How the stock market responds to a big shock
About the author:
- Author name:
- By Michael Knox
- Job title:
- Chief Economist and Director of Strategy
- Date posted:
- 08 February 2018, 8:15 AM
If you have a large stockmarket shock as we have had in the last couple of days, the market will vary in a broad range in order to discover the prices that people want to buy at and sell at.
Market clearing is important. If markets always went up, no one would ever sell. There would be no supply of stock and the market would never clear itself. That's why corrections are really important.
When we go into periods of big volatility like this, it is the amount of liquidity in the US wholesale system that decides how long that period of volatility will last.
I think this period will last weeks rather than days. I think by the time we get to the end of March and into April, the amount of volatility will be absorbed and the market will be returning to its normal buoyant self.
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We are in a period like 2006 where there is a very large amount of US corporate liquidity. We can tell that because the spreads between US corporate debt in the US wholesale market and sovereign debt have fallen to the lowest levels since 2006. So there is a vast amount of liquidity and that is providing a lot of money to the stock markets.
If I value the Australian stock market in terms of earnings per share and bond yield right now I get a value of around 5700 points. But if I include the additional supply of US corporate debt in the US wholesale market to a model, I get a fair value of 6300 points. I think that estimate is what is appropriate right now. I think that our market right now is hundreds of points too cheap.
When we came into this correction, the US market was about 9% too high including all of the factors I've just spoken about and the Australian market was about 4% too low.
That is because the US market is extending a run towards the end of its cycle whereas we are starting a new cycle based on the improvement of commodity prices.
We are going through a period of high volatility. Because of the size of that volatility I think it will take weeks to clear and not days. By the end of March we will be out of this period.
When we come out of this period we should realise we are in a period of a huge amount of US corporate wholesale liquidity which will continue to bid up markets. My fair value of the Australian stock market including that liquidity is 6300 points. This means that when this volatility eases we will be in a market which is hundreds of points too cheap.
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