Is it good news for the economy now, bad news for the stock market? It certainly looked that way in early February when a better than expected wage report led to concerns of rising interest rates and triggered massive stock market volatility and a roughly 10% selloff in the major stock indices.
Let me break that down for you...
One would think that higher wages would lead to greater consumer spending and stronger economic growth. This higher economic growth would lead to greater corporate profits and higher stock prices. It didn’t quite work that way. Instead, the higher wages were seen as an indication the economy may be too strong, leading to a more significant increase in interest rates (to help slow the velocity of money and cool the economy) than previously thought. These higher interest rates could attract some stock investor’s capital who see the better rates as more attractive than a stock market that is at all-time highs.
This sell off was exacerbated by leveraged hedge funds who were betting that the low volatility in the stock market would continue. When they began to sell to meet margin calls and pay down debt, key technical levels in the stock market (200 and 50 day moving average) were breached. This lead computerized driven stock market models to indiscriminately sell. This selling begat selling and the rout was on. Because the fundamentals of the economy hadn’t changed, much of the correction was recouped within the next six trading days.
The stock market is now seeking to determine a new valuation for earnings given the current economic cycle. There is some debate about the effect the stock market correction will have on the underlying economy. Some believe that the dramatic decline can lead consumers and business to scale back plans to spend and invest. I tend to believe the effect will be minimal. The effect of the recent tax cuts, and repatriation of cash overseas (not to mention the infrastructure spending bill stimulus). Combine this with a global economic recovery and you have a recipe for a strong economy.
This recovery is perhaps a bit long in the tooth, going on almost 9 years now. What are the risks to derail the expansion? A trade war, higher rates which would encourage saving, an exploding budget deficit just to name a few. In summary, the stock market has a history of climbing a wall of worry. Ironically, when there is nothing to worry about, you should be worried!