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5 Observations In This Irrational Stock Market

Roughly $4.5 trillion has evaporated from the Chinese markets since the middle of June – real, tangible wealth that no longer exists. Equities on mainland Chinese exchanges still trade at a median reported earnings multiple of 60+ times, according to Bloomberg. After direct government intervention in the country’s markets failed, China has now moved to cut interest rates and reduce bank reserve requirements, and this somehow has the US markets cheering. Does such irrational behavior by US investors finally mark the peak?

Here are 5 observations worth noting.

1. The Financial and Capital Markets are Fragile

If the Financial Crisis of 2008-2009 taught this generation anything, it was a lesson in the fragility of the financial and capital markets and the stages of denial as market developments unfold.

Many couldn’t have dreamed that Lehman would be wiped from the map, and Washington Mutual (“WaMu”) would experience the equivalent of a 1930s-type “bank run” in the 21st century. The reality is that the stock market will always be a function of human behavior–all the good and all the bad–and the banking system will always operate on the basis of leverage–banks will never hold enough capital to cover all deposits.

These dynamics are core to the financial and capital markets, but they also second in making them forever fragile and exposed to “crash-like” tendencies. The huge drops in the Dow on Friday and Monday coupled with the bounce on Tuesday speak to a situation that bears watching closely. In our view, if this “reckless” market has rattled business and consumer confidence, it’s very likely we’ll start to see implications on the broader US economy.

It is well known that the stock market leads economic activity as both a measure of investor confidence and as a well-defined wealth effect (lower stock prices mean consumes feel less wealthy). Without confidence, business investment dries up and job growth slows (or even layoffs ensue), which impacts consumer spending, which hurts businesses, which then cut more jobs and so on. The probability that such a “fickle” market may have finally stemmed the marginal “animal spirits” required for incremental economic risk-taking has become elevated.

The risks of spillover effects from the “crash in the Dow” on the US economy are real.

2. Volatility Often Marks Tops and Bottoms

Though some of the best investors are able to call market tops and bottoms, for us mere mortals, the best we can do is “get close.” Most...