Dow Pullback: Do Past Corrections Predict the Future?
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This is Your Money Matters from The Wall Street Journal. Welcome to Your Money Matters. I'm J.R. Whalen in New York. February's stock market dive put Wall Street in a tailspin and it put some investors in a bind. But did it put us in a time machine? Wall Street Journal chief economics commentator Greg Ip joins us from our Washington bureau to discuss which historical marker we should use to predict where the market goes from here. So, Greg, we could try to compare this year's steep market drop to a few sharp declines in the recent past. Let's start with the freshest in our mind, 2007 and the onset of what many call the Great Recession. Is that a legitimate fear of what this year's market drop could be portending?
Most market drops have some kind of fundamental trigger to them, whether it's concerns about the economic outlook or concerns about inflation and interest rates. This one's no different, and that was the same in 2007. But what was special about 2007 was that the market drop was a symptom of much more severe underlying problems in the economy. Essentially, you had trillions of dollars of badly underwritten mortgages issued, and they were backed by housing prices that were too high. So when you saw things like hedge funds run by Bear Stearns collapse or subprime lending start to implode, that wasn't just some isolated market event that was unsettling investors. That was a tip of a serious iceberg. When I look at the market downdraft that we've experienced in the last few weeks, it doesn't seem anything like 2007 or 2008.
Yes, there's been a bit of a scare over inflation and interest rates, and that could indeed be a headwind to the market for some time to come. But I don't see the severe economic fragilities underneath the surface that we had 10 years ago.
All right, so let's go further back to 1998. There was a lot of market volatility back then, and the Dow dropped 19%, but it wasn't the domestic economy that was spooking the market back then.
Now, going into 1998, you had a lot of turmoil in the global economy. The East Asian financial crisis had been underway for a year, and in the summer of 1998, all eyes were on Russia. They thought it was too nuclear to fail, but fail it did, and that ricocheted into markets in the United States. Only with hindsight did we discover that a lot of that downdraft in the markets was being driven by one very large hedge fund called long-term capital management, which had taken on very highly levered positions in a variety of markets, bonds and stocks, and was being forced to unwind those and essentially triggering fire sales of assets, putting huge stress on the markets. You had things like bond yields going haywire and not at all behaving like we were used to.
It was worrisome and scary, but in the end it did not tell us about anything special about what was going on in the economy itself. And indeed, once that was out of the way, with a little bit of help from the Federal Reserve, which arranged a bailout of long-term capital management, the economy turned out to be fine.
And in your column, you also take us back to 1987, and that year we saw a more dubious milestone. That was the stock market crash in which the Dow lost about 23% of its value.
How does February's Dow pullback compare to the 2007–2008 Great Recession crash?
And that year, concerns included rising bond yields, inflation, and how a newly seated Federal Reserve chairman might pull the trigger on interest rates. That sounds a lot like today, but you say not a fair comparison, and don't let that comparison keep you up at night.
There are similarities and differences with 1987. And let's start with the similarities. Even though we think of the bear market as being all about Black Monday, the decline in stocks had actually started weeks, if not months, earlier. Interest rates had been rising. The Fed had raised the discount rate quite sharply in September. There was a fight between Germany and the United States about the value of the dollar. And there had been a lot of froth related to leveraged buyouts, which was starting to come undone.
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