that the fundamentals of the economy are strong regardless of the effects of a few days of trading activity.

“The President’s focus is on our long-term economic fundamentals, which remain exceptionally strong, with strengthening U.S. economic growth, historically low unemployment, and increasing wages for American workers," White House Press Secretary Sarah Sanders said in a statement. "The President’s tax cuts and regulatory reforms will further enhance the U.S. economy and continue to increase prosperity for the American people.”

The fundamentals of the economy are largely strong at the moment—GDP growth is up, unemployment is down—but Lachman expects the stock market is eventually heading for a real correction.

“If we’ve got this courtesy of a bubble, that’s not too healthy of a situation,” he said.

That said, the economic cheerleading coming from the likes of Sanders and Mnuchin to keep the public and the markets from overreacting is not unexpected, even at times when it does not fully reflect reality.

“You don’t expect the fire brigade to come in and shout ‘fire’ in a theater,” Lachman said.

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