02/04/2014 12:37 pm ET Updated Apr 06, 2014

Recent Volatility in Stock and Emerging Markets: How Worrisome?

So you're visiting some not-very-well-off friends and you think their not-very-stable house is on fire. So you run across the street to the solid house of a well-off friend. But you think you smell smoke there too, so you run out in the street, not knowing what to do with yourself.

That's a slightly amped up version of what's going on in global financial markets in recent days.

I generally resist commenting on twists and turns in the stock market because really, who knows? But for the past few days markets have been responding to some interesting global dynamics that are worth a closer look.

Yesterday's big losses -- S&P down over 2 percent -- relate to the short story above. There's been a flight to safety in recent weeks from emerging markets to advanced economies (over $6 billion from EM equity funds just last week). But yesterday started out with a surprisingly weak report on U.S. manufacturing, which follows a weak durable goods report and the surprising soft December jobs numbers (which I'm betting gets revised up in this Friday's release). So when the flight to safety looks less safe, you get a big selloff.

How worrisome is all this?

-A lot of what's happening is rebalancing. Both U.S. and Japanese equity markets, up about 30 and 60 percent respectively last year, are overvalued and need to correct.

-Similarly, large investment flows to EMs were driven less by fundamental analysis and more by looking for returns in a climate where U.S. bond yields were low (e.g., Fed funds rate near zero), growth was just OK, and investment domestic opportunities were not plentiful.

-Thus, it doesn't take much to cue a mini freak-out. In this case it was the Fed taper, slower Chinese growth driven partly by more internal investment and consumption (another very important rebalancing act), and jitters about the quality of governing, fiscal, and external accounts (trade deficits) in the EMs.

-Add in nervousness about yet another US economic head fake and you get the picture.

"Um... dude... you didn't answer the question: how worrisome?!"

Right. My bad.

I'm 58 percent not too worried. The hard numbers don't look so bad. For example, our exposure to the EMs is minimal. The U.S. share of exports to EMs in general is about 5 percent of GDP, and to the specific countries hit by the outflows, it's less than 1 percent. Banks assets and corporate profits are similarly sized. An equity market correction was, as noted, in the cards, and the US growth picture is likely better than some of these recent downside surprises suggest.

But that 42 percent ain't nothin' either. It's less about the numbers and more about the psychology (that's why the word 'think' is in bold above) and correlations of contagion. When large capital flows start moving around like the guy smelling smoke up there in the intro, there's increased volatility, impatient if not downright skittish capital, and a lousy climate for investment in lasting projects that undergird lasting growth.

You also get the correlations I worry about here, where nervous investors all respond in chorus to the same perceptions, which may or may not be real. Instead of one guy running out into the street in his jammies, you get a whole crowd running out of all the houses and onto the cul-de-sac...and that can't end well.

And yes, the 42 percent also includes head fake risk. My readers well know that I've been a staunch advocate that it takes more than just growth to get things back on track here in the US economy. But it definitely takes growth. I'm not talking recession risk-I think that's very low. I'm talking sinking back into slog risk, i.e., growing 1-2 percent instead of 3-4 percent. And even the latter is still slow given the output gaps that still exist.

I noticed that the U.S. markets opened with a rebound today after yesterday's selloff, so go figure. Like I said, who knows why indexes bump and grind on a daily and intra-daily basis? But these larger issues are very much worth keeping a close eye upon.

This post originally appeared at Jared Bernstein's On The Economy blog.