We Clearly Need to Discuss the Stock Market

All the news has been focused on are the “plunges” in the US stock market, with headlines pounding home the fact that “the stock market” has had “historic” drops this week. Before you sell off your 401(k) and hide in the basement, let’s consider some less-hyped facts.

First of all, the US stock market is an incredibly big, complex, and barely regulated beast. It is almost impossible to measure its performance in any meaningful way, which is why various companies, notably Standard & Poor, create indexes to try and represent the overall state of the market. The most storied of these is the “Dow,” actually the Dow Jones Industrial Average. This “average,” in existence since 1896, includes only 30 stocks. Now, I’m not statistician, but I’m pretty sure 30 is a pretty small number compared to the 1.4B stocks traded on the NYSE alone, to say nothing of the NASDAQ.
The other thing you have to remember – especially when the news media would rather you not do so, because you’ll stop panicking and change the channel – is that “points” in the Dow are an arbitrary unit of measure. A 100-point drop doesn’t, in and of itself, mean a whole lot to the average working Joe. Percentages are far more useful, if you’re going to use any index to measure the performance of the entire US market. Keep in mind that, prior to the 2008-era US econopocalypse, the Dow had just teetered over 10,000 points, and throughout 2008 it was subject to double-digit percentage drops.
Let’s put that in context: if you have $10,000, and you lose 12%, you have lost a notable amount of money. If you have $100,000,000, and you lose 12%, it’s perhaps notable but not anywhere near as epic. In fact, the larger a system gets, the more volatility you should expect at the point level; you start looking at percentages to decide when you’re in trouble. A 5% drop in a system containing 10,000 units is perhaps bad; a 5% drop in a system containing 20,000 units is probably not as bad. To put it another way, a 5% drop in 2008 was twice as bad, at a unit level, than a 5% drop today, because there’s twice as much in the system today to absorb the shock. And to put it another way, when a system gets to be as historically gigantic as the Dow has, you should expect its fluctuations to also be historically large on a point basis. 
Context: On October 19, 1987, the Dow suffered its largest percentage drop, of 22.61%, in a single day of trading, closing at 1,738. That was only 508 points, which is only about a third of this week’s biggest single-day drop, and it was bad for the market. If you lose 22.61% of the cells in your body in one day, you’d be dead. If you lost 5%, you’d probably make it. The 2.54% drop of February 2nd, 2018, barely squeaked into the top 20 in terms of percentage.
The other really critical thing to remember is that the Dow does not provide a meaningful measuring stick of the market health. The news focuses on it because they’re used to doing so; the S&P 500, which is massively larger than the Dow, has had much smaller percentage moves, and it still only represents a vanishing fraction of the overall market.
It’s also worth looking at why the Dow and the S&P, along with other indexes, have dropped. A mere drop should not even be reason for news; the reasons for the drop are what’s newsworthy, or should be.
One reason is the US’ approach to historically low unemployment. This means that businesses are going to start facing an employment crunch, making labor more expensive. This is bad for stockholders, who can expect to see returns diminish, and good for literally everyone else, because low unemployment. Income taxes can afford to drop when more people are paying taxes, for example. Less will be spent on social benefits programs that help to protect the unemployed. Yes, the stock market will take a brief dive, but a healthy labor pool will inevitably let those stocks recover sustainably. I say “inevitably” because this has happened at least two dozen times on record that I can track down.
Another reason for the stock market dip is the bond market. You see, if you want your money to make money, you’ve really got two options: buy bonds, or buy stocks. Bonds are literally a loan, typically to a government, and when you buy-in, you’re more or less locked into a rate of return. Recently, this return has been shitty, and so anyone with any sense has avoided buying bonds. The low bond yield has been great for people borrowing money, meaning companies could get access to capital super-cheap, both by borrowing, and by selling their stock, since in a crappy bond market people sink everything into the stock market. But the bond market has started creeping up. That means borrowing money will become more expensive, so corporate stocks slide, because “more expensive borrowing” means “lower profit margins for stockholders.” It also means people want to sell some of their stocks to get back into bonds, what with bonds finally paying better. Again – this is actually good for the economy, because you want a better balance between stocks and bonds. The stock market has been a little runaway recently, and this recent movement is more or less just putting down the whiskey and taking a good, hard look at its life.
Anyone worried about their 401(k) simply needs to ensure they’re in a good mix of investments. We call this a portfolio, and it’s meant to be diversified. 401(k) managers are helping create the stock market dip as they rebalance their holdings back into bonds, municipal funds, and things other than “just stocks.” Yes, your 401(k) value is likely to take a dip, but it’ll also pick up a gain elsewhere in a short period of time. I had a distant acquaintance fussing about this on Facebook, and he’s like, 30 years old. When you’re 30, just keep plowing money into your 401(k). Don’t worry about it. You’ve got a minute, and what the Dow taketh away, the Dow inevitably returneth in time.
Remember, during the 2008 crisis, we were constantly reminded that the Dow had fallen below 10,000, a level it has only recently retained. The sucker is over 20,000 now. The Dow comes back. All the indexes do, because the stock market always does. 
This is also a good time to ask, “how does the US economy grow?” Economic growth equals better stock market, so how does growth happen? Unemployment doesn’t lead to growth. Consider this: suppose you make widgets. It takes one person to make 100 widgets. You can make 200 widgets if you hire two people. This is not economic growth; it’s merely revenue growth. Economic growth – essentially, creating money out of thin air. happens when you reduce the costs needed to produce the same output. Automation is a good way to think about that: if you get a widget-making machine that can be run by one person and produce 500 widgets, then you’ve created 5x economic growth.
