Markets Are Smart Even When They Seem To Panic
The stock market may look irrational, but it's repricing risk faster than ever. Sometimes, that's a feature, not a bug.
The S&P 500 recently dropped 9 percent in a single week thanks to fears of a global trade war. On April 3 and 4, it was down 11 percent following President Donald Trump announcing his "Liberation Day" tariffs. Only days later, it surged 9.5 percent in one day after Trump announced he would pause many of the tariffs.
With this level of volatility, one might be led to believe that the markets are an inefficient tool that serves no economic purpose. But the stock market has, in fact, been doing a fairly good job of discounting the effects of a global trade war into corporate earnings.
If you add up all the corporate earnings for every S&P 500 company and assign a multiple to it, you get a rough estimate of what these companies are worth. In good times, the multiple will expand: We are willing to pay more for a dollar of earnings. In bad times, the multiple will contract: We are willing to pay less, and the market is saying that earnings are going to go down. These adjustments usually take place over a period of months or years. Now they are taking place in a matter of minutes. On April 9, when Trump announced that tariffs would be paused, the stock market gapped higher. It simply repriced.
Algorithmic trading has made markets more efficient. But occasionally, that efficiency breaks down.
Last week the Treasury bond market got crushed—which seemed to make no sense. During times of stress, bond prices usually go up and interest rates usually go down. Instead, interest rates soared. Yields on the 30-year bond blew out to 5 percent.
There are two likely explanations for this anomaly. First, China—angry over tariffs and holding $800 billion in Treasury bonds—retaliated by selling bonds in the open market. Second, a popular hedge fund strategy called the "bond basis trade" may have been unwinding. (This bond basis trade involves hedge funds selling bond futures and buying the underlying bonds to profit from small price discrepancies with leverage. The bond basis trade had grown to $800 billion in recent months and was seen as a source of instability.) Both these explanations are probably true, and would be temporary dislocations—not signs of a fundamental breakdown.
Speculators try to predict the future. Sometimes it isn't that hard. Trump said throughout his campaign that "tariffs" was his favorite word. After getting elected, he promised incessantly that he was going to impose tariffs. Knowing the deleterious effects that tariffs would have on the global economy, it would have made sense for someone to short the stock market after the election or just to sell the existing stocks in their portfolio. Correspondingly, if you believed that the administration had one eye on the market during the crash and had concerns about financial stability, you might have been able to predict that they would pause the tariffs or say something to ease financial conditions.
These speculators perform a crucial function. In commodity markets, for instance, if traders believe a drought is coming, they'll buy corn futures. That pushes prices up, giving farmers an incentive to plant more corn and consumers an incentive to conserve. As a result, the shortage may be avoided before it even hits. In places where price discovery is prevented from happening—by price caps or floors, for example—markets are plagued by shortages and chaos.
Speculation works similarly in stock markets. If traders think tariffs will hurt company profits, they'll sell stocks. That selling pressure lowers share prices, making it harder for those companies to raise money—and potentially preventing poor investment decisions. Speculators also provide liquidity in markets: the ability to turn an asset into cash. This is the primary reason why a financial transactions tax would be bad: It would fundamentally harm liquidity while raising practically no revenue.
Volatility of the kind we've experienced the last two weeks is exhausting. But even volatility serves an important function. Markets become volatile with the arrival of new information. As investors digest and process the information, volatility fades, and normalcy returns. Traders like volatility; long-term investors don't.
Financial talking heads will tell you not to panic. But there is definitely a time for investors to act in fear—you just have to do it before everyone else does. Now it is too late.
