How Now Low Dow?

Don’t blame China for the stock market plunge.

Alan Greenspan

Wall Street and the media have mostly blamed yesterday’s huge U.S. stock market drop on frenzied, irrational Chinese investors. After a parabolic run up, China’s stock market fell nearly 9 percent on Tuesday, triggering drops across Asia and Europe, and ultimately, in the United States. According to the conventional wisdom, sophisticated U.S. investors were taken unawares by unpredictable, irrational overseas behavior. For globalists, the domino effect is yet more proof that the world is flat. For anti-globalists, it’s another warning about what happens when we tie our established economy too closely to China’s emerging one.

Or maybe not. Sure, the quick fall in China’s market may have alerted American investors to global risks and caused them to dump U.S. shares. But in fact, U.S. investors were rationally processing (albeit in a somewhat frenzied manner) investing information that was almost purely domestic in nature. China’s plummet may have set off the conflagration, but the kindling was entirely homegrown.

Consider what was floating around yesterday: (1) a precipitous drop in U.S. durable goods orders in January, not including defense, which bodes ill for the manufacturing sector; (2) perhaps the most esteemed economist of our era, former Federal Reserve Chairman Alan Greenspan, publicly mused that the U.S. economy might—might—be headed for a recession later this year; (3) a slew of stories in the Wall Street Journal on the continuing problems with subprime lending, the possible failure of American banks to set aside reserves for bad debt, and a general pullback of the liberal extension of credit; (4) existing home-sales data that showed an increase in volume but a 5 percent drop in the prices of homes sold in the United States between December 2006 and January 2007; (5) the anticipation of this morning’s sharply downward revision to Gross Domestic Product for the fourth quarter, from 3.5 percent to 2.2 percent.

While the durable goods number was unexpected and Greenspan’s comments came out of the blue, the other data points were not surprises. The fact that the housing bubble has popped and that subprime lenders and borrowers are in trouble is one of the least well-kept secrets on Wall Street. Meanwhile, smart analysts have been punching holes in the preliminary fourth-quarter GDP data since it was first released in January.

U.S. stock markets have routinely shrugged off negative information during the recent bull run. What made yesterday different? This time, the signs of a slowdown—not a recession but a slowdown—are clearly evident. The plunge in durable goods orders indicated that the manufacturing sector may be in danger of recession. (Thankfully, the U.S. economy relies less and less on manufacturing for growth, which is why a manufacturing recession may not trigger an economy-wide one.)

And the twin turbines that have driven the U.S. economy in recent years are clearly sputtering. When housing is doing well, it stimulates a great deal of economic activity, creates jobs, and makes people feel wealthier—and hence more likely to spend. When housing is doing poorly, the opposite holds. And as today’s new home-sales report confirms, housing is still struggling. Prices and home values are down marginally, but when assets are encumbered with huge amounts of debt—as houses are—it doesn’t take much of a decline to make an impact. (If you put 10 percent down on a house, and it declines 10 percent in value, you’ve lost your entire investment.)

Second, and more important, there has been a precipitous decline in the business of housing-related credit. In recent years, cheap and abundant mortgages have allowed people to buy ever-more-expensive homes with little money down and to borrow against homes they already own to expand and renovate, thus fueling consumer spending. The huge volume of so-called mortgage-equity withdrawal, Alan Greenspan and his Federal Reserve colleague Mark Kennedy have argued, has been a significant contributor to the late consumer-spending binge.

Here, too, the trend may no longer be the economy’s friend. Interest rates are still low. But with subprime-lending operations failing, and with big banks taking big hits to their mortgage portfolios, pressure is mounting among regulators and investors for lenders to become more parsimonious. Freddie Mac, the government-sponsored enterprise that is a huge force in the mortgage market, yesterday announced it would no longer buy certain types of subprime loans. In the economy, one overreaction—in this case, extending too much credit on easy terms—tends to inspire a counter overreaction. And so it’s reasonable to assume that housing-related credit will become more difficult to obtain in the coming months.

Individually, each of the above items bodes poorly for the short-term performance of the U.S. economy. Taken together, they are the ingredients for one big slowdown sandwich. It’s as if investors woke up yesterday and realized that the U.S. economy could really be slowing down, which is generally bad for stocks. Sell!

In addition to the hard data signaling the possibility of a hard landing, there were less tangible—but still meaningful—signs of the sort of widespread complacency that frequently cometh before the fall. Buyout maven Henry Kravis, whose 1988 biggest-ever deal to take RJR-Nabisco private signaled the top of that decade’s credit cycle, on Monday announced the new biggest-ever deal to take energy company TXU private. The market had gone nearly four years without a day in which the S&P 500 fell more than 2 percent. And the cover of the issue of Forbesnow available on the newsstand plugged an article titled, “Has the Bull Market Just Started?”