The recent economic news has been about as investor-friendly as anyone could imagine.

It started with last week’s strong U.S. employment figures; continued through Tuesday’s reassuring International Monetary Fund forecasts, which put the probability of avoiding a global recession this year to 99.9 percent, and culminated in dovish Federal Reserve minutes, which soothed concerns about an earlier than expected increase in U.S. interest rates.

Considering all this good news, investors could justifiably feel surprised — even shocked — by Wall Street’s sharp falls this week. By Thursday afternoon, the Standard & Poor’s 500 had given back its entire gain for the year, and the Nasdaq 100 gauge of leading technology stocks had suffered its biggest setback since 2011. Many market analysts interpreted the negative reaction to good news as a classic sign of a market top, warning that the uninterrupted rise in share prices that began more than five years ago is overdue for a sharp reversal.

But looking at the economic and financial data, it was hard to see justification for such anxiety. Last week’s rebound in U.S. employment growth — the crucial monthly statistic that tends to set the tone for asset markets around the world — could only be interpreted as good news. Especially after the shockingly weak December payrolls that triggered the global equity correction at the start of the year.

February and March monthly employment growth reverted to almost exactly its three-year average of 184,000. For equity investors, this meant much less concern about a U.S. economic slowdown, never mind the stagnation or recession that some bearish economists were predicting as recently as a few weeks ago.

For bond investors, the remarkably steady rate of employment growth meant there was little chance that the Fed would start raising interest rates earlier than the middle of 2015. These U.S. job figures were close to the “Goldilocks” ideal of an economy — neither too cold nor too hot for equity and bond markets alike.

Why then did Wall Street suffer such a sharp setback last Friday and early this week? The simple answer is that short-term market movements often have no logical explanation. “More sellers than buyers” (or vice versa) is often a better explanation for sudden price movements than the post hoc rationalisations in stock-market commentaries.

For this week’s the sell-off, however, two other possibilities are worth considering.

The first is that the five-year bull market that began on March 9, 2009 is indeed past its sell-by date, as pessimistic commentators have repeatedly warned. Even if the U.S. and global economic outlook is as favourable as IMF forecasts suggests, Wall Street valuations are historically high. The current upswing has continued longer than any bull market on Wall Street since the 1920s, according to Brian Marber, a leading technical analyst in London.

But have stock markets really become so complacent and over-extended that even a minor catalyst could trigger a severe bear market? The evidence suggests otherwise. Equity valuations are only modestly above their long-term averages. The 500 stocks in the S&P 500, for example, are trading at roughly 15 times their expected earnings this year — only slightly higher than the 10-year average of 14. And an average means, by definition, that the market will spend about as much time above this level as below.

In addition, while surveys of investor sentiment are bullish, most surveys of the actual portfolio allocations remain fairly conservative, with hedge funds more cautious than average and private investors still sitting on vast amounts of cash.

Another reason for reassurance is that the Wall Street gains have been steady and orderly, without much sign of the exuberant acceleration that preceded major corrections in 1968, 1974, 1987, 2000 and 2007.

The adjective “exuberant,” however, points to a second, more plausible, reason for the volatile — even panicky — behavior on Wall Street. As confidence revives in the U.S. and global economies, investors around the world are looking for stocks that are still under-valued because of exaggerated concerns about economic weakness.

As investors seek out these pockets of neglected value, they have noticed that the prices of many fashionable Wall Street stocks cannot be justified by any known metrics apart from greed and hope.

Companies including Facebook, Netflix, Twitter, Tesla and Alexion, not to mention newcomers such as Grubhub doubled or redoubled in price, as their valuations shifted from extravagant multiples of expected earnings to extravagant multiples of expected revenues and then to extravagant multiples of users, eyeballs or Internet hits. The speculative bubbles in many Internet, mobile phone and biotech stocks have become as evident as in 1999.

This does not mean, however, that stock market prices in general are condemned to suffer severe losses, as they did from 2000 to 2002. There are many companies outside the bubble sectors that are reasonably priced and have good prospects — provided the world economic expansion continues to gather pace. Further gains in equity prices in the next few years are quite possible. But they are likely to be driven by very different companies than the leaders of the past five years.

This is what investment analysts call a leadership rotation. The bad news for investors is that leadership rotations generally coincide with temporary market setbacks, since the old leaders tend to retreat faster than the laggards advance.

Perhaps this is the process that has now started.



Anatole Kaletsky is an award-winning journalist and financial economist who has written since 1976 for The Economist, the Financial Times and The Times of London before joining Reuters.