Investors spend hours crunching numbers and economic fundamentals, price-to-earnings ratios, and relative valuations. But at the end of the day, they trust their gut the most.
“This market’s current temperament feels so much like either Japan in 1989 or the United States in 1999. And the events that have transpired so far this January make me feel more convinced than ever of this repeating history,” hedge fund great Paul Tudor Jones wrote in a note to clients obtained by Bloomberg.
And who can blame him for this feeling? The market fundamentals do resemble Japan in 1989 or the United States in 1999. GDP growth is healthy, unemployment is down, and corporate earnings are solid.
“We are in this Goldilocks period right now. Inflation isn’t a problem. Growth is good, everything is pretty good with a big jolt of stimulation coming from changes in tax laws. If you’re holding cash, you’re going to feel pretty stupid,” said another hedge fund legend, Ray Dalio, the founder of Bridgewater Associates, at the World Economic Forum in Davos in January, before the recent correction.
However, that’s as good as it gets in terms of fundamentals. Both stocks and bonds are very expensive relative to historical valuations, and both companies and the government are drowning in debt, one of the reasons rates have been creeping up since January.
Rising Treasury rates alongside a Fed in tightening mode is probably one of the reasons that triggered the collapse of the “short volatility trade” and the following market sell-off. In further echoes of previous episodes, Japanese central bank also started raising rates a year before the Japanese stock market crashed in the late 1980s, and the Fed began tightening a year and a half before the dot-com bubble burst in 2001.
Central Bank Tightening
Why were the Bank of Japan and the Greenspan Fed so persistent in raising rates back then, and why is it very likely the Powell Fed will continue to hike in 2018 despite market stress? All of them were worried about irrational exuberance and financial market bubbles as well as consumer price inflation.
The reason the Fed got away with keeping rates too low for too long since 2009 is due to the fact that consumer price inflation never caught on, even as asset price inflation took hold in the stock, bond, and real estate markets.
Consumer price inflation kicks in when wage inflation starts to rise. Thanks to millions of people outside of the labor force and not counted in the headline unemployment figure, average hourly earnings have been stagnant for most of the last decade—until December of 2017. The data released on Feb. 2 shows hourly earnings spiked up 2.9 percent, the largest increase since 2009.
Market inflation expectations, together with rates, have been creeping up since January, which will keep the Fed on the back foot. And while the Fed generally doesn’t want the market to decline too fast and too far, they generally do not mind a 20 percent correction, especially when they believe the market is ahead of itself anyway.
This was the case in 2011, when the market suffered an almost 20 percent drop in less than a week because Standard & Poor’s downgraded U.S. sovereign debt. Ben Bernanke only saved stocks later in August with a very supportive speech at the annual Jackson Hole Fed conference.
Irrespective of the Fed’s course to raise rates another one or two times this year, Treasury yields are rising because of inflation expectations, and because President Trump’s tax cuts and budget are going to see the Federal government bleed red ink all through 2018 and 2019.
White House budget director Mick Mulvaney hopes this can be avoided if growth picks up in the long-term.
“If we can keep the economy humming and generate more money for you and me and for everybody else, then government takes in more money and that’s how we hope to be able to keep the debt under control,” Mulvaney told Fox News.
In the short-term, however, even he admits that new government debt issuance could lead to another spike in interest rates, if the deficit blows out to $1.2 trillion in 2019 as expected, due to additional spending on infrastructure and defense.
So fundamentally, we are in a similar era to 1989 Japan and 1999 United States—a great underlying economy, but rising interest rates and a lot of private debt—the only difference is that on both of those occasions, governments only racked up spending and debt after the bubble burst. History doesn’t always repeat itself, but it usually rhymes—and the added government debt risk this time doesn’t help.
From a technical perspective, this correction feels more like 1987 than 2001 because the market sold-off so quickly and without warning. The S&P 500 lost 11.8 percent in only 10 days before a significant relief rally.
This sell-off is different from the market tops in 1999, 2007, 1987, and even the 20 percent drop in 2011 because the market experienced some drops and subsequent rallies before the final top and steep decline.
This year looks more like the Nikkei in 1989. A long run up without a 2 percent correction resulting in a 19 percent gain since August for the S&P. Then without warning, the 11.8 percent drop.
If Paul Tudor Jones and the technicals are right, and the current market action reflects 1989 Japan and 1999 United States, then we are in for a tough 2018. The Nikkei lost almost 50 percent of its value in 1990 after topping out early that year. The S&P 500 did better in 2000, only losing 20 percent after topping out in March.
But the final bottom did not come until 2003, with a 50 percent correction, and a very accommodative central bank which regretted its hawkish stance from the years before.