Since 1998, markets have been stuck in a vicious boom and bust cycle which is a direct result of the Fed's over tampering with monetary policy. The last 3 major global financial crises have all been caused by prolonged periods of easy credit which were then followed by rapid tightening phases. There are quite a few parallels that can be drawn between the previous 3 situations and the current market environment.
The 3 past crises we are referring to are:
- The 1998 Asian financial crisis
- The Internet bust from 2000-2002
- The housing crisis of 2008
1998 is remembered most commonly in the financial markets as the year of Asian crisis. In reality it was far more widespread than just Asia. The crisis spread to other emerging markets including Russia and Latin America and was averted in the US by some deft maneuvering by the Federal Reserve who intervened to shore up market confidence by bailing out Long Term Capital Management.
The Asian bubble of 1998 was fueled by a massive inflow of global capital into the Asian markets that resulted in the funding of poor projects that eventually went bankrupt. Recession and low interest rates in the developed capitalist world generated substantial interest on the part of investment houses and international banks in the "emerging" markets of Southeast Asia. The trigger for the crisis was the eventual realization by foreign investors that their investments were not performing, which led to concerted selling, loss of confidence and a massive outflow of capital.
Fast forward to the present and once again it is quite clear that a rush of capital into certain asset classes over the past 4 years has been engineered by cheap credit and a lack of global investment opportunities.
Case study 2; the internet bust of 2000. If you remember, the Fed had cut rates aggressively in the US as a result of the 1998 Asian crisis and had also flooded the market with liquidity in anticipation of disruption from the Y2K computer bug. This had led to aggressive buying of internet stocks, a lot of which was done on margin, leading the NASDAQ to record heights of 4,572 and the Fed Chairman, Alan Greenspan to remark about the "irrational exuberance" of the markets. To curb the market exuberance, the Fed had started hiking interest rates, as it took them from 5% to 6% all through 2000. The result was the bursting of the internet bubble and a subsequent drop of 74% in the NASDAQ.
Case study 3; the more recent housing bubble burst of 2008. Once again a lot of fingers have been pointed at the Fed for keeping monetary policy too easy for too long after the internet crisis of 2000. The Fed Fund rates had dropped to a low of 1% in 2003 and it took the Fed 3 years to normalize them. This prolonged period of cheap credit fueled the housing market bubble which eventually burst in 2008 as once again investors realized that they were invested en-masse in non-performing assets.
In all the 3 cases, asset bubbles were inflated by cheap credit and a lack of investment opportunities, which caused capital to rush into a few select asset classes and markets. And then the bubbles burst, when investors realized that they were invested in non-performing assets and the Fed realized that credit needed to be tightened.
Once again when we see the market dynamics of the past 4 years, we are seeing history repeat itself. The housing crisis of 2008 caused the Fed to lower rates to effectively 0 and embark on quantitative easing to promote US equity markets. The 3 asset classes that have been the best beneficiaries of the current Fed policy have been Gold, Bonds and the US equity markets both on an absolute basis as well as a relative basis.
1/2008 - 3/2012:
Gold + 100%
30 year US Treasury Bond Price: +50%
S&P 500: +21%
Over the same period, the European equity markets have returned -38% (SPDR EURO STOXX 50) and the emerging markets indices have returned anywhere from -1% for MSCI ASIA APEX 50 to -9% for the BRIC Index.
I think it is quite easy to see which market has been the beneficiary of easy credit policy and where the largest bubble potential lies. In the past 2 months, gold has fallen from a high of $1,900 to $1,250, a drop of 34%. The market is calling for a fair value bottom around $1,100, but rarely does the market stop at its fair value. It always overshoots, so if is not unrealistic to conclude that gold might fall to below $1,000.
US 30 year bonds yields hit a low of 2.47% and have since risen to 3.60% a drop in price of nearly 15%. Yields could easily rise to 5% as the Fed normalizes the yield curve and stops buying bonds.
The S&P 500 has been resilient thus far, with a drop of only 6% from its high of 1,660. But if history is a guide, the US equity markets have a lot further to correct if the Fed's credit spigot is turned off.
The chart below is a comparison of the expansion of the Fed's balance sheet and the performance of the S&P 500 as money has been driven from bonds into stocks. The data from 2008 shows an 86% positive correlation between the S&P 500 performance and the size of the Fed's balance sheet. So, it is logical to assume that as the Fed's balance sheet stops expanding, we can see the S&P 500 lose steam. Also, if the Fed's balance sheet starts contracting, the S&P 500 could go in reverse quite sharply.
Therefore, it is no surprise that the smart money is listening very closely to what the Fed governors are saying and selling the S&P in anticipation of such an announcement.
The problem with credit driven crises is that the unwind is never orderly. This is mostly because in times of cheap and plentiful credit, leverage is abused heavily and during an exodus the selling gets magnified by the leverage in the system. We see no reason why the past 4 years of asset binging period be any different as investor behavior rarely changes. The best course of action is to be smart and recognize that the party is over and head for the exits before the masses do.