The new trading week will open with the major U.S. stock market indices at their lowest levels in almost two years. The Dow Jones Industrials will begin trading at 11,100.54. The last time it closed lower was on August 14, 2006 when it closed at 11,097.87. The S&P 500 will start trading at 1,239.49. The last time it closed below that figure occurred on July 18, 2006 when that index closed at 1,236.86. The Dow has now fallen 21.6% from its October peak and 24.9% in inflation-adjusted terms. The S&P 500 has fallen 20.8% and 24.1% in real terms.
On June 19,
The Telegraph reported, “The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks.” At that time, I argued the odds remained against such a meltdown. Full-fledged crashes (drops of 10% or more over 1-2 trading days) are rare events. Market psychology plays a leading role in precipitating such events. Instead, I noted that I believed that a fairly significant contraction over a period of time is still possible, though a crash (10% or greater fall over 1-2 days) is probably unlikely.
Since that time, there has been some deterioration in market psychology as the major indices have continued to fall. The combination of IndyMac’s being taken over by the Federal Deposit Insurance Corporation (FDIC) and
New York Times business columnist Gretchen Morgenson’s
piece today might add to the erosion in confidence that has occurred in recent weeks. In part, Ms. Morgenson raised questions about the credibility of key federal officials, writing:
Even as investors were stampeding out of these stocks, the claque in Washington rushed to reassure them. Both Ben S. Bernanke, the Federal Reserve Board chairman, and Henry M. Paulson Jr., the Treasury secretary, said the mortgage giants’ regulators confirmed that the companies were “adequately capitalized.”
That was supposed to signal that the companies wouldn’t have to raise capital immediately because regulators had the problem firmly in hand. But investors have good reason to be skeptical. In the first half of 2007, both Mr. Bernanke and Mr. Paulson sang a similar tune when they opined that problems in the mortgage market were “contained” to subprime loans.
The recent worsening of the situation confronting Fannie Mae and Freddie Mac raise anew the question as to whether a crash, as defined above, is imminent. I continue to believe that odds remain against such a development over the timeframe specified by RBS. Nevertheless, a push toward new lows remains quite likely given past experience with Bear markets and the uncertainty surrounding Fannie Mae and Freddie Mac.
If a crash were to occur, one would need an event or development that would serve as a trigger to create the kind of breakdown in market psychology necessary to spark a dramatic and overwhelming rush out of stocks to bring stocks down 10% or more in a day or two. While there remain many unknowns, the following kind of events could provide such a trigger:
● A rupture in earnings expectations in which investors would expect significantly lower earnings growth, in general, and would expect this downgraded outlook to be permanent. A possible transmission mechanism for such a shift in expectations would be investors’ calculating that the enormous mortgage debt overhang (currently > 100% of GDP) would lead to a long-term deleveraging. Such a deleveraging would create a semi-permanent credit squeeze that would inhibit rapid earnings growth. At this time, recent lowering of earnings growth expectations among analysts have focused on the overall macroeconomic slowdown rather than a long-term credit squeeze. To bring about a crash, the new expectations would need to be substantially worse than current expectations so that a stock market that is valued at historic price-earnings ratios would be substantially lower than current levels and investors would need to overreact to such a development so that the process of price discovery is not more gradual. Research by Robert Shiller, et al., suggested that such an investor overreaction to worsened long-term earnings growth expectations contributed to the crash in Japan’s Nikkei Index.
● Military operations directed against Iran’s nuclear facilities lead to the kind of massive Iranian retaliation against Israel, U.S. bases, and oil infrastructure/shipping that Iran has threatened. Under such a scenario, the price of crude oil could potentially double or triple on the news as investors worry that some 25%-30% of the world’s oil supply could wind up off the market for some time. That scenario could likely fuel a stock market crash given the combination of adverse economic impact and market psychology.
● Collapse or imminent collapse of either Fannie Mae or Freddie Mac or both. There has been increasing concern about the finances of these organizations. Freddie Mac’s success in its previously-scheduled debt offering on Monday could have an impact on marketplace concerns.
Given that these government-sponsored enterprises (GSEs) hold $5.2 trillion in mortgage debt, a scenario in which they collapse would likely trigger systemic failure of the nation’s financial infrastructure. Given that potential impact, a collapse would not be permitted to occur. Federal intervention would be undertaken so as to avoid such an outcome.
Considering the near certainty of federal intervention, then investors would need to focus on the impact of such intervention. Two possibilities could still create an environment conducive to an equities crash:
1) Fear that the solution would spark substantial inflation on account of resorting to the printing press (or concern that it could do so) and/or significantly impair the federal government’s ability to borrow from abroad on account of the federal government’s essentially guaranteeing all of Fannie Mae’s and Freddie Mac’s obligations. Under such a scenario, the U.S. dollar’s ongoing decline could turn disorderly and a currency crisis could erupt. Given that the dollar is a world reserve currency, such an scenario would have a global adverse impact. Prior to the 1987 stock market crash, there had been concern that the U.S. government was losing its ability to borrow from abroad.
On October 16, 1987 edition of
The New York Times reported:
Thus far this year net capital inflow into the United States has been zero. That would have caused the dollar to fall even further had it not been for heavy intervention by foreign central banks, which spent $90 billion during the first three quarters of this year in supporting the dollar. How long the foreign central banks will keep on doing this is one of the critical questions for the future…
Recently, there has been some reluctance e.g., among South Korean institutional investments, to purchase U.S. Treasuries given their negative real returns.
2) Fear that the solution would be insufficient. The magnitude of problems at the GSEs could raise concerns as to whether the Federal Reserve could provide sufficient liquidity without resorting to the kind of monetization that could provoke substantial inflation. It could raise concerns as to whether the Fed would need to curtail its other temporary liquidity facilities so as to provide for the GSEs’ liquidity needs. Overall concern that the solution would be insufficient could fail to alleviate market expectations for a collapse. Such a collapse could provoke economically-destructive debt deflation as occurred in Japan following the implosion of stock market and real estate bubbles there.
It should be noted that two big factors were present during several major deflationary episodes in the U.S., including the severe 1920-21 and 1929-32 events: a gold standard that constrained monetary policy and widespread expectations for deflation. The Japanese deflation episode occurred in the absence of a gold standard. However, Japan fell into a liquidity trap when nominal interest rates fell to 0% but deflation was already underway (creating positive real rates).
Recent consumer surveys continue to show worsening inflation expectations on account of increasing inflation. There also is no gold standard to constrain monetary policy. The U.S. government is also running a record fiscal deficit and, given the breakdown in fiscal discipline that has occurred in recent years, the public is not likely to expect any meaningful tightening of fiscal policy. Global aggregate supply and demand interactions are creating inflationary pressures even as demand in the U.S. for some commodities has lessened modestly. A weakening U.S. dollar is amplifying import price pressures.
In the end, while downside risks have increased for the stock market and volatility as measured by the CBOE’s volatility index (VIX) has increased hinting at some erosion in investor confidence, the dynamics likely continue to lean against a crash.
How the situation confronting the GSEs is handled and how the enormous body of mortgage debt leftover from the dissipating real estate bubble impacts long-run earnings expectations will be important in the months ahead. Iran’s nuclear program remains another wildcard. For now, while I could be wrong, I believe a more orderly and perhaps persistent decline in stock prices amidst fluctuations remains a more plausible outcome than a crash in the near-term.