As stocks encountered headwinds and a wide range of risk assets came under pressure in the week ended Nov. 18, some market observers again rushed to announce the end of what has been an impressive and rewarding rally. But rather than decline further, these markets bounced back yet again. Both the S&P 500 and the Nasdaq indexes ended last week at record highs; and the Dow Jones Industrial Average almost finished the holiday-shortened week at a record, too.
Yet there was plenty of news last week that could have amplified the initial move downward.
In China, stocks were buffeted amid doubts about the government’s ability to maintain economic growth and deal with high debt and pockets of excessive leverage. The selloff in the country’s bond market added to the nervousness.
In Europe, the minutes of the European Central Bank policy meeting suggested a wider range of views on the Governing Council than initially believed, especially when it comes to the advisability of maintaining the large-scale asset purchases program. This added to the uncertainty associated with the collapse of talks on forming a coalition government in Germany under the continued leadership of Chancellor Angela Merkel.
And in the U.S. the Fed minutes did more than support the view that the central bank would hike rates in December. They also seemed to contain an implicit warning from central bankers on the policy committee that “in light of elevated asset valuations and low financial market volatility” some members “worried that a sharp reversal in asset prices could have damaging effects on the economy.”
Rather than respond to all of this with further price declines, stocks resumed their upward movement bringing the year-to-date gains to almost 20 percent for the Dow and almost 30 percent for the Nasdaq, and helping the S&P to a record 55 closing highs this year.
Equities were helped by data showing that the advanced economies, led by the U.S. and Europe, continue to build growth momentum, as well as indications that Congress was progressing on the administration’s tax plan. And with European growth and new manufacturing orders at 17-year highs, this reinforced the view that a synchronized pick-up in global growth provides support for the very strong and profitable conditioning of investors in recent years to buy the dip, and virtually any dip.
This highlights a market phenomenon I have emphasized in the past that is deeply ingrained in investor behavior. Despite widespread recognition of elevated asset prices, artificially low financial volatility and a continuing gap between financial and economic risk-taking, only a big and durable shock can shake the confidence of investors and traders in what remains a very profitable strategy of taking advantage of market declines to add risk exposures. And, notwithstanding lower corporate buyback activities, this confidence is supported by pro-growth policy hopes and a deep market belief that central bank policies will continue to repress volatility and remain supportive of asset prices.
Nothing sticks around longer in markets than a simple investing strategy that has proven to be profitable. But it can also overstay its welcome, especially if fundamentals do not improve sufficiently and rapidly enough to validate the elevated asset prices.
That brings us back to the importance of policy implementation in sustaining and buttressing the historic rally in stocks.
To maintain the uptick in growth, Europe and the U.S. need to implement measures that reverse persistent downward pressures on potential — that is, the ability of advanced economies to grow not just today but also in the future; and to do so in a more inclusive manner.
In the U.S., this requires progress on Capitol Hill on the tax plan, as well as congressional support for the administration’s infrastructure initiative and steps to enhance labor productivity and improve the benefit-to-cost ratio of technological innovation. In Europe, as I argued last week, it takes a more complicated combination of top-down and bottom-up policy measures at both the national and regional levels.
By buying every dip, traders and investors have essentially brought forward future economic growth and financial returns. They are betting that a comprehensive pro-growth policy response in advanced countries will eventually validate what, otherwise, would be quite fragile markets.
Mohamed El-Erian is a Bloomberg View columnist.