SHARE prices have been falling persistently since the start of 2016 with markets in Europe and Japan falling more than 20% from their recent highs, the technical definition of a bear market. Bear phases are reasonably common; the S&P 500 index has suffered at least 15 of them since 1929, although it has yet to meet the definition this time round.
It is never possible to be definitive about the reasons for a stockmarket fall. Investors don’t have to fill in a form explaining their reasons for selling shares. The popular explanations for the current decline involve worries about the health of the Chinese (and thus the global) economy; concerns that corporate profits may be falling; and fears that the Federal Reserve may have tightened monetary policy too soon when it raised interest rates in December. And a survey of fund managers by Bank of America Merrill Lynch indicates these explanations are roughly right; optimism about the global economy has declined, more than half think profits will fall over the next 12 months and a Chinese recession is perceived to be the biggest risk.
Another way of understanding the decline is to focus on the theoretical basis for share valuations; a share represents the future cashflows the investor will receive, discounted at the appropriate rate (the higher the discount rate, the lower the current price). So falling share prices either indicate that investors have become more pessimistic about future cashflows (they fear falling profits) or that they have raised the discount rate they apply (a sign they have become more cautious, and demand a higher return for the risk of owning shares). The plunge in oil prices and other commodity prices may explain that caution; perhaps they are telling us something about the health of the global economy. Another sign of caution is the rise in the yields paid by junk bonds (those issued by the riskiest companies); investors are demanding a higher return for the risk of lending.
Does a bear market inevitably mean recession? No. The 23% one-day decline in American equities in October 1987 (Black Monday) was not followed by an economic downturn. The dotcom boom, and the surge in house prices in America and elsewhere, showed that prices can lose track with fundamentals. The recent decline may merely indicate that share prices were overvalued, and are now coming back to earth, or even a sign that investors have become too pessimistic. More economic news, and more company results, will be needed to tell whether this market signal is the real thing, or just a fake.
