Is History About To Rhyme?
Someone wise once said that “History doesn’t repeat itself, but it DOES rhyme”. That quote, sometimes attributed to Mark Twain, is extraordinarily relevant today. The Dow Jones Industrial Average (Dow) is somewhere in the middle of a “Waterfall Decline” that began on December 1. Since then, the Dow has lost 16.2% in 14 Trading days. “Christmas Market Crash: The Credit Crisis of 2019”. (https://markonomics101.com/2018/12/23/christmas-market-crash-the-credit-crisis-of-2019/).
A “Crash” is a one or two day event resulting in a 10% or greater loss. A “Waterfall”, on the other hand, usually takes 4 to 6 weeks during which prices fall by 15-50%. One can think of a Waterfall as a Crash in slow motion.
A Crash is the result of a very sudden and MASSIVE preponderance of SELLERS versus BUYERS. This creates extreme illiquidity, trading halts and price gaps. Ironically, despite the illiquidity, volume during Crashes EXPLODES to many times normal levels.
The Slide Show below compares the Crashes of 1929, 1987 versus today, December 25, 2018. These are the key takeaways:
- Crashes BEGIN at levels WELL BELOW the preceding peak. In 1929, the Dow had already lost nearly 25%, while in 1987, the Crash BEGAN AFTER the Dow had fallen 18%. As of the close on Monday, December 24th, 2018, the Dow has lost 19%.
- Crashes occur after several days of large daily declines creating an escalating Waterfall. The actual Crash occurs within days of breaking key support levels. In the last 7 trading days, the Dow lost nearly 3,000 points.
- Leading up to the Crash, volume explodes. Crash lows occur on HUGE VOLUME.
Crashes Occur Despite Great Reported Fundamentals
The Great Depression is thought to have begun with a slowdown in 1929, but real GDP that year was up a solid 6%. The following year, however, GDP fell a staggering 11%! (https://www.thebalance.com/us-gdp-by-year-3305543).
The economy in 1987 was also robust. The Crash loss of 22% and Waterfall Decline of nearly 40% were NOT followed by any substantial economic contraction. The economy grew until the next minor recession in 1990.
GDP has exceeded 3% for the last two quarters. Forecasts for 2019 are generally for 2.5% GDP growth, followed by 2% in 2020. Wall Street analysts still maintain a consensus forecast for the Standard & Poor’s 500 of 3000 by next year. (https://www.zerohedge.com/news/2018-12-24/wall-street-has-not-been-wrong-2008).
The Visible Hand of the Federal Reserve
The Crashes of 1929 and 1987 were both preceded by interest rate hikes. In 1928, the Fed raised the Discount Rate from 3.5% to 5% to discourage rampant speculation in the equity markets. Since prices were actually falling by about 1% annually, “Real” (or inflation adjusted) interest rates were about 6%, very high historically.
In December 1986, the Fed began raising rates, with a near 50 basis points hike to 6%. On September 22nd, 1987, the Fed raised the Fed Funds rate to 7.25%, nearly 3% HIGHER than prevailing inflation of 4.4%. The market crashed 4 weeks later on October 19th. (https://www.thebalance.com/fed-funds-rate-history-highs-lows-3306135).
Monetary policy remained relatively restrictive throughout the Great Depression. Measures of the Money supply actually FELL substantially as banks failed. Falling prices prevailed for EVERYTHING.
Many academicians, notably the late Milton Friedman, attribute the severity of the Great Depression directly to Federal Reserve mismanagement. (https://fee.org/articles/the-great-depression-according-to-milton-friedman/).
The current Federal Reserve policy can hardly be considered comparable. Yes, the Federal Funds rate has been raised 9 times since late 2015, but this tightening cycle started from ZERO. And, the Federal Funds rate target at 2.25-2.5% is still below the historical long run average.
However, inflation, currently reported at 2.2% annually, is bound to fall substantially in light of plunging commodity prices. “Are We Heading Straight Into Global Deflation?” (https://markonomics101.com/2018/12/19/are-we-heading-straight-into-global-deflation/)
Crude Oil, the commodity whose price most directly impacts the cost of EVERYTHING, traded down further to $43 on Christmas Eve. It has now lost 45% in less than a Calendar Quarter! The impact on prices in general will require many months to fully incorporate. It is conceivable that the Consumer Price Index (CPI) could even slip below ZERO.
If so, the “Real” Federal Funds Rate could actually be HIGHER than 3%, and MORE restrictive than it appears.
Reversing Quantitative Easing
Critics point out that the rate hikes are amplified by the unwinding of many years of “Quantitative Easing” (QE). This program was designed to prevent a falling money supply and a repetition of the mistakes made prior to the Great Depression.
Under its QE policy, the Federal Reserve’s total assets exploded from less than $1 Trillion to $4.5 Trillion in 6 years. The increase was effectuated through MASSIVE Fed purchases of Treasury and Mortgage-Backed Securities. (https://www.cnbc.com/2017/11/24/the-fed-launched-qe-nine-years-ago–these-four-charts-show-its-impact.html).
The Fed is finally reducing these holdings by systematically selling $50 Billion per month.
As the illuminating chart above illustrates, when the Federal Reserve is a net buyer, stocks tend to rise. Ominously, when the Fed turns net SELLER, markets become illiquid and STOCKS FALL. (https://www.zerohedge.com/news/2018-12-24/seeds-market-collapse-lie-feds-autopilot-balance-sheet-normalization).
The Fed still has Trillions of Dollars of Treasury Holdings left to liquidate.
While many of the conditions that accompanied both the 1929 AND 1987 Crashes are eerily present, the odds of a TRUE Crash are very small. That said, the conditions are ripe and the odds are MUCH higher than they would be normally.
What should you do now if you’re invested? Unfortunately, history is of NO use as a guide. In 1929, the Dow went on to lose ANOTHER 80% from the Crash lows of 200. The Dow did not recover for 25 years.
In 1987, the Crash WAS the bottom. Markets recovered within a couple of years.
If you’re interested in learning some AMAZING facts about the 1929, 1987 and 1990 Nikkei Crashes: “The Stock Market’s Wile E. Coyote Moment”. (https://markonomics101.com/2018/10/22/the-stock-markets-wile-e-coyote-moment/).
Capital Preservation and liquidity is key here. Keep in mind, that opportunities are available to those who have liquidity when others are desperate for it.
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