A Worst-Case Scenario for Stocks — It’s Ugly

A Worst-Case Scenario for Stocks — It’s Ugly

Why you should care

Because if the markets do enter a bear market, where stocks retreat for months on end, they tend to end in panic selling.

Simonomics: A regular look at the global economy from a former staff columnist at The Wall Street Journal.

Oh, how it hurts to see, U.S. stocks slowly (and sometimes not so slowly) sinking in recent weeks like so many Titanics. And yet, it could be worse. A lot worse. The 2008 financial crisis is the kind of thing you want to just shut out from your mind, a time when the only option seemed to be gallows humor. (The best joke: How your 401(k) retirement, now worth half its value, was only a “201(k)” plan.) Nobody, at least nobody who really understood money, wanted to look at their monthly financial statements. Doing so left a sinking feeling in the pit of the stomach.

Thank goodness we’re not living through that again! Or could we be? Fair warning, what some smart observers think may not exactly make your day.

“Expect a financial market rout every bit as large as 2008,” states an August-dated report from Albert Edwards of Société Générale. Back then, Standard & Poor’s 500 index lost 48 percent of its value, through the low that year. This year, the index is down around 6 percent, recently trading around 1942. A similar move down nearly 50 percent would put the index at around 1070, a level last seen in 2010.

We know. It hurts to hear. Why does Edwards think this? Broadly speaking, the problem is China and other emerging market countries. Earlier this summer, China abruptly devalued its currency, surprising investors. It happened multiple times. The idea was to make China’s exports cheaper and so help boost its flagging economy. The problem for the world economy, though, is too many cheaper goods may cause deflation — that’s when the general price level of goods and services falls. Japan has suffered this phenomenon periodically over the past two decades. The result: economic stagnation. The worry now is that the United States and the other developed economies will catch this economic flu.

For stock markets, it could be even worse than 2008 and 2009.

“We are only one misstep from outright deflation in the West,” says Edwards, noting that the core level of inflation, which excludes food and energy, is around 1 percent in the U.S. and the eurozone, which is considered very low. He foresees more devaluations sending “waves of deflation to the West to overwhelm already struggling corporate profitability.” Edwards’ colleague, Robbert van Batenburg, a market strategist at SocGen, says, “There are many who believe this is just the beginning of the devaluation [by China.]” Or put another way, more devaluations will send more waves of cheaper goods raising the risks of deflation.

Why is this such a concern? After all, falling prices mean cheaper goods, right? (Also, put aside whether the government inflation statistics are a precise measure of this phenomenon.) Cheaper goods are great for consumers, but not for corporations that might have borrowed. Falling prices result in lower revenue, yet the debt companies owe stays the same. Likewise, the mortgage on your home doesn’t get reduced just because your salary dropped. In fact, it’s probably fair to say that many workers may already feel that their pay hasn’t kept up with the cost of living since the financial crisis — a form of relative wage deflation.

Another factor contributing to the falling prices is technology, says Vinny Catalano, global investment strategist at Blue Marble Research, and a longtime market participant. Catalano isn’t sure what can be done to help fight deflation if it actually arrives. Interest rates are already low and there’s little appetite for the government to borrow more money to stimulate demand, he explains.

We aren’t there yet, though, Catalano says. But we’ll know soon, and, he adds, for stock markets it could be even worse than 2008 and 2009. Bear markets, where stocks retreat for months on end, are “violent” and “relatively short,” Catalano says. They tend to end in “panic selling,” like what we saw in 2009. If the markets do enter a bear market, he advises going for low-risk quality investments.

“We are all hoping this is wrong,” Catalano says, “but hope is not a strategy.”

Comment

OZYOpinion

Interviews, op-eds, and analysis to help you make sense of the news of the day and the news of the future.