US Markets: Unlikely A Reprise of 1998

``The good times of too-high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, . . . . there is a happy opportunity for ingenious mendacity.” Walter Bagehot, Lombard Street (p. 158)

Figure 6: Economagic: FED Cut case of 1998 versus 2002

The bulls argue that today’s actions has a precedent; the 1998 scenario. Then the FED applied its FIRST AID kit during the Long Term Capital Management (LTCM) induced liquidity crisis, where following the monetary treatment, its financial markets take off, as shown in Figure 6.

The leftmost red arrow shows of the FED cuts (red line) in response to the drop in the S&P (blue line) to our threshold levels. The S&P bottomed out in 3 months following the monetary remedy and speeded away for good.

However, this looks like apples to oranges comparison.

As seen above US economic growth (yellow green line) remained robust even during the selloff and looked unaffected. Second, US households and the global financial system were not as leveraged as it is today. Third, the source of stress came from external forces, following the 1997 Asian Financial Crisis. Russia went into a debt default which collapsed the highly geared LTCM run by two Nobel Laureates. And following the back-to-back crisis outside the US, money flows appeared to have shifted into the US markets which seems to have boosted the US dollar (green line), aside from its equity markets.

Today, the US economy has been growing below its average trend, US households have been levered to the eyeballs, the global financial system has exploded in size due to excessive leverage (the size of derivatives at $415 trillion is mind boggling enough!), global current account imbalances ballooned to record levels, and most importantly, the source of the present stress emanates from the US.

Fundamentally speaking, we don’t buy such arguments. However, we would keep an open mind and base our judgments on how the markets, especially the financial benchmarks, RESPONDS to the central bank impelled stimulus.

The bullish side critically DEPENDS on the central bank medicines to restore the present order. The bearish side is that central bank actions have always been SHORT-TERM in nature, and yet could go awry, as in the tech bust in 2000 (top red arrow). Besides, such inflationary actions usually involve longer term unintended consequences.

Finally, it is unlikely that a healing would occur soon. Even under the optimistic 1998 scenario, it took a QUARTER from peak-to-trough before a bottom was found. We are only about a month into this correction. It is too soon to tell.

Remember, NO trend goes in a straight line. There will always be massive relief rallies or bull traps within bear market cycles (refer to the Phisix 1997 chart). The latest Fed activities are likely to feed into the bullish insurgencies, but if problems continue to weigh on the financial system then eventually this would falter anew. Take such opportunities to exit instead as the risks prospects remain high.