By Mark Kolakowski | July 17, 2017 — 6:00 AM EDT
The bull market in stocks faces a major threat from the end of low interest rates as the U.S. Federal Reserve and other central banks worldwide unwind their balance sheets and withdraw massive injections of liquidity, according to Barron's. One scenario is that actions by the Federal Reserve will push the yield on the 10-year U.S. Treasury Note to 3% and the S&P 500 Index (SPX) will peak at around 2600, a precarious level at those bond yields. That could spur a stock decline along the lines of Black Monday 1987, though less severe, according to the analysis of Jim Paulsen, chief investment strategist at The Leuthold Group LLC, as reported by Barron's.
Black Monday Revisited
On Black Monday, October 19, 1987, the Dow Jones Industrial Average (DJIA) plummeted 22.6% in a single day, marking the beginning of a global stock market decline and panic selling, with most of the major exchanges dropping significantly by the end of the month. No single news event spurred the drop. It took a year and a day, until October 20, 1988, for the S&P 500 to return to its opening value on Black Monday. While a number of protective mechanisms since 1987 have been built into the market to prevent panic selling, such as trading curbs and circuit breakers, many investors say the market remains vulnerable.
To be sure, many investors argue that the broader stock market still has room for sizable gains even if technology stocks, once the leaders, begin to lose momentum. The Fed remains supportive, and earnings and the economy are growing, albeit at a slower pace. (See also: "Tech Breakdown Won't Kill the Broader Market.")
Parallels to Today
Nonetheless, several factors that led to the 1987 crash are familiar today. These include: high stock valuations, a slowing economy, rising inflation, investor overconfidence, and automated program trading that facilitated a sudden avalanche of sell orders when indicators turned negative. One difference between 1987 and today is that the U.S. dollar was strong then, depressing corporate earnings from exports. (For more, see also:What caused Black Monday, the stock market crash of 1987.)
'Closer to the Exit'
Paulsen argues that the Fed should quickly raise interest rates and shrink its balance sheet before it hurts the broader economy, according to Barron's. He also worries that the falling dollar threatens to feed inflation just as the Fed is increasing borrowing costs through its rate hikes, all of which will put pressure on stocks, he told Barron's in its July 8 "Up and Down Wall Street" column.
Ray Dalio, founder of hedge fund management firm Bridgewater Associates LP, also believes that the era of near-zero interest rates manufactured by central banks is coming to end, per comments that he posted on social networking site LinkedIn, as quoted by Barron's. While central banks including The Fed will attempt to unwind their balance sheets in a deliberate fashion that keeps inflation and growth within acceptable bounds, Dalio suggests that they inevitably will have a miscalculation that produces a recession. As for the markets, he recognizes that central banks' massive infusions of liquidity have propped up the prices of financial assets, and suggests that he has moved "closer to the exit," but does not indicate what would be a clear sell signal in his opinion, Barron's reports. (For more, see also: "Bill Gross: QE is "Financial Methadone.")
Weakening Market Underpinnings
Other equity market underpinnings are starting to weaken. PIMCO Chief Investment Officer Dan Ivascyn says the growing political crisis over the Trump administration's Russia ties is dimming chances that the White House can speed up the economy through major tax reform and deregulation, according to Bloomberg.
Meanwhile, Christine Lagarde, managing director of the International Monetary Fund (IMF), does not rule out the possibility of another financial crisis in her lifetime and says that policy makers should be prepared. "Typically the crisis never comes from where we expect it," she told CNBC. Lagarde was responding, in part, to earlier remarks by Federal Reserve Chair Janet Yellen, who does not expect to see a similar crisis again in her own lifetime.
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