Why Have the Markets Crashed?

The major US stock market averages have lost over 20% in two weeks alone, and over 10% just in the first four days of this week. Every single day, a major bank on some continent fails. We are in the midst of a full-fledged run on the financial system (I hasten to add: NOT your neighborhood savings bank) that by all definitions except the formal one of a 10% loss in a single day, should be called a crash.

I'll confess right here. I did not believe a crash would happen. In 1929 and again in 1987, crashes occurred less than 3 months after a fresh, exuberant high had been reached. It was exactly one year ago today that the DJIA reached its all time high of 14,165. Until 2 weeks ago, the decline was a slow grinding inexorable washing out much like 2000-2002 or 1973-1974. So much pessimism was already in the system that a crash seemed almost impossible. Then, after Lehman was allowed to fail, suddenly the emergency was upon us. Kudos to Lee Adler of the Wall Street Examiner who exactly cautioned a couple of weeks ago that his technical indicators were consistent with an imminent crash. He was right.

But that does not tell us WHY the market has crashed. This diary is somewhat stream of consciousness, and I'll add on graphs if I can later on, but for now, a narrative of why.

In the first place, you should throw out any market indicators that only date from the post World-War 2 era (and that is nearly all of them). This includes among other things, post World War 2 readings of the bond yield curve, one of my favorites. As I blogged a few months back, between the period of 1927-1954, indicators simply worked differently than they did in the half century since. The fundamental reason is that the entire post WW2 economic experience has been one of unremitting inflation -- sometimes ebbing, sometimes surging, but always present. Even in recessions, the rate of inflation may have declined, from say 6% to 3%, but it was always positive.

What is happening now is that for the first time in 70 years, the forces of deflation are overcoming the forces of inflation. Assets: houses, stocks, land -- are all declining in price. That asset deflation is lethal to debtors who were counting on their assets to increase in value and finance their borrowing. With those assets wasting away, everybody who has been relying on debt to fuel their business model or their lifestyle of consumption, whether underwater mortgagors in homes they can no longer afford, or Wall Street hedge funds or financial firms, is for all intents and purposes, broke. All that remains now is for the corpses to fall.

The apex of price inflation was probably reached in early July when the price for a barrel of Oil reached $147.50. Oil -- and indeed all commodities save gold -- have fallen relentlessly since then. A barrel of Oil now costs ~$85, exactly its price a year ago and over 40% less than just three months ago. This kind of commodity collapse does not happen in an inflationary environment, but is exactly what you would expect from an old fashioned panic or bust from the 1800s or early 1900s.

As deflation is lethal to debtors, and one of the very best ways to ensure that credit will constrict and deflation will occur, is for short term -- overnight or 3 month interest rates -- to b higher than longer term interest rates on things like 30 year bonds or 15 year mortgages. While the Federal Reserve has cut interest rates all the way to 1.5%, the interbank lending rate in the last year has spiked on numerous occasions to over 3%, including almost the entire last month.

One thing we learned from studying the 1929-33 Great Depression is that once deflation has taken root, it can be vicious and relentless until all debt has been destroyed. In August we had a significant negative number for the consumer price index, and I suspect September's number will be significantly negative as well. And the deflationary contraction will be most severe in the face of an inverted yield curve, which if we use the interbank lending rate, is exactly what we have now. Add in injunctions by government, officially as in Bush's "Panic NOW!" speech of a couple of weeks ago, or indirectly by the daily massive interventions and rule changes by governments and financial agencies all over the world -- what I have called "Global Financial Calvinball" -- and consumers will take the hint. Shoppertrak, a private retail agency, reported that consumer traffic in shops and malls was down over 10% from the year before by the end of September.

A "tight money" yield curve, where short term money is more expensive than long term money, and rapid and severe consumer retrenchment, broght on by and reinforcing the vacuum of deflation, is exactly what happened in 1929, and (again, with the notable and important exception of FDIC insured savings banks) it may be exactly what is happening now. At very least, the "invisible hand" of the markets suspects that the deflationary spiral may have started.

That is why the markets have crashed.



