It may be a new year, but 2016 is starting off with much of the same old bad news that plagued stocks last year, leading to turbulent and often violent swings in the stock market. Fasten your seatbelts!
The year is just three full trading days old and stocks are down 2.7% already!
Does this inauspicious start doom stocks to repeat the volatile trading-range market of 2015 again this year … or worse, does it signal a steeper selloff ahead?
The historical record offers some hope for the bulls. Since 1928 there have been 14 other declines of 1% or worse to start the new year. And yet the S&P 500 went on to post median gains of 5% for the rest of January, and 7% for the balance of the year.
So bad beginnings don’t always lead to unhappy endings, but there are always exceptions.
In times of unusual financial stress, early market losses do seem to snowball. In 1930, 1937, 2001 and 2008, stocks tumbled an average of 1.7% on the first day of trading, and went on to plunge 28.3% on average over the rest of the year!
The 1937 example is eerily similar to the economic and financial
environment we face today, so perhaps it’s worth a closer look.
Picture if you will … a Federal Reserve that cuts interest rates to zero in response to an unprecedented contraction in the economy, and keeps them there for years …
Desperate to restart growth, the Fed and Treasury also make extraordinary efforts to expand the money supply through quantitative easing (QE) …
The Fed’s money printing works, at least for a while; by pumping extra liquidity into the financial system and creating a wealth effect that inflates stock and bond prices, temporarily stimulating the economy …
But it proves to be a phony recovery. Soon the Fed makes a mistake by tightening interest rates too soon, and the illusion of a recovering economy and financial markets is quickly shattered.
If this sounds like the scenario we’ve all been living through since the Great Recession and financial crisis in 2007-08, you’re right!
But it also accurately describes the aftermath of the Great
Depression in the 1930s. In fact, the parallels are stunningly similar.
Ray Dalio, founder of the world’s largest hedge fund company, Bridgewater Associates, has been highlighting the eerie similarities between Fed policy and the path of our economy and markets both then and now.
|Will the Fed repeat the same mistakes today that were made in 1937, and consequently send the economy right back into recession?|
And he warns we are in grave danger of repeating the same mistakes today that were made in 1937, plunging the economy right back into recession, and financial markets into another tailspin.
* In both periods (1931-36 and 2008-15) the Fed cut interest rates to zero and held them there an extended period …
* In both periods (1932-36 and 2008-14) the Fed’s balance sheet expanded massively with multiple rounds of QE bond buying …
* And in both periods, stocks enjoyed sizeable rallies off the lows (+300% from 1932-37 and +200% from 2009-15).
But as the economy improved from 1933 to 1936, just as it did from 2009 to 2015, the Federal Reserve decided it was time to begin tightening interest rates again to start mopping up excess liquidity.
In August 1936, the Fed raised interest rates by half a percent, the first rate hike in many years. It didn’t seem to hurt the stock market or slow the economy much.
So the Fed tightened again, twice, in March and May 1937. The dollar surged, credit markets tightened and soon both bonds and stocks began to selloff.
From the 1937 peak through March 1938, stocks plunged by 50%, prompting the Fed to reverse course and start easing monetary policy again.
The lesson as Dalio sees it: “We don’t know — nor does the Fed know — exactly how much tightening will knock over the apple cart. We think it would be best for the Fed to err on the side of being later …” when it comes to raising rates.
Since the Federal Reserve is widely expected to raise interest rates several more times in 2016, I certainly hope this lesson of 1937 is not lost. Those who forget the past are condemned to repeat it.
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