Economic growth is so commonly driven by automation that automation is almost a shorthand for growth. And automation typically requires capital investment – you gotta buy machines. Companies have not been making lots of capital investments, recently. They’ve been sitting on their cash hordes and simply hiring up. That drives revenue, perhaps, but it isn’t growth per se. With a tighter labor market, they’re going to be forced to start looking at capital investment again. That investment is no longer going to be historically cheap, because the bond markets and interest rates are finally creeping up. So, investors start selling stocks, which triggers people’s stupid auto-sell bots, which creates a selloff. It’s fine – it’s an adjustment to a market which was frankly behaving like a six year-old with a box of sugar and a Red Bull. As the market goes back to creeping up, which it always does, the next phase of growth is likely to be more stable and sustainable, and to represent actual economic growth, not just higher revenues.
The media likes to sound the alarm on the stock market because it sells ad time. They know it works because of a human behavior called loss avoidance. Humans work about 3x harder to avoid loss than they do to achieve a gain; we get 3x sadder about loss than we get happy about a gain. Headlines about the stock market’s runaway success tend to fall on more or less deaf ears. Remember that headline about how the stock market has grown 50% since 2008? No, you do not. Stock market gains historic 10,000 points! Nope. But when it sheds 5% of that, everyone’s headlines make sure you know it. Ask yourself why that might be.
After the 2008 recession, the market started to recover roughly in 2010 (it depends a lot on what you mean by “recover,” but by 2010 the downward trend had reversed; the upward trend started in 2009). The was about 8 years ago. 10,000+ point gain in 8 years is about 1,250 points a year, right? So on Feb 5th, we lost a year’s worth of gains. That’s historical, but is it notable? Maybe. Maybe not. It only took about a year to recover most of 2008’s losses, which were far bigger as a percentage of the whole. The market, when it’s as large as it is, can move a lot, in either direction.
Anyway – I’m not suggesting you panic or not panic. I’m simply suggesting that it’s worth understanding the context around all this. Personally, I regard the recent drops as an imminently good thing, for two reasons. First, the damn market was overvalued. We were on an unsustainable upward spiral, and we were either going to see a series of smaller corrections (preferable) or a major recession again (not preferable). Second, the market was too expensive to get into. Now, it’s practically a fire sale, and with the absolute assurance of history that it’ll go back up again, it’s a great time to buy in – in a responsible, diversified manner. I frankly still think too many companies are overvalued and overcapitalized, and we may yet see some downward shifts as people move their investments from these risky, overvalued companies into safer, up-and-coming bonds. Again, that is a good thing if you understand how our total market economy works, and if you’re investing in a responsible, diversified fashion.
Here’s another analogy: suppose you’ve been eating at a really expensive restaurant, because all the cheaper places nearby were closed. This one restaurant, knowing they’re the only game in town, has been letting their food quality slide. The servers have become jerks. And the menu prices keep going up! That’s where the stock market has been – we’ve been a captive audience, locked into something we really shouldn’t have been happy about. Well now some of the cheaper places are opening, and we’re all walking out the door. Yes, that expensive restaurant is going to take a financial hit – but it’ll also force them to behave like a competitor, meaning they’re going to have to go back to earning our business. Oh, we’ll all go back in time, after they’ve returned to a more responsible and respectful way of doing business. But we’ve got options now, and markets operate better when there are options.
Addendum: There’s another bit, too. Someone mentioned that, “sure, that all sounds great, but if your retirement account just lost all its value, it doesn’t help.” I get that – but there’s a perspective, there. First, from a very technical standpoint, no retirement account lost any “value” in all this. Your account never contained dollars, although I understand you’re accustomed to viewing it in terms of the dollars it would be worth if you liquidated it right then. Your account contains stocks and bonds, and likely some cash. All of those retain their intrinsic value. When you invest in, say, Apple, you’re investing in your assessment of how that company will perform and return on your investment. Most likely, you’re actually invested in funds, a collection of stocks and whatnot where someone you pay – a fund manager – has made the choices for you. Stock market performance has neither added to, nor removed, any of that from your account. It’s all simply “worth less money” at this exact point in time. That will change. It may go up, and it may go down – over a long enough period of time, it will assuredly do both, many times over. That’s why I ignore my accounts and keep dumping money in, especially when the market has a Spring Clearance Sale as it’s doing right now. Come age 55 or so, I’ll start migrating my riskier investments to lower-earning, less-volatile ones, like cash and bonds. I’ll continue that as I approach retirement, to begin protecting the value that’s there. But consider this: In 2008, when people were bailing on the market, if you’d sunk $10k in it, you’d have over $20k now, a doubling of your money. The market eventually goes up, always, and “buy low” remains evergreen advice.
Have a great weekend!

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Don - I subscribe to your blog mainly to read your tech articles. In light of all the articles that I've read from you, this one is near the top. Very well articulated and a breath of fresh air amongst all of the recent fear mongering going on. You bring a voice of reason in this post and I'm very appreciative of it!