On Monday, February 5, 2018, the Dow went down by 1,175 points. It wiped out all of the gains from the previous month. It shouldn’t have been that big of a surprise, as U.S. stocks were going the closest to parabolic as we have seen since the Nasdaq bubble of the late 1990s.
Still, the financial media needs an explanation for everything, other than just saying that there were more willing buyers and sellers at lower prices that day.
For the record, it is inaccurate to say that there were more sellers than buyers because every transaction needs at least one of each. It is just that there may be more willing sellers, or fewer buyers at the previous high prices.
On Tuesday, stocks finished much higher, but that was after some major volatility. We can probably count on a lot more volatility for a while now, which if often a precursor to a prolonged downturn.
The financial media is saying that the downturn in stocks is due to investor fear over rising interest rates. In other words, rising rates, or the threat of rising rates, is causing stocks to fall.
And while this could be a small piece of the puzzle, it doesn’t really fit in with what actually happened on Monday, and is likely to happen again in massive down days for stocks. I was watching the 10-year yield on Monday, and it was falling. Or stated differently, bonds were going up.
I suppose one could argue that the cure for higher rates is lower stock prices, but this certainly doesn’t fit in neatly with history. And why would rates be falling in almost direct correlation with stocks on the worst day in a long while?
I don’t think that higher interest rates, or the threat of higher rates, is causing the downturn and increased volatility in stocks. If it is, it is a minor player.
If we want an explanation, other than just saying that there were more willing buyers and sellers at lower prices, I think it mainly lies in the business cycle. Specifically, if this downturn continues, it is just the bust phase as described in the Austrian Business Cycle Theory.
The Federal Reserve engaged in massive monetary inflation from 2008 to 2014. While the so-called recovery has been weak for middle class America in a lot of ways, it did result in something of an asset boom, particularly in stocks. Now that the Fed is tightening, albeit slowly, the air may be finally coming out of the bubble.
Now, it is possible that the bull run in stocks may resume and we may see new all-time highs again before this is all over. But with the last few days, the inevitable seems to be closer at hand than what it seemed a week before.
It is very easy to confuse cause and effect when dealing with the economy and financial markets. Most people think we need some kind of event to initiate a precipitous fall in stocks or a recession. In 2008, the fall of Lehman Brothers is seen as the triggering event. But we have to be careful in how we analyze these things. It wasn’t Lehman Brothers that caused the financial crisis in 2008. It was just one of the symptoms.
Therefore, we don’t necessarily have to see any big financial news to get a drop in stocks or the beginning of an economic downturn. The drop in stocks can be the triggering news in itself. Sometimes things have just run as far as they can run.
As for interest rates, we should expect them to fall in a major crash of stocks and an economic recession. Even if you don’t care too much for the federal government, U.S. Treasury bills and bonds are still seen as the safest investment there is. The only exception to that rule is when there is a significant threat of price inflation. So until we see a big pickup in the price inflation numbers, expect interest rates to stay relatively low. And in a stock crash, investors will flee to safety, which will drive down rates further.
Incidentally, the new Fed chair, Jerome Powell, was sworn in the day after his 65th birthday on Monday, February 5. He was sworn in on the same day that stocks took a dive. Timing is everything, and now he gets to deal with the problems ahead. If things get bad enough, expect the Fed to stop its slow draining of its balance sheet. And if things get really bad, then we can start talking about QE4, or whatever the next round of monetary inflation will be called.
The last few days are a good example of why I advocate a permanent portfolio. It has been tough not seeing the big gains that all-in stock investors have seen over the last several years. But when things go the other way, you will be in a lot less misery with a good portion of your assets in a permanent portfolio.