The Fearful Rise of Markets: A Timeline
The Rise
November 23, 1954: U.S. stock market recovers from the Great Crash
Strict post-Depression regulation of U.S. finance is in place: Commercial banks are covered by deposit insurance and barred from investment banking. Fixed exchange rates are linked to gold under Bretton Woods. Banks dominate finance. Investment is dominated by individuals investing their own money. The young world is in the post-war Baby Boom, while the capitalist world is divided from the Third World and the Communist Bloc. Mainstream investors have no access to investing in commodities, foreign exchange, credit default risk, or emerging markets. All these factors change in the next half century, creating the conditions for unrelated markets to overheat and crash together in a synchronized bubble.
1962: Launch of Fidelity’s Magellan Fund
Investment managers like Fidelity start publicizing their returns and launching big new funds. The industry is driven by the aim to accumulate assets. Ranking organizations start publishing league tables comparing funds’ short-term performance. Markets are now driven by people using other people’s money; their pay and their benchmarks encourage them to herd together.
1969: Launch of the first Money Market Fund
Capital markets strip banks of many core functions. Money market mutual funds even offer checkbooks. This gets around strict 1930s restrictions to avert bank runs but creates apparent bank deposits that do not have deposit insurance; it takes lending decisions from banks’ lending officers and gives them to markets; and it forces banks to look for new, often riskier lines of business.
1971: Gold standard ends
Nixon exits the gold standard; a necessary condition for bubbles. With gold no longer the anchor, currencies depend on central banks. If they lose their credibility, the anchor of the world economy is now the price of oil, not gold.
1975: First index fund launched
Index funds create benchmarks for managers to crowd around and make the market more prone to bubbles as they take a growing share of assets.
1982: Launch of the first Emerging Markets Fund
The World Bank rebrands Lesser Developed Countries as “Emerging Markets,” and sets up funds to buy shares on their stock markets, opening them as a new asset class to mainstream investors for the first time. Once uncorrelated with developed world stocks, they start to synchronize with them when the same investors hold both, and the creation of emerging market indexes helps create a “herding” effect in emerging markets.
1984: Reform of mortgage-backed bonds
Ronald Reagan allows investment banks to trade bonds that are backed by big pools of mortgages and makes it easier for investors to buy them. This increases the power of Fannie Mae and Freddie Mac and eases the problems for struggling small U.S. banks. It also means the agents who decide to extend loans are not on the hook if the mortgage defaults—and that investors in other markets could trade in and out of mortgage debt—helping to inflate the synchronized bubble.
January 1990: Crash of Japan leads to the yen carry trade
A carry trade creates cheap money by borrowing in a currency with low interest rates, putting money into currencies with high interest rates and pocketing the difference. When Japan’s bubble bursts in 1990, low rates in yen create a carry trade. Equity investors finance themselves this way—so the yen starts to move in line with stocks.
September 1992: Sterling’s Black Monday spurs foreign exchange as an asset class
Big coups for currency investors in the early 1990s prompt interest in forex as its own asset class. Big investors set up funds just to make bets on exchange rates.
December 1996: Alan Greenspan warns against irrational exuberance
Aging baby boomers’ confidence, and their need to save for retirement, drive huge flows of money into mutual funds. That inflates the stock market and further pushes fund managers to crowd into hot stocks. They become the world’s investor of last resort.
1997: Asia crisis prompts Asian countries to build up reserves of dollars
Asian countries suffer a series of devaluations, come close to default, and then suffer years of austerity. This prompts China and other Asian countries to build stockpiles of dollars—making U.S. interest rates lower, pumping more money into markets.
March 1998: Citigroup and Bank of America mergers create banks that are “too big to fail”
Global mega-mergers leave many banks so big and important to the economy that they know governments cannot let them fail, creating moral hazard—and incentives to take risks. Banks go global with operations around the world, increasing global correlations.
August 1998: Long-Term Capital Management melts down
Long-Term Capital Management, the biggest hedge fund at the time, sparks an international seizure for credit markets—an early warning of a super-bubble. It is rescued and the Fed cuts rates, inflating a bubble in tech stocks and stoking moral hazard.
2000: Dot-com bubble bursts
Technology stocks crash after forming history’s biggest stock market bubble—the culmination of irrational exuberance, decades of herd-like behavior, and the recent injection of cheap money and moral hazard by the Federal Reserve. The Fed responds by cutting rates, prompting an early rebound for stock markets, the rise of hedge funds, and bubbles in credit and housing.
