Why the Stock Markets Are Overreacting

The last few months have been tough for the stock market. We had the Debt Ceiling debacle, the European debt crisis, a slowdown in the world economy, rating agencies looking to downgrade treasuries, and countless other problems. It is no wonder that equity markets have sold off sharply as a result of the accumulated fatigue.

While the factors listed above are real problems, history suggest that markets tend to overreact to both good and bad news. The reaction to bad news normally involves declining stock prices and, among other things, rising gold prices.

Bloomberg published a chart recently that shows how many dollars in earnings you can buy for an ounce of gold. If gold is expensive and stocks are cheap (both signs of fearful markets), you can exchange you gold for a lot of stock, which in turn generate a lot of earnings.

Gold to Earnings Ratio
The Bloomberg chart above shows how the earnings per ounce of gold have evolved over time. Gold is at its most expensive ever relative to stocks. By this measure the markets have never been as fearful as they are now.

Other fear measures, e.g. the volatility index (VIX), paint a similar picture, but the current levels of fear are not even close to all-time highs. The chart below shows the VIX over the same period of time.

The two measures share the property that sharp spikes are transient. Markets cannot sustain extreme levels of fear for very long.

When the markets calm down, the VIX and the Gold to Earnings Ratio are likely to return to more normal levels. For the Gold to Earnings Ratio, some of it will probably come from declines in the gold price, and some will come from a recovery of stock values.

Once markets have calmed down again, a real assessment of the economic situation can take place. Right now we mostly see knee-jerk reactions to data, rumors, and opinions that are amplified by the overall level of fatigue from months of multiple crises and stresses.

Addendum: 90-day treasury yields briefly dropped below zero today. This is another indicator that the markets are very spooked. Rational investors would not pay the US government or anyone else to hold their cash for three months, but panicked ones might before they come to their senses and put the money under the mattress instead.

About the author

Marc Schindler, CFP®

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