Why are stocks cratering?
Plenty of other economic indicators are quite healthy. GDP growth for the third quarter was 3.5 percent. That's down from the 4.2 percent boom in the second quarter — but it's still good for America's best back-to-back quarterly growth in four years.
But stock markets are getting hammered. Sure, they recovered ground on Tuesday, but they remain well below their peaks at the beginning of October.
So why is the stock market tanking even as economic growth booms?
Well for starters, because the stock market is not the real economy. But also, in this case, stock markets are likely falling because the real economy is returning to something like healthy normalcy.
This requires some explanation.
The dividend payments you get as a stockholder are pulled from company profits. Thus, the value of a given stock is largely a function of the business' expected profits. To understand why the stock market as a whole has been booming in recent years, notice that corporate profits as a whole have boomed as well.
At the same time, however, as interest rates rise, stocks become less valuable. Higher interest rates make it more expensive for businesses to borrow and finance their operations, which eats into profits. Higher interest rates also increase the yield for safe assets like U.S. Treasuries, which lowers the comparable return on riskier bets like stocks.
Here's the Federal Reserve's target for national interest rates. As you can see, they fell to nothing during the same period corporate profits boomed.
In recent years, you may have seen a lot of financial stories about the "goldilocks economy." This is why. That unique combination of surging corporate profits and rock-bottom interest rates delivered an absolute bonanza for the investor class.
But now interest rates are rising and the real economy is growing. Investors are worried the party is coming to a close.
Indeed, the Fed is finally increasing interest rates largely because GDP growth is firming up. The central bank's job is to maximize job creation and stabilize prices. As the economy heats up, the Fed is worried that will increase inflationary pressure. Now, the central bank arguably has a habit of over-prioritizing inflation. But this is why it's tapping the brakes.
On top of that, as the economy strengthens, there will be more opportunities for profitable investments, and banks will be able to charge higher interest rates on the loans they offer.
All of which translates into higher interest rates for the national economy.
Now, obviously there's a lot out there scaring investors, from a slowdown in China’s growth to President Trump’s trade war. But rising interest rates and the potential end of the "goldilocks economy" is a big part of the stock panic.
And there's one more factor: unemployment.
The jobless rate is at a near-historic low. This at least theoretically gives workers more leverage to demand higher wages. When their services are more in demand, they can charge businesses more for them — and that rising worker pay eats into corporate profits. More competition may also simultaneously force businesses to cut prices to hold onto market share. As you may have noticed from that graph, the boom years of both the midcentury and the late 1990s line up with lower corporate profits. In fact, corporate profits have already taken a dip as the economy has strengthened — though they remain historically high.
America's economy faces real threats. But that's not why stock markets are freaking out. Rather, investors have been spoiled rotten by an economy that spent years granting them massive returns at the expense of the rest of the economy. They're freaking out because we're finally seeing signs — and really just very modest signs — that maybe things are returning to normal.