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.