The markets and the macroeconomic regime, although not exactly the same, are beginning to show analogies with the period that led us to the last crisis of 2008. The stock market has had an incredible rally since it bottomed out during the last market crash in March 2009. However, this past year has seen it struggle to gain higher ground after reaching an all-time record in May 2015.
Scenario in 2007 running up to early 2008
In October of 2007, the stock market had rallied to a new high at the time of 1,576.09, after having bottomed out from the 2001 tech bubble in July 2002 at 775.68. That was a consecutive run of 5 straight winning years for the general stock market. That run in simple percentage terms was an increase of 103% from low to high.
The following 10 months the stock market stumbled and failed to make higher ground, yet enthusiasm was still at its highest. Although economic forecasts where more contained, they were still positive from even the most notable sources.
What there is in common
Looking at the two periods that go from 2002 to 2007 and 2010 to 2015, there are some analogies. Something that immediately catches the eye is the length of the positive run enjoyed by the stock market in both periods. We see positive results for 6 consecutive years, where in both periods the stock markets recorded consistently higher highs and higher lows.
The chart below shows the S&P 500 index against the national GDP indexed to 100 for July 2002. The chart starts in July 2002, which was the month with the lowest low for the S&P 500. We can see that at the peak of 2007, the S&P 500 was more than 37 basis points above the GDP at the time. Data for July 2015 GDP shows that S&P 500 is currently 67 basis points above GDP.
Data source, FRED and Yahoo Finance
The chart below shows the monthly performance for the S&P GSCI broad commodity index from 2007. We can see that at the onset of the crisis commodities as an asset class started seeing a large rise in volatility. The first sharp increase started in January 2007 and leading the way in the sharp drop in price was crude oil.
We can also see similar sharp declines with increased volatility over the past several months, again led by the constant decrease in crude oil prices. Investors were exiting assets that had had a previously outstanding run. Increased volatility was also beginning to create a cause for concern, the one commodity that greatly outperformed the rest of the basket was gold.
There has been plenty of talk recently of a reduced capability of the markets to contain a price shock. Liquidity is what is needed when everyone is trying to exit the same positions at the same time. A lack of it can create extremely high levels of volatility, with very undesirable effects. New rules have been put in place designed to specifically protect banks. They are obligated to have higher levels of capital and are not allowed to take proprietary positions with clients' money. This, however, means that there will be fewer counterparties when the time comes. There have already been flash warnings, sharp and sudden rises in price volatility in the bond markets.
Current macro scenario
What makes this period different to the previous is the level of interest rates. Despite the recent rate hike, they are still at a level unprecedented in history and have been so for several years. Companies have become used to having access to cheap money, which makes it easier to turn a profit. Companies' values are also the sum of future cash flows which are discounted by extremely low interest rates right now, further boosting their valuations.
All that seems about to change, although higher interest rates may well be absorbed if the economy is strong enough. Yet, employment, which is one of the Fed's metrics for raising interest rates, is still not at the same levels. Unemployment leading up to the 2008 crisis was below 5% for all of 2007 and only began creeping above that level in 2008.
The period between 2002 and 2007 also showed higher overall GDP growth when compared to the GDP growth for the period between 2010 and 2015. GDP grew a cumulative 37.23% for the six years from 2002 to 2007, for a geometric annual growth average of 5.42%. Looking at the six-year period that starts after the end of the crisis, 2010 to 2015, this period has shown a cumulative growth of 24.47% and a geometric average annual growth of 3.72%.
What is the threat for the next crisis
The 2008 crisis was probably caused by the excessive leverage used by many institutions to invest in subprime assets. The leverage was not considered excessive at the time because the risks were misunderstood. The correlation matrixes used to determine that a pool of risky mortgages carried very little overall risk when packaged together with higher credit loans proved to be wrong.
What ensued when everyone started to hit the exit door was exactly a lack of liquidity. Banks, investors, pension funds and so on all needed to exit their risky assets. And the more these assets fell in value, the more they also needed to sell.
The same liquidity crisis could be caused this time around by increasing interest rates. When developed economies have higher yielding assets that pay fixed coupons, risky assets, especially in emerging markets, become less attractive. There may be another selloff of risky assets which may simply spill over into other risky assets such as stocks.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.