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Stock Market Plunge More Fear Than Fundamentals

BU economist Laurence Kotlikoff: average investor should do nothing

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The Dow Jones industrial average plunged more than 1,000 points Monday morning, recovered some, but closed off more than 3.5 percent in a volatile day that saw Wall Street reflecting market turmoil in China and elsewhere around the globe. Why did it happen?

BU economist Laurence Kotlikoff says it was fear rather than sound economics that drove the sell-off.

“A lot of what traders are focused on is what they think other people are thinking,” says Kotlikoff, a William Fairfield Warren Distinguished Professor and a College of Arts & Sciences professor of economics. “That leads to the maxim Franklin Roosevelt came up with: The only thing we have to fear is fear itself.

“Whether there’s anything truly fundamental here is an open question,” he says.

Kotlikoff is not a fan of the idea often expressed by TV pundits that this a market correction, or even that it’s overdue. “The market has done well for a long time, so some people may think it’s overvalued,” he says. “On the other hand, we can’t disprove the theory that the market is being priced correctly at every point in time. So the fact that it’s gone up over time doesn’t mean that it’s necessarily got to come down.”

The main driver of the sell-off seemed to be several days of bad news about currency devaluation and cutbacks in economic forecasts from China, the world’s second largest economy. But, says Kotlikoff, despite the importance of China in the world economy, such reports should not drive US investor behavior. “They’ve cut their estimate of growth down from some astronomical number like 9 percent to 7 percent,” he says. “We don’t know how good these data are.”

Monday’s events do not mean that people should sell the stock in their retirement account, Kotlikoff says: “This stuff happens, but people who are investing for the long term should let the people who want to panic, panic, and just have faith in the underlying economy.”

He says the events so far lack the underlying concern about the health of financial institutions that came to the fore in 2008. In other words, the sky is not falling. “If we look at 1987, we had an even bigger one-day crash than they had in 1929, and the market came back. It was a collective panic,” he says.

In the meantime, consumers may be more enthralled about low gas prices, well under $2.50 a gallon in some places, than concerned about the market drop. That’s fine, Kotlikoff says: “Usually, if oil prices drop, that’s a good sign for the economy, and if they go up, it’s a bad sign, so there’s a lot of good news out there as well as today’s events.”

Many observers say they expect the Federal Reserve to hold off on a long-delayed interest rate hike because of the China situation and related events.

There’s always a small chance that panic could snowball, Kotlikoff says, but he doesn’t expect that self-fulfilling prophecy to occur in this case.

The Dow closed off 588.47.

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Joel Brown, writer, BU Today at Boston University
Joel Brown

Joel Brown can be reached at jbnbpt@bu.edu.

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