Stock Sell-Off Shows Consequences of Central Bank Actions

New_York_Stock_Exhcange_panic_of_1893The global stock market sell-off continued on Monday with a vengeance as Asian markets plunged, followed by one of the worst one-day sell-offs in U.S. market history. The Dow ended down nearly 600 points or just over 3.5%, but at the opening of trading, it was down nearly 1,100 points! While investors and market participants can never know all of the reasons for the sell-off, there is an underlying theme to the global market rout that will continue to play an outsized role in the coming months: central banks.

Monday’s turmoil was certainly severe, and although it doesn’t make the cut for some of the worst days in stock market history, that didn’t stop some from taking to Twitter with #BlackMonday trending (for comparison, on the Black Monday of 1987, the Dow lost nearly 23% in one day.) Monday’s drop put many indices in or near ‘a correction’ which is usually regarded as being 10% off their highs.

The first question on everyone’s lips is “Why?” or “What started it?” but that is like asking “Which straw was it that broke the camel’s back?” However, it is true that the U.S. was taking cues from China’s markets with the Shanghai composite index down 8.5% the previous night, the biggest drop since the beginning of the last crisis in 2007. China’s stock market bubble continues to deflate because the government has either decided not to, or is unable to, prop up the markets, this being something we have covered here in the past. Feeding the China decline was their government’s surprise announcement to devalue the yuan a couple of weeks ago, prompting fears their economy’s growth is slowing.  

More important than trying to discern the snowflake that caused the avalanche is to assess why and how markets came into such a fragile state that they could be caught off guard. After all, the decline was incredibly sharp and fast, and yet it wasn’t due to a comparable world event shock such as 9-11. I personally believe investors had previously been lulled to sleep by low interest rates, easy money, and a warm feeling that the Fed and other central bankers around the world have things under control.

It is not hard to see why market participants would feel this way. Not only did it appear the Fed successfully ‘rescued’ the world, but other central banks have staved off the crisis in Greece (multiple times) and helped to spur growth in Japan, Europe and, most recently, in China. These and other factors led to this being the third longest bull market without a 10% correction in the history of the S&P 500.

But Monday may signal a general reassessment of this fantasy. As global growth slows and markets crash, many may finally be realizing that the actions of central banks have only served to inflate asset prices, whereas they have no actual power to create real wealth. James Grant succinctly pointed this out in a CNBC interview on Monday, stating:

“We have too much of something, which is financed by an excess of credit or debt. That, to me, is the essential backstory to this morning’s difficulties. It’s the mispricing of asset values, led by central banks who think that by inflating or lifting up stocks, bonds and real estate, they will thereby engender prosperity…”

Interest rates should be a reflection of how risk-averse investors are, and should reflect the risk in various assets and financial projects. By suppressing interest rates and enabling easy credit, global central banks make it seem that there is much less risk out there. More projects and investments are undertaken as a result, and financial assets are inflated. Investors may now be realizing those risks were never dissolved, but merely papered over.

So where do we go from here, and what are investors to do? First, nobody really knows what will happen next; we could see the market decline a little further and then rebound and go on to make new highs. A perfect example of this would be in late 2011 when U.S. stocks declined nearly 20% only to go on and rally over 65% as the Fed continued quantitative easing.

Conversely, this could be the start of a larger market correction. I previously noted how the market appeared extremely overvalued based on long-term fundamentals. But valuations are the driver of long-term returns, while the short-run is influenced more by the attitudes and perceptions of investors. The market continued to go from expensive to more expensive as investors grew less concerned about risk. It now appears that risk is playing an important role again, which could send stocks down another 20% or more based on historical valuation measures.

As we have advised in the past, if you are a long-run buy-and-hold type investor who consistently puts away money in index funds month after month, then don’t even pay attention to these moves. But as volatility returns, and because these drops will likely put pressure on central banks to keep rates low, or even restart quantitative easing, remember to continue to keep a set percentage of your wealth in gold and other precious metals. This will further diversify your assets and should act as a dampener to the volatility.

Chris Kuiper CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.