Stock markets are in disarray because the U.S. economy is thriving

In just two trading days, much of the gains made by equity investors in latter half of 2017 were erased across major global stock markets—a mini flash crash of sorts, according to traders and equity strategists.

On Monday, the Dow Jones Industrial Average charted its biggest single-day drop in history. The S&P 500, an index of 500 large companies, saw its worst day since 2011. In Canada, the Toronto Stock Exchange plunged more than four percent on Friday, and continued its decline the following Monday. Across Europe and Asia, markets reacted to the North American crash — Japan’s Nikkei Stock Average declined almost five percent on Tuesday, and the UK’s FTSE 100 saw a plunge reminiscent of the Brexit vote.

At the time of publishing, the Dow has recovered substantially from its two day decline — but that still doesn't explain what exactly is going on and why, all of a sudden, stock markets are in complete disarray. By most key economic measures — the unemployment rate, GDP growth, wage growth — America is breaking all kinds of records. Shouldn’t the stock market reflect that?

The Friday sell-off

Most ironically, the first trigger that sparked a sell-off in stocks was a very positive January jobs report. The U.S. economy added 200,000 jobs, far surpassing expectations. But more importantly, average hourly earnings increased by 2.9 percent, the best gain since early 2009. That set in motion fears that interest rates would continue to rise throughout the year to negate inflationary pressures that come with a thriving economy.

“Higher inflation erodes the value of an investment over time, so higher interest rates are needed to compensate for that,” currency strategist Karl Schamotta at Cambridge Global Payments told VICE Money.

Markets have been buoyed by a sense of security ever since the Federal Reserve lowered interest rates in 2008. The Dow Jones, for instance, hovered at a measly 8,000 points back in mid-2009 — despite this week’s flash crash, it’s still in the 24,000-25,000 point range.

In a sense, one could argue that asset prices — stocks, bonds, real estate, even wine — have been falsely inflated over the last decade by design. Low interest rates inject confidence into markets because the cost of borrowing for companies becomes markedly lower. When interest rates go up, anyone in the lending business now needs a larger payback for lending that same amount of money. Markets, naturally, react negatively to that.

“We are going back to a much more normal market,” Greg Taylor, a portfolio manager at Redwood Asset Management, told VICE Money. “The last few years have been a complete anomaly. We’re now going to see more volatility, but that’s much more normal.”

The Bond Yield Factor

The second trigger that sparked the start of a crash was the fact that bond yields have been rising over time – they even reached a four year high last week. That matters because a yield on a bond is the return an investor realizes on a bond.

When interest rates go up, or are threatening to go up (like in our current economic climate), bond yields go up too. The sell-off was in part, triggered by this rise in bond yields, but investors exacerbated it by pulling their money away from stocks and into the safety of bonds — ironically the very market that triggered the sell-off to begin with.

“In a sense, markets are reacting very negatively to something that is very positive — a sharing of wealth. It’s great for most people, because frankly many people are not invested in the stock market. But traders and investors don’t like what’s happening right now,” Schamotta told VICE Money.

Monday afternoon’s flash crash

U.S. stocks saw their biggest one-day fall in six years on Monday. Some analysts believe that our modern system of trading where computers do most of the work, effectively aggravated the crash.

“A lot of people had set up computers to have stop-losses, meaning that when stocks go below a certain point, they automatically are sold off,” explains Taylor. “On Monday afternoon, that started happening in bulk, one stop-loss after another, leading to a mini flash crash.”

Schamotta calls this phenomenon a “self-reinforcing doom loop”. “We’ve seen this over and over again. Prices do something unexpected, the computers take over and add to the momentum that is already underway.”

So what next for investors?

Craig Basinger, Chief Investment Officer at GMP Richardson told VICE Money that he does not believe that markets have peaked, only that they’ve been dealt with a harsh sense of reality. “Look, stock markets are still higher than they were a year ago, this is just the first salvo of its kind,” he said.

The job of the central bank, according to Schamotta, is to remove the “monetary punchbowl from inebriated party guests.” Indeed, markets have been riding high on a false sense of security that was spawned by low interest rates, and now that the economy is back on track, markets have to stand on their own two feet.

Or, as Basinger surmised: “The elastic band got stretched too much and you’re now seeing the first kind of correction. You can actually make a lot of money in this period.”

Follow Vanmala on Twitter