A Disturbing Market Signal on the First Trading Day of the Year

January 2, 2014

The Dow Jones Industrial Average suffered a triple-digit point loss today, equivalent to 0.8%.  It’s not unusual to see big gains on a year’s first trading session even in years after a strong share price performance.  On such first days of January in recent years, the Dow went up 3.0% in 2009 (even before the bear market had ended), 1.5% in 2010, 0.8% in 2011, 1.5% in 2012 and 2.4% one year ago. 

Among the last twenty-five years back to 1990, only four first trading days of the year experienced a bigger decline in the Dow than today, and each was associated with a U.S. recession.  The greatest drop came in 2008, a slide of 1.7% on its first trading day.  The Great Recession began in December 2007 and would not end until June 2009.  The next two largest plunges of the Dow to start a year occurred in consecutive years, 1.2% on the first day of 2000 and 1.3% on the first day of 2001.  The Dot-com bust began January 2000, and there was a recession in 2001 from March through November.  The other bad first day was a 0.9% drop of the Dow in 1991 during the recession that lasted from July 1990 through March 1991.

My first thought on seeing that U.S. stocks kicked off 2014 with a sizable loss after closing 2013 at a record high in fact came from a different economy, Japan.  The Nikkei-225 ended 1989 at a record peak of 38,916.  Nearly a quarter of a century later, that level remains the all-time peak.  Can’t you imagine Keynes, who coined the warning to investors and economists that we’re all dead in the proverbial long run, smiling somewhere.  Anyway, the Nikkei began 1990 with a seemingly innocuous drop of 0.5% but would eventually plunge 38.7% from the end-1989 peak within the coming twelve months.  And that was just the opening act of a multi-decade disaster for investors.  By March 2009 when Japan like so many other stock markets was caught up in the post-Lehman Brothers market bloodbath and financial market meltdown, the Nikkei at 7,055 was 82% below its record high.  Just try imagining the DOW Jones Industrials quoted at 3,005 in March 2033.  That’s how bad it was for Japan or could be if the same lightning strikes Wall Street.

It was not just a quirk that the reversal of the Nikkei’s course coincided with the ringing in of a new year.  The stage was set with a changing of the guard in BOJ leadership.  Yasushi Mieno began a five-year term as governor on December 17, 1989 and just eight days later — on Christmas Day no less when the rest of the world was on holiday — showed the audacity to authorize a hike of the official discount rate of 50 basis points.  A similar move had been done just eleven weeks earlier by Mieno’s predecessor and while Mieno was Deputy Governor.  So in less than a calendar quarter, the rate climbed to 4.25% from 3.25%, a 31% leap.  Another 100-basis point increase followed in March 1990 and then a 75-bp jump some five months later.  Within just ten months, monetary officials had engineered more than a doubling of the rate to 6.0%.  In explaining the Christmas Day massacre, Mieno asserted the move would help sustain domestic demand-led growth while maintaining price stability, and he said that the value of the yen, level of domestic business activity, money growth and especially inflation were critical considerations behind the action.  One expressed concern was that dollar strength against the yen might drive firms to boost prices in 1990.  Another concern was the perceived real estate boom.  Well, BOJ officials sure made sure that wasn’t going to happen, didn’t they?  Japanese consumer prices between December 1988 and December 1989 had incidentally risen 2.6%, but that was far too much for the conservatives running the central bank, who let overnight money rates — yes the rate that’s now being targeted between zero and 0.1% — shoot eventually above 8.0% and didn’t relax the discount rate tourniquet until a whole year had passed and Japan was gasping for air.  The rest is history.  Disinflation yielded to deflation, and the power hegemony in Asia slipped out of Tokyo’s hands and into Beijing’s.

What does this have to do with the Fed’s recent tapering, one might ask?  Well, it’s common for newly installed central bank leadership to cement a reputation as an inflation fighter early in their stewardship.  It happens everywhere.  That certainly was part of Mieno’s thinking.  Greenspan also tightened very early after taking over at the Fed in the summer of 1987, a move that contributed to an eventual 22.6% stock market collapse on October 19 of that year.  Markets love to see tightening and didn’t question any of these moves, just as the tapering last month was received much better than the delay back in September.  With hindsight, Japan was less inflation-prone when Mieno took over than he thought, and an unrecognized disinflation/deflation danger went entirely unnoticed.  To its credit, the Fed wants to proceed with baby steps, but long-term interest rates may not comply.  Ten-year Treasury yields are almost double their lows of last May.  Can the U.S. economy handle another possible percentage point increase in the first half of 2014?  And what happens to vulnerable emerging economies like Turkey, Brazil, South Africa, and Indonesia if that happens?  It’s not just the consequences for the United States.  The whole world has a stake in how this experiment turns out.

As the pundits and politicians applaud the Fed’s belated decision to start tapering, people with money at risk actually revealed some nervousness today as they looked into the future.  2014 could be an interesting year.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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