NEWSFeb 10, 2018

The Irrational Prosperity in The U.S. Stock market

The market had expected the next economic crisis to come next year, but it seems that the crisis may have arrived earlier.

The current U.S. stock market

On the 2nd of February, the U.S. stocks fell sharply, the three major U.S. indexes erased all their increases this year. Last Friday's stock crash happened in this week, the Dow Jones index achieved its one day’s biggest drop - more than 1000 points - on Monday. At the same time, the panic index VIX has once rose by 116%, and then fell to 30, indicating the "irrational prosperity" in the stock market. The U.S. stock crashes have triggered the following stock crashes in Europe, Japan, China and Hong Kong.

The U.S. stock market has strong economic fundamentals to support its bull market, meanwhile, it is currently in the gap between stock repurchase periods. Analysts from Goldman Sachs believe that about 45% of listed companies in the S&P 500 have not yet announced their fourth quarter results. Historically, most companies do not buy back shares at this time. In the United States, the listed companies are the largest demand side of the stock market, and this round of market crash is also affected by the interruption of stock repurchase.

The present crisis and the 1929 stock market crash has many similarities, even though the economic fundamentals are not bad, but the stability itself ultimately led to the end of economic stability. Therefore, once the trend of global crisis is determined, the exchange rate fluctuations and negative market sentiment will affect the whole world. Considering that global economy is still steady and optimistic, the negative impact of the emerging market will not exceed that of the developed countries.

The economic fundamentals of America

Since the financial tsunami in 2008, the U.S. economy has recovered from the severe economic recession. The Federal Reserve has stopped quantitative easing and then increased interest rates for several times. The unemployment rate dropped to 4.1%. The economic growth rate reached 3% and the inflation rate was controlled below 2%. These are important elements to support the continuing rise of US stock prices.

Here is some existence of hidden threats:

1. International perspective: Middle East and North Korea issues; The possible trade friction between China and the United States.

2. Domestic perspective: The unpredictable future policy of the Trump government may impact the confidence of stock market.

As a result, once a negative event breaks out, it is estimated that, the investor sentiment will not be effectively guaranteed.

What causes the current situation?

The U.S. nonagricultural employment rate and salary growth rate exceed market expectations, the level of inflation rate is expected to increase, therefore, it is likely for the Federal Reserve to tighten monetary policy. On the one hand, the liquidity of the stock market is threatened. On the other hand, the market expectation of the upward enterprise profit is weakening, the stock market is not favored among most of investors, which will lead to the capital outflow from stock market.

The U.S. dollar index sustained strength. The rise in US dollar preferences, coupled with the recovery of the global economy, will attract capital to emerging markets or US currency to hedge risks.

A bear U.S. bond market. According to the China Securities Daily, the interest rate of the U.S. ten-year-bond has reached a highest point (2.85%) within 4 years.

Many investors have begun to consider investing into the bond market to control risks and guarantee benefits. Capital tends to flow from the stock market to the bond market, bringing a negative impact to the stock market.

The end of the era of low capital cost. The increase in borrowing costs makes it difficult for enterprises to expand their operation and investment, which will decrease the market expectation of companies’ profit.

Risk-free interest rates have risen significantly. The global economic fundamentals are positive and there is no clear news causing worries. However, the increase in the yield of national treasury bonds has led to a great adjustment of the global stock market.

The U.S. shares are overvalued. Despite the good performances of the U.S. listed companies and the benefits brought by the new tax reform policy, the U.S. stock market still has a high risk of being overvalued. After the nine-year’s recovery, the U.S. stock index is now too high to continue the upward trend.

The quantitative easing policy in the U.S, has formed the environment of low interest rate and high leveraged investment. The Dow Jones index has increased by more than 300% in 2009. Investors will naturally worry about the future of the market.

The average price to earnings (P/E) ratio is too high. The P/E ratio in the U.S. is now higher than that in the beginning of the 2007 financial tsunami. The statistics from Economic Observes show that in 2017, the S&P-weighted P/E ratio had reached 27, compared with the value of 33 at present. Although the U.S. listed companies have good profitability, the average P/E ratio is still far higher than the average value in recent years. Therefore, the uprising risk interest-free interest rate reminds investors with the irrational stock prices, the stock market starts to make a self-correction of its own valuation.

The United States had maintained a strong momentum because of the stable development of American economy and various beneficial US policies, while every market needs appropriate re-evaluation. Some analysts, therefore, believe that this stock crash is only a short period of adjustment and re-evaluation.

American investors are overconfident. According to a survey performed by Gallup and Wells Fargo Bank, US investor confidence maintained increasing in every quarter since 2016. This growing optimism has also contributed to the bubble in the US stock market, which also prepared for the plunge in the stock market. It is now more likely that a new round of financial crisis will be confirmed if the plunge lasts for a period of time and finally reverses the confidence of investors.

The "fall down effect" caused by quantitative investing strategies. As is reported by the Economic Observer, China Life’s Insurance Security Fund believes that the volatility of global stock market has decreased since 2017, quantitative strategies are increasingly being used by fund managers. If one market is volatile in the short term, the fund will be forced to start selling off, thus further impact the whole U.S. and global stock markets.

Has the Minsky Moment arrived?

Previously, the U.S. stock market has sufficient confidence and liquidity. Enterprises invest their profits and debts to expand production and gain profits. Banks actively cooperate with companies’ demand for funds in order to earn more interest income. While the increasing burden of corporate debts need to be matched with efficient fluidity to guarantee the normal operation of the financial system. However, on the other hand, this makes the financial system more fragile to shocks. In this case, if the interest rate rises (or the expected interest rate rises), the cash flow is not sufficient to pay back the principal and interests of the bond. The enterprise needs to sell its assets, resulting in further collapse of the market, which is the so-called financial tsunami - “the Minsky Moment”.

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