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So Far, the Stock Market Looks More Like 1998 Than 2007

The Wall Street Journal. logo The Wall Street Journal. 2/12/2018 Greg Ip

Is it 1998 or 2007?

Last week’s stock market dive has triggered a search for parallels: Was it like the stock drops of 1987 and 1998, frightening but of little lasting economic consequence? Or was it more like 2007 when several failed hedge funds and subprime lenders were the tip of an iceberg that sank the entire economy?

So far, the right analogies appear to be 1987 or 1998, both cases when some market players were clobbered but, unlike in 2007, had few linkages to the real economy.

In 1987, as now, there were fears of a weak dollar, rising bond yields and inflation just as a new Federal Reserve chairman, in that case Alan Greenspan, was determined to prove his credentials. Congress was mulling a tax change to discourage leveraged corporate buyouts, a big driver of that year’s bull market. But these were merely catalysts. The driver of the Oct. 19, 1987, crash was “portfolio insurance,” a strategy that effectively forced big investors to sell into a falling market.

In 1998, Russia’s debt default was the catalyst that forced Long Term Capital Management, a massive hedge fund, to suffer large losses. As it liquidated positions, the Dow Jones Industrial Average dove 19% and other market prices went haywire, such as the difference in yields between nearly identical Treasury bonds. But a strong U.S. expansion continued.

By contrast, in 2007 the failure of hedge funds operated by Bear Stearns Cos. and steep losses on subprime loans such as at HSBC Holdings PLC turned out to be symptoms, not the cause, of the problem: trillions of dollars of shoddily underwritten mortgages backed by soon-to-collapse housing prices, much of it held by banks in opaque instruments.

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The latest selloff was triggered by worries that central banks would respond to stirrings of inflation with more rapid interest-rate increases. That, however, was merely the spark. The fuel was a market belief, implemented in complex trades, that a period of low market volatility would persist.

The late economist Hyman Minsky once said that stability is destabilizing: Long periods of calm encourage risk-taking that aggravates the eventual bust. Stocks and bonds have been unusually docile over the last decade, in part because central banks have been so determined to meet each economic threat (and decline in stocks) with more monetary stimulus.

Investors devised strategies to exploit this low volatility, such as betting that the VIX, a barometer of market volatility derived from options prices, would stay low. As those bets grew, they in turn dampened volatility further. Also in play were “risk parity” trades that use borrowed money to take larger positions in stocks and bonds as volatility drops. Evercore ISI, a brokerage, estimates more than $2 trillion may be invested in all these strategies.

Once volatility rose, though, those strategies sustained steep reversals, and as they closed out positions or reduced borrowing, volatility spiked further.

Like in 1987 and 1998, these moves are self-reinforcing: as positions are liquidated, they force prices to levels that inflict losses on other players, forcing them to liquidate. Such selling eventually burns itself out, though it’s impossible to predict when. The low volatility of the last 18 months “allowed for massive accumulation of risk exposure,” Nomura Securities strategist Charlie McElligott wrote last week. If volatility remains high, he said, that could trigger waves of selling by funds following investment rules linked to volatility.

In 1987 and 1998 this sort of forced selling was just a temporary detour for markets. This could be a repeat.

“I hope I’m not just convincing myself that this has nothing to do with fundamentals,” said one nervous fund manager. “But I still think that’s the case.”

Even if the inflation scare is overdone, events have clearly shifted the bond market’s mood. Bond prices have been sky high. Now bond investors worry low unemployment, higher oil prices, a lower dollar, and protectionism could shift inflation higher. That, along with U.S. budget deficits topping $1 trillion and central banks shrinking their bond holdings, would push bond prices down and yields up.

Monetary policy is also a question mark. “We had a strong sense of what [former Fed chair] Janet Yellen was going to do,” one hedge fund manager said. “We don’t know what Jerome Powell is going to do.”

Although Mr. Powell hasn’t addressed the market turmoil since being sworn in as chairman last Monday, his colleagues have played it down, even welcomed it. “A little more volatility in markets…can be a healthy thing,” said Dallas Fed President Robert Kaplan.  That may be true, but coming from a central banker it sounds complacent, even complicit, which could compound investors’ inclination to pull back.

As investors reassess the risk of inflation and higher interest rates, bond yields and volatility could grind higher, which would depress stock valuations even if profits are fine. And eventually, market moves don’t just reflect the economy; they can also drive the economy. The turmoil in 1987, 1998 and 2007-08 inflicted damaging losses on market participants that required intervention by the Federal Reserve. Postcrisis reforms have strengthened the financial system but volatility may expose weak links. When the dot-com bubble burst in 2000, that sapped spending by wealthy stockholders and tech companies who could no longer issue bonds and shares.

“What if we get a tightening in financial conditions because of this forced deleveraging that spills into auto loans and subprime and housing?” one manager warned. “It’s classic late cycle, but each time is different. That’s what I’m worried about. This needs to burn itself out, fast.”

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