Why are global stock markets crashing and for how long?

Global stock markets serve as a brutal reminder that nothing can ever be taken for granted when investing.

In the first nine trading days of the year, $5.7 trillion evaporated from world equity markets — the equivalent of the gross domestic products of France and the UK combined, according to analysts at Bank of America Merrill Lynch.

What are the reasons for what has been shaping up to be the worst start to the year ever in the history of equity markets?

Nothing out of the ordinary happened in the world economy, no sudden breakdown in trade, no new, devastating wars or geopolitical conflicts can explain the market rout. Rather, it’s another leg in the collapse in confidence that analysts have been warning about for a while. And it’s all down to central bank policy.

Even the “bank of central banks,” the Bank for International Settlements (BIS), has acknowledged, in a recent speech by its general manager Jaime Caruana, that the major central banks’ policies of zero interest rates and quantitative easing poses challenges ahead.

The BIS believes that the recession that followed the financial crisis that started in 2007 and intensified in 2008 with the collapse of Lehman Brothers was not a “typical post-war business cycle recession. Rather, it was a balance sheet recession, associated with the bust phase of the financial cycle.”

This means that the growth experienced during the boom before the global financial crisis was unsustainable, and its legacy is a permanent loss of output, coupled with a big debt overhang. To prevent the debt bubble from bursting completely and take down the whole global economy, central banks took extraordinary monetary easing measures, which slowed the economic collapse.

However, now it is becoming more and more obvious that they cannot control things indefinitely. Even before the Federal Reserve’s interest rate hike last December, a selloff in bond markets in May last year signalled decreased confidence in central bank policies.

Misallocation of resources

In his speech, Caruana quoted recent research by the BIS that shows that misallocation of resources during credit booms hurts the economy for a long time after the boom has turned to bust. That’s because during the boom, workers tend to shift to sectors that grow rapidly but have lower productivity gains, such as the construction sector.

Because of this, aggregate productivity growth slows down, and so does potential output. When the boom turns to bust, the effects of this misallocation of resources are amplified because the previously overextended sectors are forced to fire staff.

What central banks have done is to just try to re-inflate the credit bubble with cheap money. But this has had as consequences excessive risk-taking and asset price bubbles. What we are seeing now in stock markets around the world is investors realising that there is a price to pay for cheap money.

Two bearish strategists said last week that the Fed’s money printing has actually caused world deflation, because it encouraged capital into emerging markets and now the flight of this capital is devaluing currencies, lowering prices everywhere.

Other analysts note that, with the median price/earnings ratio for U.S. stocks above 24, there are no cheap stocks, and the selloff is just a long-needed correction in which stock prices catch up with earnings expectations.

‘Vicious subsurface bear market’

Brad Lamensdorf, a market strategist and the CIO of The Lamensdorf Market Timing Report, warned in his newsletter that “a vicious subsurface bear market has already begun.” It started with commodities, energy and emerging markets, but “it is only a matter of time before most asset classes, including stocks, are impacted.”

Contrarian indicators keep sending out “buy” signals. The Bank of America Merrill Lynch bull/bear index has now fallen down to 1 and the banks’ Breadth Rule stays in “buy” territory, with 93% of global equity markets trading below their 200-day and 50-day moving averages.

Risk assets are “vulnerable to vicious short-term rallies,” according to the analysts at the investment bank– but they recommend staying long cash.

In their opinion, the resumption of the uptrend depends on an increase in PMI data accompanied by stability in oil prices and in the Chinese currency’s exchange rate, or on a weaker US dollar, which would signal a pause in the Fed’s monetary tightening.

The latter is the most likely scenario. After all, the Fed has yielded to market pressure before.