The thing is that prospects for the global economy aren't all bad. Yes, China is slowing, Japan is struggling and the eurozone might be slipping into recession. But, on the other hand, the UK and US are expected to grow well next year; interest rate rises in both countries might be some way off; and the fall in commodity prices acts like a tax cut for most major economies.
Hence the question: how can investors switch so quickly from seeing the glass half-full to seeing it half-empty?
One reason is that equity trading is a form of co-ordination game: the big payoffs go to the trader who successfully anticipates others' beliefs. As Maynard Keynes said, investing is like one of those old newspaper competitions in which people try to guess other people's opinions. This means that markets can fall a long way not because the economic outlook deteriorates significantly, but because quite small triggers cause investors to worry that others will worry (or worry that others will worry that others will worry - there's a potentially infinite number of iterations). When this happens, we'll shift from low volatility - in which prices don't change much because 'glass half-empty' investors trade against 'glass half-full' ones - to high volatility, wherein investors fear that others will panic.
This is especially possible because there might be good reasons to panic.
For one thing, what's at stake isn't just whether there will be a cyclical downturn that depresses earnings for just one or two years. The eurozone slowdown raises the danger that the region might have fallen into secular stagnation - exacerbated by the fragility of the banking system and inadequate policy response. And China's slowdown might be a transition to a permanently slower growth rate. If this is the case, then shares should be derated a lot, to reflect lower long-term growth.
Even if such fears eventually prove to be exaggerated, they would justify a big sell-off now: a small chance of a big disaster should mean lower share prices. Researchers at Cardiff Business School have shown that small and reasonable changes in the probabilities attached to future scenarios for growth can produce large and rational swings in share prices.
However, even if we are seeing a merely cyclical slowdown this is little comfort. The fact that there will eventually be a cyclical upturn means nothing for those companies that might not survive long enough to see it. High corporate debt, of course, increases the risk here. It also poses the danger of debt deflation, whereby defaults by some companies cause banks to lose money, which prevents them lending to otherwise sound companies which thus exacerbates the downturn. This isn't so great a danger in the UK - where corporate debt has fallen a lot since the crisis - but it could be in China or the eurozone.
I say 'could be' because aggregate data on debt levels is no help here. What matters is whether the individual companies hit by the slowdowns are indebted or not. A given rate of growth might or might not trigger a financial crisis depending upon the balance sheets of the individual companies that suffer from slower demand.
In fact, there's a further problem. It's that risk aversion can feed on itself. Already, yields on Greek government debt have risen sharply since the summer, which brings into question whether the government will be able to service future debt obligations. And Erik Britton at Fathom Consulting warns that a similar fate might befall Italy. But the threat generalises: a lack of appetite for risk worsens banks' balance sheets by reducing the value of their equity and would make it harder for indebted companies generally to refinance themselves.
Yet another problem is that a slowdown - especially if it is accompanied by rising bond yields in southern Europe or bad debts in China - would increase political uncertainty. For example, will the European Central Bank undertake full-blown quantitative easing and if so will it work? Will slower growth increase the popularity of non-centrist parties across Europe such as Golden Dawn in Greece or AfD in Germany, and if so what will governments do to placate them? What sort of policy response will there be to China's slowdown? Will it trigger unrest on the mainland of the sort we've seen in Hong Kong? Whatever the answers to these questions are, the fact is that policy uncertainty in itself is bad for shares.
I don't say all this to say that we are definitely heading for bad times. Quite the opposite. Yes, there is the possibility of a vicious downward spiral of economic stagnation, risk aversion, financial crisis and policy uncertainty. But there's another scenario in which reasonable growth in the US sustains investors' appetite for risk and encourages them to anticipate that others will expect the world economy to muddle through. Small - and reasonable - changes in the probabilities which investors attach to these scenarios can justify quite large price movements either up or down.
Volatility - and changes in volatility - can be quite rational.
