Samuelson: Parsing the Global Stock Drop

Watching global stock markets drop has been at best unnerving. From their recent peak on Feb. 20, American stocks last week lost about $900 billion in value, or almost 5 percent, reports Wilshire Associates. With unemployment at 4.6 percent, the U.S. economy can hardly be described as sickly. It's not just the United States. "We've had the best global economic growth in 25 years," says economist Larry Meyer of Macroeconomic Advisers. Yet, stock markets have dropped worldwide, and business and consumer confidence are wobbly.

What explains the contrast?

Well, stocks could be signaling a bleaker future. The U.S. economy will slow or even slip into recession; indeed, former Federal Reserve Chairman Alan Greenspan raised just that possibility last week. Profits will be weaker than expected; therefore, stocks drop in anticipation. Up to a point, slower economic growth is precisely what the Federal Reserve intends. Through higher interest rates and weaker demand, it wants to nudge down inflation by creating more price and wage competition. But of course, a desired slowdown could become an undesired recession. Housing is already in a deep slump. Homeowners can borrow less against swollen house prices, which are generally now either stagnating or falling. Consumer spending, more than two-thirds of the economy, may weaken.

Or global financial markets—for stocks, bonds, foreign exchange and other securities—may simply be misbehaving. It's crowd psychology. Investors sell because they think others will sell, even though U.S. stocks don't appear to be wildly overvalued, as they were in the late 1990s. Consider. Since World War II, the price-to-earnings ratio (P/E) of stocks in the Standard & Poor's 500 index averaged 16.15. That means that stock prices averaged sixteen times profits (earnings). At the end of January, the P/E was 16.74, hardly out of line. It was also well below the average for the past 20 years (22) and the peak in 2001 (47), despite big gains in stocks since mid-2006. (At their recent peak, stocks were up about 20 percent from their 52-week low point.)

It's also said that the sell-off demonstrates China's growing financial significance. True, the worldwide stock slide started in China last Tuesday, when its market lost almost 9 percent. But China's market is too small to matter much in a global context. At year-end 2006, the value ("capitalization") of all China's stocks was $1.4 trillion. That was less than 10 percent of U.S. market capitalization. In 2006, China's market rose 130 percent; it seemed due for a drop. Conceivably, the decline foreshadows a slowdown in China's economy, which has been growing 10 percent annually. But it's doubtful that enough Chinese own stock for losses to hurt the
economy significantly. "The markets are not telling us anything about the state of the Chinese economy,'' writes Jonathan Anderson, UBS' chief Asian economist.

So: we don't really understand what's happening.

For Americans, what's curious is that people seem to feel more economically insecure even though the economy has become more stable. Since 1982, there have been only two recessions, lasting 16 months. In the past 10 years, unemployment has averaged 4.9 percent; in the 1970s, the average was 6.2 percent. Yet in 2006, only about half of workers were satisfied with their job security, reports a poll from the Conference Board. In 1987,
when unemployment was higher, about 60 percent were satisfied.

One explanation of the paradox is that the uncertainties and insecurities that assault workers, investors and firms actually foster overall economic stability. There are constant upsets—business expansions and closures; greater competition from emerging technologies and foreign economies; shifting prices for stocks and bonds. These put people on edge. But many small adjustments may smooth out the business cycle. They may minimize deep recessions, stock crashes and financial panics.

By this view, recent stock losses might be healthy. To many observers, the global financial system had become dangerously speculative. The vulnerabilities lay less in stock prices than in low interest rates on credits to riskier borrowers: emerging-market countries, weaker corporations and U.S. home buyers with "subprime" mortgages. After large losses in subprime mortgages, investors are growing more cautious. Stock prices took a hit because there was a general retreat toward safer investments (Treasury bonds, cash).

It's comforting to think that markets usually self-correct in time to avert broader economic havoc. But sometimes markets go to extremes—and stay there too long. Stocks became hugely overpriced in the 1990s. Big imbalances now in global trade and capital flows might portend deeper instability. What's unsettling is that global financial markets seem increasingly synchronized. "Everyone's investing everywhere,'' says David Wyss, chief economist of Standard & Poor's. "All the bets seem to move in the same direction.'' And that means bad news—like good—could be contagious.