What Would Create a Repeat of 1973?

Barry Ritholtz put up a chart of the 1987 Dow vs. today's Dow. I guess a few people have emailed this chart to him, although he wasn't entirely too sure that this scenario would play out. Barry thinks the 1973 comparison would play out more than the '87. That makes more sense. I don't remember there being much inflation in 1987 compared to '73:

click to enlarge

Here's my take: I see this scenario potentially playing out, but for different reasons.

There is this little annoying thing called the "Carry Trade" that I've been playing/following/cajoling over for some time. The carry has some potential to make this happen. In order for this to really dig in, other elements have to occur, and it's possible we're seeing these factors play out.

China just came out with some stellar news on their GDP. At 11.1%, they are seeing growth that is pushing even their threshold of what is sustainable. They are very likely to move rates higher.

That poses two problems.

First, global equity markets already shuddered at the thought of higher rates coming out of China. Fortunately, the U.S. equities have put up some support, and markets are moderating (although lower). However, you will remember that the moves that shook the world first started in China back in the end of February. So, by no means are we out of the woods just yet. In fact, lower equity market make sense moving forward with China pushing rates up enough to control their growth. So, brace yourself.

The other element that would have to be considered is the proxy between the Japanese yen and the Chinese yuan. Since the yuan is so tightly controlled, and since the economies in China and Japan are tightly liked, then one thing that we may start seeing is the move higher in the yen. That's not good news as the carry depends heavily on the continued erosion of the yen, and continued stability within the world equity markets. If we do start to see global equity markets move lower, the carry will melt away, and that would actually perpetuate the global market meltdown. Then all of a sudden, that chart up above looks a lot more probable.

It's almost as if there is a perfect storm brewing. Two fronts are moving in one direction. At some point they may be pushed together creating one huge financial catastrophe. Unwinding the carry is going to have to be a very delicate operation. If market forces get too aggressive, I don't see the word "delicate" and unwind occurring in the same sentence.

Let's see how aggressive the markets start to get.

Comments

[Malkiel:]

If by the 1973 scenario you mean a long year-and-a-half recession in stock prices after the fall, then I say forget it. The markets are so much more liquid, trading is so much cheaper and faster, regulations are so less protectionist and manipulative, credit is so easy, that there will be plenty of arbitragers throughout the world ready to pick up the pieces at lightspeed. There's also a shortage of stock for the money pouring into the market. We may really be on an up elevator here that can't go down easily until the new worldwide financial markets have a glut of product to sell to the new interconnected global investorship.

2007 Apr 20 04:34 PM

[k_denninger:]

To Malkiel - don't drink the KoolAid man. You're listening to CNBC too much.

Read the <b>DATA</b>... The data is your friend.

The DATA says that the consumer is overheated, the home building sector is dead, and inflation is very much alive. Coke Products from $2.50/12 pack last summer to $3.83 - at Walmart - same store, same product, same price? Hmmmm..... 3% inflation eh? Not what my grocery bill says.

Oh, you want ex-food? What - you don't eat? That's what I thought.

When everyone's a bull, be careful. If you want to try to scalp the blow-off top go ahead, but please - buy some protection. IF it gets bad, its too late - kinda like trying to buy insurance on your house when there's a hurricane warning up.

2007 Apr 20 08:00 PM

[Johnny Bitc...:]

I agree that grocery inflation seems higher than the reported stats.

Its hard to argue that everyone's a bull though. There is plenty of negative sentiment out there.

I think alot of folks get way too excited about the indices reaching nominal highs. When these nominal highs are looked at on an inflation adjusted, real, basis......it's just not that impressive to make new highs.

'73, '87 ?

Nice to be a historian, but let's be realistic here: The world has changed tremendously in terms of globally integrated markets, rapid movement of information and money, etc. I can't create a model that deals with all the variables, but the idea that we can find the answer in history doesn't strike me as very likely. Not saying it's not a worthwhile exercise, but I think simplistic thinking might be more instructive.....here's my attempt:

housing values became disconnected from reality (see rent vs. buy)

lending models became disconnected from risk / return (see purchase of securitized mortgage products on faith)

the house is the most important source of savings/wealth accumulation for most Americans

ergo: things are not looking good.

there you have it: things are not looking good.

john ewing.

2007 Apr 21 12:22 AM

[CBLACKSAX:]

Does the correlation change now that the Dow has posted yet another high? This may mean a large final ride to a top is indicated later this year, minor corrections and global meltdown could have some impact, but the chart does not now correspond.
C. R. Black

2007 Apr 22 08:55 AM

[BillCust:]

Here is some numbers of the Yen Carry Trade as of March. That number is equivalent to US $800 Billion.
The question is then how much is too much? Consider this:
Japan is an actual country with actual people. They don't all trade the yen to invest in Australian$ or Brazilian bond, or Chinese stocks. They need yen to buy food, housing, cars, and the good things in life. A real crisis can happen when speculative yen demand interferes with the real economy demand of yen.

Take the M2 supply: deposit, cash, and quasi money - that number is 700 Trillion Yen, or 6 Trillion US$, or 6000 billion US$. A rule of thumb would suggest that a crisis could be in the making if the business/public suddenly compete with speculators to get Yen!

Currently we are at about 10-15% Yen money supply in terms of the amount being speculated! Common sense suggests to me that there is beginning to be a competition of demand for yen not just among speculators but business as well. I would say if we ever reached 100% of the money being loaned for speculation, there will be serious consequences in terms of regional monetary stabilities.

It's up to the Japanese government to determine whether there should be a stampede today or a monumental stampede later.

2007 Apr 23 11:01 PM