Globalization, for all its vast economic benefits, added a second wrinkle. As appetites for risk were rising in the United States, they were also spreading throughout the globe. An often overlooked feature of the past boom is that it was the first ever to rise and fall in a truly integrated global market. Optimists hoped traders from Singapore to Lisbon would spread risks and make markets more efficient. That did happen. But that interconnectedness also meant a far larger number of investors around the globe began operating on the same set of flawed assumptions (that U.S. housing prices don't fall, for example). In the end, global stock markets acted in tandem when financial turmoil hit, and many emerging market indexes fell even harder than their U.S. counterparts. In a 2004 speech, Federal Reserve Chairman Ben Bernanke, who was then a Fed governor, summed up the Great Moderation as a product of structural changes, better macroeconomic policy, and good luck. If that luck has run out, its demise could bring a return of higher volatility and lower asset prices.
Damage at home. American wealth declined by $11 trillion in 2008, and if we feel poorer for long, it will be a problem for stocks. Future equity gains are closely tied to the health of the U.S. consumer. For years, that was a good thing. Floating on that same wave of stability, unprecedented access to credit, and booming prices for major assets (stocks in the '90s, homes in this decade), the phrase "Don't bet against the American consumer" became something of a mantra for many investors despite stagnant wages and soaring levels of household debt. At its peak, consumer spending soared to nearly 71 percent of GDP. Now many Americans are simply tapped out. Their recovery will be a big factor in determining when stocks will rebound. Unfortunately, consumer spending is closely tied to jobs, and once spiking unemployment reverses, some worry that those lost jobs may not come back. Recently, former Federal Reserve Chairman Paul Volcker warned of an extended "Great Recession" in which lost jobs in finance or the auto sector are not replaced, boosting the "natural" unemployment rate above the level of joblessness considered "full" employment today (about 5 percent) to something substantially higher.
At the same time, the financial crisis rages on. "Stress tests," bailouts, and executive bonuses still regularly top the financial pages, and the ultimate sign of success—normalized lending—is still probably a ways off. So, when might the financial crisis ease up? Not soon, according to research by Harvard's Kenneth Rogoff and University of Maryland economist Carmen Reinhart. They estimate a full recovery to pre-crisis levels could take four years. Stocks often rebound before a recovery gets going, but this time other challenges remain. The problem could be prolonged by the aftermath of huge amounts of debt. "There is a debt overhang problem that we haven't solved here," Reinhart says. "I see it as a lasting damper on equity markets. It is in the financial companies, it is in the households, and it will be in the government."
They estimate the government deficit could increase by $8.5 trillion over the next three years, and Reinhart warns that such spending, when combined with billions more being spent around the globe on stimulus packages, could spur higher taxes and renewed inflation, which eats away at all manner of investment gains and produces historically poor returns for stocks. Looking ahead, she warns that the damage from our banking crisis that rippled around the world could come sloshing back if eroding emerging market economies face banking crises of their own.
Reasons not to love stocks (as much). Wall Street trouble always brings out the bears, but this time the pessimists are getting more of a hearing, including those who think the current weakness in stocks is just getting started. Martin Weiss, author of The Ultimate Depression Survival Guide, advises investors to abandon stocks altogether. Other longtime bears like Jeremy Grantham say subpar market returns could last a biblical seven years as consumers and businesses reckon with a long-lasting debt overhang. The long-term value of slavish devotion to holding shares is being debated as well. A much-discussed paper published by Robert Arnott of Research Affiliates challenges the assumption that the "risk premium" that comes with stocks may be slimmer than many investors believe.