Reflecting on the stock market, Sir Isaac Newton remarked that he could calculate the motion of the celestial bodies, but he could not calculate “the folly of man.”
We have to wonder what he would be saying about the current American stock market.
While the main economic and geopolitical risks to the economic recovery are in sight, markets established new all-time highs as if there were no tomorrow.
The Dow Jones closed above 38,000 points for the first time on Monday and the S&P 500 also had a record close.
How quickly markets have forgotten how caught off guard they were caught in 2008 with the bursting of the U.S. subprime mortgage and housing market bubbles.
Those events caused the steepest market crash since the 1929 stock market crash.
The main economic risk we face now is the result of the Federal Reserve's hawkish monetary policy stance and the consequences of the COVID-19 pandemic on work and shopping habits.
Since June 2022, the Federal Reserve has embarked on the most aggressive interest rate hiking cycle of the postwar period.
In the short space of 15 months, it raised interest rates by 5¼ percentage points.
At the same time, it reduced the size of its balance sheet by more than $1 trillion through quantitative tightening.
That caused interest rates to rise sharply and caused significant damage to banks' balance sheets by reducing the value of their bond portfolio.
Thanks to the Federal Reserve's actions, banks have market value bond losses estimated at more than $600 billion.
We are also seeing an increase in default rates on auto loans, home mortgages, and credit card debt due to higher interest rates.
The COVID pandemic has notably disrupted the $20 trillion commercial real estate market.
Employers have discovered that they do not need their workers to go to the office every day.
As a result, office vacancy rates have risen to a record level of nearly 20%.
In New York alone, it is estimated that empty office space is equivalent to 30 Empire State buildings.
And the retail space is under considerable pressure as the trend toward online shopping accelerated during the pandemic.
Early last year, we had a regional bank crisis centered on Silicon Valley Bank and First Republic Bank that required intervention by the Federal Reserve.
High interest rates and falling commercial real estate prices now pose a very real risk of triggering a crueler round of the regional bank crisis.
It's especially a danger since commercial property loans make up nearly 20% of regional banks' loan portfolio and it's difficult to see how real estate developers will be able to roll over the estimated $500 billion in loans coming due this year. .
In a disturbing sign of what may happen, major real estate developers like Brookfield and Blackstone are handing the keys back to lenders.
A recent paper from the National Bureau of Economic Research estimates that high interest rates and a possible wave of commercial property loan defaults could cause nearly 400 small and medium-sized banks to fail.
If that were to happen, the all-important small and medium-sized business sector, which represents about half of the US economy, would be starved of credit.
As if these economic risks were not enough of a concern, we have a combination of geopolitical risks of a severity not experienced in decades.
The war between Russia and Ukraine is the largest European land war since 1945.
The war between Israel and Hamas risks spreading to the rest of the Middle East.
The Houthis threaten to block the vital passage from the Red Sea to the Suez Canal.
The Chinese are expressing their discontent over the recent Taiwanese presidential election.
That increases the risk of deteriorating already tense relations between the United States and China and increasing tensions in the South China Sea.
However, despite all these major economic and geopolitical dangers, the stock market continues to rise.
It is setting all-time highs and trading at inflated valuations.
We must wonder if this might not be a repeat of the way the stock market rallied on the eve of World War I only to find that the markets had to be closed for several months to avoid a complete panic when the war broke out.
Or perhaps it's a repeat of the way markets remained blissfully unaware of the consequences of the bursting of the housing and subprime market bubbles until the bankruptcy of Lehman Brothers in September 2008.
In any case, it would certainly leave Isaac Newton scratching his head.
