Friday’s jobs report led to a sudden shift in the economic narrative from soft to hard landing, prompting a sell-off. Add to that a period of AI hype and the Bank of Japan’s interest rate hikes to strengthen the yen. Adding to the panic, Warren Buffett’s Berkshire Hathaway sold half its Apple shares and increased its cash holdings.
But the reasons can’t explain the scale of the collapses. The sell-off — which saw Nvidia’s shares fall by 15 percent at one point — was so big because investors had bet so much on the company’s success. The question is how long the unwinding of those bets and the factors behind them will last. If it does, will the sell-off turn into a surge in savings and a weaker economy, or worse, a crash in the financial system?
The question is how far will these bets and the financial factors behind them go? And if it continues, will the mass selling turn into increased saving and a weaker economy, or worse, a hit to the financial system?
Extreme past examples of the effects of major market crashes are the 1987 crash, the 1998 collapse of Long Term Capital Management, and the 2008 global financial crisis. History is never perfect, but this currently looks more like a (softer) version of 1987 than the previous global financial crisis, according to a report in the Wall Street Journal seen by Sky News Arabia.
In 1987, the stock market experienced its biggest single-day drop ever, with the S&P 500 falling more than 20 percent on Black Monday in October. Investors had built up excessive leverage after a spectacular run to a record high in August, and the crash led to massive margin calls and poorly designed automated trading that exacerbated the selling. But the Federal Reserve pumped cash into banks, brokers didn’t default, and the market recovered all its losses within two years. The economy was fine.
The good news is that 1987 was all about the markets: Markets went up and then down, and nobody else got hurt. The S&P 500 returned 36% in the eight months leading up to its peak in August 1987, similar to its 33% gain in the eight months leading up to this year’s high. Just as they are today, investors in 1987 were nervous and ready to sell for windfall profits. The losses so far have been smaller, but the profitable trades have been reversed, as the market as a whole did in 1987.
The situation was much worse in 1998, though the stock recovered more quickly. The hedge fund LTCM collapsed when Russia’s default on its internal debt led to a safe flight. LTCM was big enough to threaten the collapse of Wall Street institutions. The Federal Reserve cut interest rates three times and assembled a group of banks to bail out the company and slowly unwind its positions. The stock recovery took only four months, but the easy money helped fuel the dot-com bubble that burst two years later, leading to a mild recession and huge losses for investors in technology stocks.
It’s not yet known whether any hedge funds have been liquidated because of the big moves in the markets, which have led to huge losses for those who participated in the “carry trade” of borrowing cheaply in yen and buying higher-yielding currencies such as the Mexican peso or the dollar. But traders are already betting that the Fed will cut rates, with a big 0.5 percentage point cut priced into futures contracts for the September meeting.
A truly bad outcome would be a repeat of 2008, but that also seems unlikely. It is true that some of the biggest U.S. banks failed last year because of bad bets on government bonds. But banks are less hedged than they were, and the system is less vulnerable to a liquidity crisis, with private lenders taking on much of the risk that used to fall on banks. Large losses are entirely possible, and private equity funds could run into trouble, but that would take time and would not create the same systemic crisis.
The best thing would be for the stock market’s excess momentum to recede as it did in 1987 without creating broader problems, and preferably more gradually than in 1987. AI hype could send stock prices much lower—even after falling 30 percent from its June high, Nvidia’s stock price has still doubled this year. But the market is much closer to normal now, with the Nasdaq 100 up just 6 percent so far this year and the S&P up less than 9 percent.
If the panic subsides, the Fed cuts rates, and the financial system doesn’t collapse, we should feel lucky. But it would be good if investors remembered the anxiety they felt this morning and tried to be wiser and less speculative.
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