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October 14, 2014

Will Markets Get Even Uglier from Here?


Understanding what happened to the stock market last week is really, really important.

That’s because we’re at a place in time where it’s possible for time to go backward…

Markets Heading Toward Time Warp

We may not be heading back into the clutches of the Great Recession, which lot of middle-income and poor people never got out of. But if markets can’t rally from here, there’s a better than 50/50 chance we will fall back into an ugly time warp.

The importance of the market at this juncture has to do with the U.S. Federal Reserve‘s prescription to get us out of the Great Recession in the first place.

The Fed told us that its zero-interest rate policies (ZIRP) would lead to higher stock prices, creating a“wealth effect.” The Fed hoped to push the economy along enough to let real GDP gather momentum and become the tailwind the economy needs for liftoff.

About that “wealth effect.” It never made sense to me. After all, if you don’t have any stock-market investments, you’re not going to feel better about other people’s wealth.

It certainly doesn’t make sense to the millions of people who can’t find a decent job, never mind a career. Or to the people who are so distraught after years of looking for work that they’ve given up.

And it especially doesn’t make sense to the millions of students who borrowed billions of dollars to get a degree to make themselves more attractive to prospective employers. Now, these students not only don’t have stock-market investments… they not only don’t have jobs, but they are shackled to the dirty, greasy, come-on loans that for-profit and not-for-profit schools peddled to them as another kind wealth-effect drug.
The wealth effect was supposed to make us all feel better as we watched asset prices rise, especially the stock market. If you feel wealthier, or at least you feel you could become wealthier, even if that must means getting a job, you’ll go out and spend, spend, spend.

And to spend, you’ll borrow. All that borrowing (at low rates, thank you, Federal Reserve) and spending will stimulate production, and more people will be hired to work factories and restaurants as demand for goods and services wafts us into the ether of economic nirvana.

Well, we’re not there.

The strong growth has never materialized. There are plenty of reasons for that, and the Fed knows them all.
What did work was the pumping up of the stock market.

Now, whether there’s been any wealth effect is about to be tested. If there’s panic-selling and stocks drop precipitously, stock investments will get hit hard, of course – and the whole economy could tip over into a massive double-dip Greater Recession.

Last week was a warning. The Dow Jones Industrial Average dropped 273 points on Tuesday, and a lot of people freaked out. Then Wednesday came along, and the Dow gained 274 points. So a lot of people figured, “That was scary, but it’s already over.”

Too bad Wednesday was methadone day. What sparked the market to erase the huge loss on Tuesday were the Fed minutes. The Fed said it was worried about the strong dollar and decelerating global growth. The market was relieved that there was no chance the Fed would let interest rates rise, and off it went.
Too bad the week doesn’t end on Wednesdays.

On Thursday, the Dow dropped 330 points. On Friday, markets tried to rally, but the Dow ended down another 100 points.

The average daily volume last week was 7.9 billion shares. That’s the highest daily volume in any one week since November 2011. In other words, not only were there more sellers than buyers, but those sellers were selling a lot more shares than usual.

Here Comes Trouble

Technically, as in “technical analysis,” all the major stock indexes are in trouble.

A week like last week doesn’t just happen out of nowhere. Forces congeal for a while before triggering bouts of selling. Last week, those forces were over in Europe. European stocks got killed last week, and U.S. markets traded off them.

What’s bad about that is that a lot of people expected sellers in a weakening European environment to park their money in U.S. stocks – but they didn’t. They still might down the road, but they didn’t last week and they certainly won’t this week.

As far as today – where’s the bounce? Europe bounced, at least some.

But there’s no bounce in the Dow as I write this at 10 a.m.

We opened higher, and there was a sigh of relief. But that sigh has turned into an audible whisper of worry.
Where the stock market is – that’s a big deal.

If the wealth effect evaporates, confidence in the Fed’s policies will go up in smoke, too. So will confidence in all the central banks’ abilities to engineer the world out of slowing global growth.

The Fed and the globe’s other central banks built dykes wherever there was water rushing into Great Recession sinkholes. Their pumping schemes seemed to dry things out.

But, “If it keeps on rainin’, levee’s going to break.”

Yep, I’m going to keep singing that Led Zeppelin line to you, ’cause I think it’s coming.

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

Courtesy Shah Gilani at Wall Street Insights & Indictments (EconMatters author archive here)

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