Monday represented the single greatest daily decline in the history of the stock market. Initially, it had plunged 1,600 points, which would have been the entire value of the stock market throughout the majority of the Reagan administration.
In beginning to understand what happened we must bear in mind how the stock market is priced, or how any stock is priced for that matter. The price is a function of supply and demand – how much is a buyer willing to pay for a share of ownership in a company vs. how much a seller is willing to sell it for.
On Friday there was a major announcement for the American economy, over 200,000 new jobs were added and wage growth has sharply increased. One would think that this would have a positive impact on the economy, as more workers and higher wages means people will be able to spend money, which is great for companies.
To be sure, the stock market has reflected a booming economy over the last year; it’s up 36% since Trump’s election. However, there are other factors at play.
Much of the market is stimulated by central banking. When the economy is poor, they lower interest rates, which will allow people to qualify for borrowing money (in the form of mortgages, car loans, business loans), which causes people to spend money – improving the economy. As the economy improves, and people continue to spend more money, the increased demand for products causes prices to rise and inflation sets in. To reduce inflation, central banks will raise interest rates to slow the economy down.
With low-interest rates, investors aren’t as keen to buy bonds (loans). The rate of return on their investment is too low to appeal to an investor, and so they buy equity in companies instead of bonds. When interest rates rise, investors are increasingly interested in buying bonds, because the rate of return is greater.
Friday’s report triggered the probability that interest rates could rise. With this information, bonds became more interesting to investors and therefore their fascination with equity stocks declined. More investors wanted to sell their stocks to get into the more lucrative bond market, and fewer investors were willing to buy stocks as they also wanted to be involved with the bond market.
One thing to remember is that as the stock market pushes upwards into uncharted highs we’re in an undiscovered country. The market has never done this well in the past coupled with historic low-interest rates. At no point in our lifetimes has the stock market been priced this high, and at no point have bonds been this unprofitable due to low-interest rates, and so it’s not shocking that we’re seeing unprecedented movements such as this.
Monday’s hiccup on the stock market isn’t concerning. There is a looming debt crisis, which higher interest rates are significantly problematic. Free trade is another element of concern, diminishing free trade, with its increased costs of production entails increased prices. For now, the stock market appears solid and strong.
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