2001: Emerging markets rebranded BRICs
Goldman Sachs predicts great growth for the BRICs (Brazil, Russia, India, and China) and ignites a new emerging markets boom. The flows of money tied the BRICs to other stock markets and pushed up commodity prices and emerging market exchange rates.
2004: Commodities become an asset class
Big investing institutions pour into commodity futures after academic research shows they offer strong returns uncorrelated to the stock market. The new money helps make commodities correlate far more with stocks. Rising commodity prices also push up emerging markets and exchange rates.
2005: Default risk becomes an asset class
Credit derivatives open the world of credit and loans to mainstream investors. Credit starts to correlate closely with equities, bonds, and commodities and drives the rise in U.S. house prices and the subprime mortgage boom. By creating cheap leverage, the credit boom inflates bubbles simultaneously across the world.
The Fall
February 27, 2007: Shanghai Surprise ends the Great Moderation
The bubble rests on the extreme low volatility and low interest rates of 2003–2006. Volatility suddenly rises, making financial engineering much harder.
June 7, 2007: Ten-year Treasury yields hit 5.05 percent
Investors sell bonds, pushing up their yields and breaking a downward trend that had lasted two decades—this changes the mathematics for all credit products.
June 19, 2007: Bear Stearns Hedge Fund appeals for help
The hedge funds’ lenders take possession of subprime-backed securities and auction them, revealing confusion over how much they are worth.
August 3, 2007: Pundit Jim Cramer declares “Armageddon” in the credit markets
U.S. retail investors discover that U.S. banks have stopped lending to each other.
August 7–9, 2007: Big quantitative hedge funds suffer unprecedented losses
One equity hedge fund liquidating its trades in the wake of the Bear Stearns incident leads to unprecedented losses for a group of big hedge funds that supposedly have no exposure to the market.
August 9, 2007: European Central Bank intervenes after BNP Paribas money funds close
This is “The Day the World Changed” according to Northern Rock—money markets panic intensifies on both sides of the Atlantic.
August 17, 2007: Fed cuts rates after Countrywide funding crisis
The biggest U.S. mortgage lender teeters on the brink of bankruptcy; then the Fed cuts rates—prompting new waves of money into emerging markets and rebounds in the U.S. and Europe.
September 13, 2007: The run on Northern Rock
UK bank customers queue up to remove their deposits, damaging confidence in the UK.
October 31, 2007: World stock markets peak
Fears of losses at Citigroup prompt a sell-off on November 1.
March 16, 2008: Bear Stearns rescued by JP Morgan
Bear Stearns falls victim to a “bank run”—the U.S. government helps JP Morgan to buy it, stoking the belief that bailouts will be available and pushing up commodity markets.
July 14, 2008: Oil peaks and the dollar rebounds—the end of the “decoupling trade”
The 2008 oil spike ends, ending an inflation scare. Oil, foreign exchange, and stock markets simultaneously reverse, creating big losses and forcing investors to repay debts.
September 7, 2008: Fannie Mae and Freddie Mac nationalized
Preferred shareholders take losses, shocking markets and prompting a run on all financial institutions seen as vulnerable.
September 15, 2008: Lehman Brothers bankrupt
Negotiations to sell it fail; Merrill Lynch sells to Bank of America; AIG appeals for help.
September 18, 2008: AIG rescued; Reserve Fund breaks the buck; money market panics
A money market fund “breaks the buck” because it holds Lehman bonds, leading to panic withdrawals from money funds; AIG requires an $85 billion rescue, prompting fears for European banks it insured.
September 29, 2008: Congress votes down the TARP bailout package.
Confidence in political institutions collapses. Confusion in European Union over how to coordinate protecting bank deposits makes this all the worse.
October 6–10, 2008: Global correlated crash
Virtually all the world’s stock markets drop by one-fifth in one week—the unprecedented fall across all asset classes demonstrates that there had been a synchronized bubble.
The Fearful Rise
October 24, 2008: Emerging markets hit bottom as China rolls out stimulus plan
China’s aggressive expansion of lending and the Fed’s supply of dollars to emerging market central banks avert an all-out emerging market default crisis.
March 9, 2009: Bank stocks, and developed markets in general, hit bottom and rally
A rally starts after Citigroup says it is trading profitably. Confidence returns that big banks can avoid nationalization.