Why Stock Market Declines Are Good

James Bullard, the St Louis Fed President, gave an interview today discussing how the stock correction has been good because it has helped to prevent a bubble. He’s inferring that lower prices are bad in the short-term and good in the long-term.  And he’s totally right.  I’ll show you why.

What happens when the stock market booms is that future returns get pulled into the present. Stock bubbles are dangerous because they pull so much of that future return into the present that they create an abnormal amount of temporal balance sheet instability. I’ve referred to this pricing change as a “price compression” in my book and elsewhere.  It’s a fairly simple concept and can help us understand what happens to prices in the short-term relative to the long-term. In essence, when prices boom in the short-term we pull future returns into the present which often reduces future returns. For instance, imagine a zero coupon bond like a Treasury Bill yielding, for fun, 3%.¹ This Bill will sell at $97.09 and will mature at par plus your 3% in 1 year.

Now, imagine that interest rates shoot higher to 6% right after you buy this Bill.  The price of your Bill will fall to $94.34 for a 2.83% loss. But that’s just a short-term unrealized loss and not necessarily a realized loss. After all, if you hold the Bill for 1 year you will still get your $100 plus 3% in interest.

So, what’s happening here?  The price of the Bill has compressed as the market environment changed.  Had you purchased another Bill immediately after the price decline you would have earned 5.99% on the second Bill. If you’d doubled down on the first Bill you would have earned an average return of 4.49% on both Bills thereby increasing your average return.  The price decline was bad in the short-term, but it was good in the long-term!  In other words, as prices compress positively (think bull market) in the short-term they tend to pull future returns into the present thereby lowering future returns, whereas, when prices compress negatively (think, bear market), they push future returns higher.