The Missing Part of the Dow Jones and Stock Market Sell-off Analysis.

The stock market keeps on sending signals of correction as the Dow Jones struggle to rebound from Monday’s 5th of February sell-off. Economic analysts began early in the week to point out to fear of high inflation due to an upward trend in workers compensation. News reports were mostly based on strong beliefs and arguments over the so-called Phillips Curve. However, instead of focusing exclusively on the weak relationship between wages and inflation, I suggest a brief look at the textbook explanation of the link between the stock market and economic activity. In this blog post, I frame the current market correction phenomenon under the arbitrage argument. If one were to consider the arbitrage argument to explain the correction, it would lead analysts to make firm conclusion not only over monetary policy but also over fiscal policy. The obvious conclusion is that Monetary Policy (Interest rates) will most likely aim at offsetting the effects of Fiscal Policy (Tax cuts).

The Arbitrage Argument (simplified):

Market sell-offs unveil a very simple investment dilemma: bonds versus stocks. In theory, investors will opt for the choice that yields higher returns. Firstly, investors look at returns yield by the interest rates, which means a safer way to make money through financial institutions. Secondly, investors look at returns yield by companies, in other words: profits. If such gains yield higher returns than saving rates, investors will choose to invest in the former. In both cases, agreements to repay the instrument will affect the contract and the financial gains, but that is the logic (Things can get messier if one includes the external sector).

The corresponding consequences are the market expectations about the economy. On the one hand, currently investors expect monetary policy to tighten. On top of jobs reports and previous announcement about rate increases, fears of inflation lead to the conclusion that the Federal Reserve Bank will most likely accelerate the pace in rising interest rates for its ten years treasury bond. Such policy will decrease the amount of circulating money, thereby making it harder for business to get funds because, following the arbitrage framework, investors will prefer to invest in safer treasury bonds. On the other hand, investors expect fiscal policy to have an impact on the economy as well. Recent corporate tax cut bolster the expectation for a higher level of profits from the stock market. Such policy may allure investors to believe that financing companies through Wall Street will yield higher returns than the bond market. Thus, sell-offs unveil the hidden expectations of investors in America.

Expectations and the Economy:

Once expectations seem formed and clear concerning declared preferences, (meaning either continuing the correction path for other indexes, or a rebound), investors begin evaluating monetary policy adjustments. They all know the Federal Reserve dual mandate as well as the Taylor Rule. The question is how the Federal Reserve would react to the market preferences based on other leading economic indicators. Will the Fed accommodate? Or will the Fed tighten? As of the first week of February, all events suggest that the Federal Reserve Bank will most likely tighten to offset and counterbalance the recent tax cut incentives and its corresponding spillovers.

Recent Narratives of Stock and Bond Bubbles.

On February 5th, 2018, Dow Jones index fell 1,175 points after the trading day. Four economic scenarios are being analyzed in the news as of the first week of February 2018. First, there are indeed both Stock Market and bonds Bubbles. Second, the Monday Dow’s selloff is just an anticipated correction move on the investor’s side. Third, the stock market returns to the old normal of higher levels of volatility. Fourth, Trump economic effect. I need not to cover the concerns on the US economy nowadays in this blog post. Hence, the analysis that I think is needed currently is the ruling out of a contagious effect from the narratives created around the Dow’s selloff on Monday. Indeed, I believe that such narrative, if any, can be traced back to former chairman Alan Greenspan’s comments when he stated on January 31st that America has both a bond market and stock market bubbles. By discarding the contagious effect in current narratives, I side with analysts who have asserted that the Dow’s fall was just an anticipated market correction.

Can economists claim there is some association between Alan Greenspan’s comments and the Monday fall of the Dow Jones? I may not have an answer for that question yet, but We can look into the dynamics of the phenomenon to better understand how narratives could either deter or foster an economic crisis in early 2018. If there is room for arguing that Mr. Greenspan’s comments triggered the Dow Selloff on Monday, I believe we should be observing some sort of panic or manifestation of economic anxiety. By looking at data from Google Trends, I spot on breakouts that may well be understood as “spreading” symptoms. In other words, if there is any effect of Mr. Greenspan’s comments on the Dow’s selloff on Monday, we should expect to see an increase in Google searches for two terms: first “Alan Greenspan”, and second “Stock Market Bubble.” The chart below shows google trends indexes for both terms. Little to nothing can be said about the graph after a visual inspection of the data. It is hard to believe that there are narratives of economic crisis fast-spreading, nor have Mr. Greenspan’s comments had any effect on the Dow’s sell-off.

How did things occur?

Economists are lagging on the study of narratives, hence the limited set of appropriate analytics tools. Robert Shiller wrote early in 2017 that “we cannot easily prove that any association between changing narratives and economic outcomes is not all reverse causality, from outcomes to the narratives,” which is certainly accurate whenever time has passed as empirical evidence become obscure. However, on February 1st of 2018 mainstream media reported extensively a couple of statements made by Alan Greenspan about bubbles. In the following two days, several market indexes closed with relatively big loses. In detail, the events occurred as follows:

  1. On January 31st, 2018 Alan Greenspan told Bloomberg News: “There are two bubbles: We have a stock market bubble, and we have a bond market bubble.”
  2. On February 5th, 2018, Dow Jones index falls 1,175 point after the trading day on Monday.

Whenever these events happen, we all rush to think about Robert Shiller. As Paul Krugman cited Shiller today February 6th, 2018, “when stocks crashed in 1987, the economist Robert Shiller carried out a real-time survey of investor motivations; it turned out that the crash was essentially a pure self-fulfilling panic. People weren’t selling because some news item caused them to revise their views about stock values; they sold because they saw that other people were selling”. In other words, Robert Shiller’s work on Narrative Economics is meant for these types of conjectures. Narratives of economic crisis play a critical role in dispersing fear whenever economic bubbles are about to burst. One way to gauge the extent to which such a contagious effect occurs is by looking at google trend search levels.

 

 

No signs of fast-spreading economic crisis narratives:

Despite the ample airtime coverage, there is little to none evidence of a market crash and economic crisis. In the wave of fast pace breaking news announcing crisis and linking them to political personalities, markets seem just to be having an expected correction after an extended period of gains. The best way to conclude such correction is by looking at the firm numbers reported lately on jobs markets as well as to investigate the collective reaction to fear and expectations. Thus, four economic scenarios are being analyzed as of the first week of February. First, there are Stock Market and bonds Bubbles. Second, the Monday Dow’s selloff is just an anticipated correction move on the investor’s side. Third, the market returns to the old normal of higher levels of volatility. Fourth, Trump effect. None of the scenarios seem plausible to me. First, the selloff appears not to have dug into the investors and people’s minds, thereby avoiding the contagious effect. Second, despite the unreliability of winter economic statistics, jobs reports on January 2018 seem optimistic (I think they will revise those number low). Third, claiming volatility is back to the stock market is like claiming Trump is back into controversy. Therefore, the only option left to explain Monday’s selloff is the argument of a market correction.