Thursday June 30, 2022

Like everyone else, I have been watching global equity markets lurch lower with terror. Clearly, the Fed has been caught red-handed as the inflation tide accelerates outwards, with markets too high, pumped up on years of cheap money. The declines have been definitive. When will the decline stop? How will we know when it has gone far enough? The only truthful answer is: Nobody knows.

The graphic shows the percentage daily movement of the Dow from the peak (14,088, on October 1, 2007) to the trough (6,547, on March 9, 2009) during the 2008 crisis; I have superposed on it the percentage daily movement of the Dow from its last peak (36,489 on December 29, 2021) to its level on June 15, 2022 (30,669). The parallels are terrifying—in the first five and a half months of the 2008 crisis, the Dow fell by around 15%; we are currently down 16% (and this is before last Thursday’s sharp decline, which took the Dow below 30,000 for the first time since December 2020). The paths have a correlation of 70%, and what is truly frightening is that, in 2008, the market continued to decline for another 12 months and later declines were sharper.

Another parallel is the “temper” of the market—a term I have coined to show how many days the market reacted to the trend by more than 1%. There were 22 days (18% of the last 120 days) when the market jumped higher compared to just 17 times (14%) during the 2008 crisis over the similar period. Incidentally, the classic market lore—that a bear market ends with capitulation, which, I assume, means there are zero up days—was not borne out in 2008; the total number of 1% plus days during that period was 75 out of 370, with the bulk (about half) of these occurring in the last third of the bear market.

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Surely, the macro circumstances during the two periods are completely different. Before the 2008 crisis, growth was strong (5% in October 2007), as the economy had recovered strongly from the dot com bust in 2000 under the Fed’s enthusiastic cheap money policy. The ultra-low rates (Fed funds had fallen to 1% in May 2004) and blind regulators led to an explosion of banks selling extremely risky investments into the retail market. By 2007, inflation was rising (peaking at 3.8% in 2008) and the Fed funds rate was climbing (reaching 5.25%). These added to the build-up of risk in every institution, leading to the collapse of Lehman Brothers on September 15, 2007. The economy rapidly closed down with no one willing to lend since nobody knew who was caught in which web of mortgage-backed derivatives. Equities tanked, growth crashed.

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The one-trick Fed once again flooded the market with money pushing rates down even more dramatically—the funds rate fell to 0.1% by September 2008. Growth, which had fallen to a low of –2.54% in 2009, picked up the following year and stayed steady (1-2.5%) for several years. However, this was jobless growth with unemployment uncomfortably high (>8%) till 2013; the Fed, of course, continued giving away money keeping rates flat on the ground (0.1-0.15%) for 7 years. This enabled the dramatic equity boom we have enjoyed and, of course, the current blowout of inflation. The entire misadventure ran for a year and a half, and, what is even worse is that the Dow did not recover to its earlier peak (of 14,088) till September 2013, a full four years after hitting bottom.

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Circumstances are different today but certainly not comforting. First, as already mentioned, the market has been falling for just 6 months (as opposed to 18 back in 2008). Secondly, growth, which had picked up smartly after the pandemic, is slowing sharply as a result of the Russian invasion, surging commodity prices (particularly oil prices), and continuing supply-chain/Covid difficulties. Third and most significant, US inflation is raging at 8-9% (as compared with a peak of 3.8% back then) and the Fed is in the midst of dramatic monetary tightening—the 75bps hike last week was the highest since 1994, with expectations of more to come. The trauma is not nearly over. All eyes and ears remain on the Fed (and other central banks) that has suddenly awakened to its primary job of controlling inflation. Unfortunately, inflation is like a runaway train, and since it has not been leashed in time, there is no telling where it will go or what damage it will do. Worse yet, it is possible and, indeed, likely, that the only antidote—steadily (or rapidly) raising interest rates and tightening money supply—will crash the economy further.

With zero visibility on the future, except that equities will fall further, the prayer is that history does not repeat itself.

The author is CEO, Mecklai Financial


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