The Yom Kippur Massacre

Today's near-crash had a different feel to it. I was expecting some sort of dead-cat bounce today. Instead we had a waterfall drop.

With the Lehman CDS settlement tomorrow, and what is likely to be tens of billions in losses, it could get very ugly. And the derivative market is where all this selling pressure is coming from. Would you want to be long over the weekend after 7 straight days of drops?
Gawd only knows what sort of strange brew the politicians and central bankers will stir up in the next couple days.

We've got banks failing all over the world. At least four nations have simply shut down their stock markets for most of the week.
I don't know how we'll get out of the month without a full-scale crash. Unless something unexpected happens soon, we'll be seeing the bankers jumping out of windows on Wall Street.

well they can join the workers

who already jumped starting in 2000.

This is something that truly bothers me when you see such despair going on that people just give up and I imagine you're right but more I expect senior citizens who are already broke, using their home equity to pay bills and for medicine and were leaving their retirement in more risky areas because ....they were broke...

those are the ones I worry about...they already got the life savings of the younger ones in the 2000 crash.

fairly good stream of consciousness

Even worse people are just "egging on" fear. I watched a Glenn Beck segment where people were saying "horde food" and "buy guns" and if that isn't the dumbest thing on the air, I just don't know.

Then, there is a "hyperinflation" fear going on now as well.

Even worse, you know what they are blaming GM on? "legacy labor costs"....they continually try to attribute all problems to "labor" being "too expensive" instead of the US middle class being broke. On top of it, GM has done so many stupid moves for so long....although I'm not an expert on their actual debt or if they have CDses, SIVs and what not.

but to me, one of the most frightening things...is we have two candidates who are simply not offering up a new New Deal which assuredly we are going to need, a Keynesian based policy structure to not enter into Hooverville land...

and instead honestly it sure appears we have two Hooverville's on policy and now they are blaming each other..absolutely absurd! We have Obama blasting McCain's HOLC...which is Hillary's HOLC and many economists are recommending some sort of hybrid of a RTC/RFC and HOLC.


It's Calvinball all over!

New "emergency" fixes every single day.

Like Midtowng, I think tomorrow (because of the Lehman CDS) will be quite interesting.

I want to do a better job on this, and I want to revisit it once we get next week's CPI, which will be more important than usual. This waterfall decline, day after day, didn't happen in 1987 and I don't recall it happening in 2001-2. It did happen, but not nearly as badly, in 1998. it also happened (unfortunately) in 1929.

I'm still not saying this is GD 2. History doesn't repeat, just rhymes. But this sure smacks of massive forced liquidation.


Maybe you or Midtowng can pick up that particular Calvin ball and run with it in a blog post. I've written fairly extensively on them and noted that the Fed is working on setting up an auction clearing house for them but it's a ways away....but that's my understanding currently on why this is all so different is derivatives are kind of creating tsunami waves of defaults.

Side note: I've seen reports now where they try to blame the mathematicians and so on who created these "models" on derivatives. I just really doubt that it's just their fault...on faulty models...right. Somewhere, somehow, someone decided it was a good idea to leverage 40:1, 50:1, 70:1 and I just don't think it was some PhD geek sitting in a cube somewhere.

Looking further back

I've recently seen articles comparing this to the Panic of 1907 and the Panic of 1873. The reasoning is that this is a bankers panic first and foremost.
I only know the basics of these two panics, so I don't know how applicable these comparisons really are.

this is different

I suspect this may not compare totally or rhymes as NDD says because of contagion (global unfettered capital moving about), technology and deriviatives. As far as I know there was no such thing (?) as structured investment vehicles, or CDSs, CDOs and how they are all linked up together...

Since all of this is fictional money I don't see why they don't just freeze this entire market. It's supposedly (unknown) but $65 trillion and I have no idea how they could unravel it all easily....

Stocks on track for worse since 1937

Stocks are on track for their worst year since 1937...

it's going like this:

Worse drop since:


Unless they want to look at the days when the tulip bulb trade collapsed....it looks like we're heading for a record.