So the Dow Jones Industrials fell 416 points today, which sounds like an awful lot, but really isn’t anymore. On Black Monday in 1987, a 508 point drop amounted to 23% of the Dow’s value. Today’s drop was just over 3%.
Still, there’s reason for there to be worry in the air. None other than Alan Greenspan has been warning for a few years now that the Federal Reserve’s success in staving off financial crises and economic meltdowns over the past couple of decades “may have encouraged investors to accept increasingly lower levels of compensation for risk.” What that means, he explained in a speech in August 2005, is that we’ve all become willing to pay more for real estate, stock, bonds, and other investments than we probably should.
Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.
Lately others have been picking up on this theme. Just yesterday, Morgan Stanley chief economist Stephen Roach warned (sorry, there’s no link that I can find) that:
After four fat years, convictions are deep that nothing can derail a Teflon-like economy. Investors, policymakers, and politicians have no succumbed to a dangerous complacency. That’s the time to worry most.
The thing is, Roach, although he’s been reasonably bullish for the past year, is a born worrywart. Greenspan, as noted, has been talking about the risks of too little concern for risk for several years now. And markets have been ignoring them.
But sometimes a chain of relatively minor–and, by themselves, unsurprising–events can shake investors out of their complacency. Last week, the subprime mortgage lending industry began to show signs of imploding. Then, on Monday, Greenspan repeated his warnings about risk and said that a recession late this year was “possible.” Then Roach had his say. Then, today, the Shanghai stock market–which everybody knew was due for a downward correction–fell 8.8%. The Taliban tried to blow up Dick Cheney. And the January durable goods number came in below expectations.
Back in early January, Merrill Lynch chief investment strategist Richard Bernstein had this to say (can’t find a link) about how the market’s risk-ignoring days would end:
We view financial risk much like popcorn popping in a microwave. Until the first kernel pops, one tends to believe that nothing is happening. The initial pop seems like a random event until a second occurs. A third. A fourth. Then the popping goes wild.
Can you hear the popping yet?