Stocks Fall, But Odds Are Still Against RBS's Crash Scenario

donsutherland1 · 06-21-08, 01:34 PM

Yesterday, a broad decline in the U.S. stock market brought the major indices to or near 3-month lows. The Dow Jones Industrials closed at 11,842.69, its lowest close since the Dow fell to 11,740.15 on March 10. The S&P 500 Index closed at 1,317.93. That is its lowest figure since March 28 when it closed at 1,315.22. Since both indices peaked on October 9, 2007, the Dow has fallen 16.4% and the S&P 500 has declined 15.8%. If one factors in inflation, the real decline in these indices exceeds 19%.

The recent decline raises questions as to whether a dire assessment from the Royal Bank of Scotland (RBS) has gained greater credence. 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.”

In my view, odds remain 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.

At the same time, a sustained recovery that would lift both indices to new all-time highs appears unlikely over at least the next 6 months. Fluctuations are likely. In terms of fluctuations, before the latest retreat commenced, the Dow had recovered from its March depths to 13,058.20 on May 2 and the S&P 500 reached 1,426.63 on May 19.

For now, a sketch of some of the more important factors shaping the present market environment includes:

• Inflation: As the Federal Reserve stands idle in the face of persistently rising inflation, a quickening of producer price inflation, and growing indications of pass-through, the markets are beginning to discount the emergence of a new inflation-tolerant Federal Reserve. Already, surveys such as those conducted by the University of Michigan, inflation expectations are rising.

Such a stance by the Fed would constitute a serious monetary policy error. “Certainly our collective experience strongly emphasizes the importance of dealing with inflation at an early stage, before it assumes a momentum of its own with deeply embedded effects on expectations,” former Federal Reserve Chairman Paul Volcker explained. He also warned hat “procrastination only invites greater difficulty.”

Longer-term persistence of elevated inflation has been unfavorable for stock prices. For example, during the inflationary 1973-81 period, the S&P 500 Index rose 20.0% from 102.09 to 122.55. However, consumer prices more than doubled and the after-inflation return on the S&P 500 Index was -54.3%.

• Oil: In recent weeks, the crude oil price has risen to as high as $139.89 in intraday trading. To date, the price of crude oil has climbed more than 90% this year. While these price trends have given a lift to energy sector profits, they have imposed strains on firms whose products require petroleum-based inputs and/or consume petroleum-based products.

The dramatic rise in crude oil prices is largely the result of a demand imbalance in which world consumption has exceeded world production for two consecutive years. The robust growth in consumption in fast-developing countries such as China and India has offset somewhat greater efficiency and recent modest conservation in the United States and Europe. A persistent decline in the U.S. dollar has aggravated the price rise, as crude oil is priced in dollars.

• Dissipating Housing Bubble: The enormous housing bubble that peaked in 2006 has continued to contract. In its wake, it has had a deflationary effect courtesy of a reverse “wealth effect.” It is entirely possible that the contraction of the housing bubble and ensuing credit squeeze have helped keep a lid on inflation to some extent.

Research by the International Monetary Fund (IMF) shows that the adverse economic impact of a housing bust is more significant and longer-lasting than that associated with a stock market crash. Banks and other financial institutions need time to repair their balance sheets. It takes time to replenish their capital and to regain a balanced appetite for risk-taking. Right now, the overall financial system post-bubble evolution may be near its mid-point. Hence, additional financial sector write-offs are likely.

That a deflationary contraction of an asset bubble is occurring within a larger framework of an increasingly inflationary environment is somewhat unusual, particularly for the United States.

• Iran’s Nuclear Program: Whether there is a military operation against Iran’s nuclear facilities would have profound economic and financial implications. In a best-case scenario, a surgical strike would take out Iran’s facilities, bring about little Iranian retaliation, and produce a brief but painful spike in oil prices, perhaps reaching or exceeding the $150 - $200 per barrel range. In a worst-case scenario, the strike would lead to massive Iranian retaliation, against Israel, the Persian Gulf’s oil infrastructure, and through Iranian operatives and Hezbollah terrorists on a worldwide scale. That development would precipitate a substantial and prolonged spike in the oil price and inflict enormous damage on the world’s economies. It would be that scenario that would provide a high risk of a stock market crash. Given Iranian rhetoric and the ideological nature of some of its senior leadership, an Iranian response in the middle of those scenarios might be likely. The U.S. could mitigate the worst-case scenario by threatening Iran with the “severest consequences” should Iran take such a course. Such a threat would have to lead Iran’s leadership to conclude that Iran might face nuclear retaliation with the hope that rational senior leaders and military commanders would limit Iran's response.

