Stock Market Drop May be Caused By Something We Don't Know Yet

Something is seriously bothering the stock market and the news that’s out there isn’t enough to justify what is going on. Such was the case in August 1998 as well. What caused the sudden bear market to appear out of nowhere in 1998 became fully evident only after the fact. The same could be the case in August 2011.

Perhaps the flash crash in October 1997 was a warning of things to come, just as the flash crash in May 2010 may have been a prelude to today’s stock market drop. In the second half of July of 1998, stocks began to nosedive suddenly, just as they did in 2011. Some stabilization took place in the market toward the middle of August in 1998 and then a new deeper plunge began. Today, the Dow Jones industrials were suddenly down over 500 points this morning on what could only be considered minor bad news.

There were actually two problems causing the market debacle in 1998. Everyone knew about one of them – the Russian debt default and devaluation of the rubble, which took place on August 17th (less than half of the eventual market decline took place before this date). Only Wall Street insiders knew about the second one – problems at Long-Term Capital Management (LTCM) – that almost brought down the financial system.

Trouble in Russia was evident as early as October 1997 and it resulted from the fallout from the Asian financial crisis, which in turn started as a currency crisis in Thailand in July of that year. Today, Europe is undergoing a crisis with the euro that began in Greece in 2010. By August 1998, the Russian central bank had spent a great deal of its dollar reserves defending the ruble and decided to give up. The default had a number of ripple effects, but the most important one on LTCM wouldn’t be known by the public until late September, only days before the market finally hit bottom.

After the Russian debt default, stocks plunged until the beginning of September. The market was close to its ultimate low at that point, but only because of the subsequent successful rescue of LTCM. Stocks then rallied for approximately three weeks. A bailout of LTCM was arranged by the Federal Reserve on September 23rd. The market then sold off until early October hitting a new low and then the decline was over.

In the rally that followed the stock market experienced huge gains led by a bubble in tech stocks. This was a consequence of the Fed lowering interest rates and pumping too much money into the financial system. The Fed had a lot of leeway to do both in 1998 and still there were serious negative results between 2000 and 2002 when the tech bubble collapsed. Inflation wasn’t a concern back then because commodity prices had been declining for almost two decades and were around their lows. It should be assumed that a failure to have successfully rescued LTCM would have caused a much bigger drop in stocks (as happened when the Fed didn’t bail out Lehman Brothers in September 2008).

The Fed has a lot less ability to maneuver in August 2011. Fed funds rates have been at zero since December 2008. The Fed has already expanded its balance sheet by approximately $2 trillion since the Credit Crisis began. Commodities are closer to their all-time highs now, not their lows. Another bailout like the one in 1998 (which was minor compared to what occurred during the Credit Crisis) could send inflation assets into a bubble. Gold is already trading over $1800 today and seems to be leading the way.

Daryl Montgomery
Author, “Inflation Investing – A Guide for the 2010s”

http://www.amazon.com/Inflation-Investing-Guide-2010s-ebook/dp/B0051GU06W/ref=sr_1_1?s=digital-text&ie=UTF8&qid=1313695213&sr=1-1

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.