All said, if one is to witness a near-term stock market crash, certainly within the next 6 months, one would need to create a toxic brew of bad or worsening expectations about fundamental factors and an increasingly fragile market psychology. At present, even as there is plenty of angst among investors and the overall environment is not hospitable to a sustained boom in stock prices, overall market psychology does not appear to be on the proverbial precipice.

The run-up to the 1987 Stock Market Crash:
Key fundamentals driving the markets were decidedly negative in the days and weeks leading up to the 1987 crash. There was concern that foreigners were becoming unwilling to continue to finance the nation’s enormous budget and trade deficits. There had actually been net cash outflows to Japan. Americans were worrying that the nation was losing control over its own economic destiny. The dollar was declining. In response, interest rates had begun to rise. On the political front, there was growing concern about tax hikes that would make merger & acquisition activity less profitable.

Representative of the increasingly dark outlook, the 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…

…seemingly endless stimulus appears to be hurting the market's mood more than helping it -by increased fears of inflation, rising interest rates and a recession that would be hard to stop if it once got rolling.

The newspaper also reported:

Yesterday's and Wednesday's combined drop of 153.07 points was the biggest two-day retrenchment ever and brought the Dow's decline over the last nine sessions to about 285 points. ''The market succumbed to a delayed reaction to the latest prime rate increase,'' said Eugene E. Peroni Jr., chief technical analyst at Janney Montgomery Scott Inc. ''Its psychological posture at this point simply can't bear that burden of higher interest rates.'' About noon yesterday, the Chemical Bank of New York raised its prime rate to 9 3/4, from 9 1/4 percent…

At the same time, the dollar closed lower on remarks by Treasury Secretary James A. Baker 3d that many in the market interpreted as meaning that the United States is prepared to see a lower dollar.

However, market psychology had grown frayed and gloomy, almost sensationalist, news headlines amplified building fears. Some headlines included, “Small investors in rough seas,” “Stocks resume sharp plunge,” “In the aftermath of market plunge, much uneasiness,” “U.S. aides calm, but worried: Baker warns against panic,” “Rates up in wild trading,” “Uneasy market and future,” among others.

In terms of market sentiment, there were references to “nervous investors,” “wild gyrations” in short- and long-term interest rates, “a confirmed major bear market,” “panic,” and a “spectacular drop in the stock market.”

Toward the end of the week ending October 17, what had been a sustained and significant decline steepened. On October 17, The New York Times reported:

Yesterday, harried traders and brokers watched in amazement as the Dow and other market gauges spiraled downward steadily during the day before dropping sharply late in the session. ''Without question, there was panic today,'' said Rudolph P. Carbone, a vice president at Shearson Lehman Brothers Inc. who handles retail accounts.

The newspaper also noted a sudden flight to quality stating, “experts said investors rushed into Treasury securities for reasons ranging from increased tensions in the Persian Gulf to rumors of large trading losses at securities houses. In times of crisis, Treasury securities and gold are considered safe havens. Gold stocks also rose yesterday, reflecting the rising price of the metal.”

On Monday, October 19, investors were greeted by stories that reinforced their unease and rebroadcast the carnage in stocks that occurred the preceding week. The New York Times reported:

Last week's spectacular drop in the stock market - 235.48 points, or 9.49 percent - has left investors searching for ways to hedge their bets and financial leaders hoping for new international policies to solve the problems that led to the plunge.

''I don't think there is reason to be alarmed, but one has to be concerned,'' David Rockefeller, the retired chairman of the Chase Manhattan bank, said yesterday.”

Even worse, the newspaper revealed, “Stocks resume sharp plunge.” That story stated, “Investors in Tokyo, Hong Kong and Sydney, Australia, dumped their shares today in a shocked reaction to Wall Street's massive sell-off last week… ‘There's a jam for the exit,'' one broker said. ''The buyers are running away.’”

With an already fragile market psychology hammered anew by bad news, fear was amplified. Once trading began, the rout was on. By day’s end, the Dow Jones Industrials had plummeted 22.6%.

At present, there are some bad fundamentals and worry about future bad news. There is not yet the kind of evidence of widespread fear, much less, wild volatility that preceded the 1987 crash.

Conclusion:
I believe it is unlikely that the Dow Jones Industrials or S&P 500 will reach or exceed their highs established on October 9, 2007 through the rest of this year. At the same time, while a fairly significant contraction over a period of time is still possible, a crash (10% or greater fall over 1-2 days) is probably unlikely.

donsutherland1 · 07-13-08, 12:09 PM

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.