The one little word that could herald a 50% plunge in the stockmarket

published 18 March 2015

150318-janet-yellen — Janet Yellen: One wrong word could send the stockmarket plunging

Is the stockmarket facing disaster?

One of the world's top investors is worried that we could be facing a 1937-style slump any day now.

The slump of 1937 was basically an echo, or a hangover, from the crash of 1929 and the Great Depression. It made it clear that the world hadn't really recovered from that earlier crash.

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He reckons we could be facing something similar now.

And it all hinges on one little word patient'.

Is a repeat of 1937 on the cards?

He's worried that we could be facing a repeat of 1937. Here's a short version of what happened, as Dalio outlines in his latest letter to clients.

In 1929, the stockmarket crashed and everything went pear-shaped. By 1931, interest rates were at rock bottom. By 1933, the US Federal Reserve was printing money (yes, it did it back then too) and asset prices took off. By 1935, the economy was recovering. The Fed started to worry about inflation.

Between mid-1936 and early-1937, monetary policy was tightened gradually (the exact mechanics are complicated but the end result was slower growth in the money supply). Meanwhile, demand for dollars was rising. Finally, in March 1937, bond yields spiked, and shares sold off by around 10%. Says Dalio: "They bottomed a year later, in March of 1938, declining more than 50%!"

Why's Dalio fretting about this now? There are a couple of reasons. As he points out, the price of shares and risk assets' in general is high, "and the expected returns are low relative to traditional levels". That's not a problem while we've got interest rates at zero and all this money flooding around. But "should interest rates rise and liquidity levels decline materially, that picture will change".

And, perhaps more to the point, the Fed is meeting tonight, and everyone is worried that it's getting closer to raising interest rates. It's not that rates will rise tonight. It's just that Wall Street expects the Fed will remove the word "patient" from its communication.

By the mysterious osmosis through which markets absorb information, that apparently means that the Fed will probably raise rates in June (September at the latest).

As I've said countless times in the past, it's somewhat pathetic that the words of one individual sitting in a meeting room somewhere in the US can upset our ostensibly free markets more than any amount of economic data.

But there you go.

What more can central banks do?

How much looser can monetary policy really get from here? If people aren't borrowing and spending, and companies aren't investing at these levels, they're never going to do it.

At the same time, tightening monetary policy should be easy. They don't need to do much stop printing, sell a few bonds back into the market, tweak rates higher. There's so much debt in the world that almost any rise in rates is potentially going to hurt someone.

In short, if the economy takes off and inflation spikes, then we know or at least hope that central banks should have plenty of power to rein that in. Rates can rise a long way before they're even approaching normal' historical levels.

But if the economy crashes again, the options are limited. How much more shock and awe' bursts of QE can the system stomach?

As Dalio puts it: "We don't know nor does the Fed know exactly how much tightening will knock over the apple cart. What we do hope the Fed knows is how exactly it will fix things if it knocks it over."

So he reckons the Fed needs to take it easy.

Will it listen? Judging by past history, the Fed has a tendency to keep monetary policy loose when it can. But with recent jobs reports suggesting a booming economy (although bear in mind that employment is a lagging indicator it goes up after everything else has), it's under pressure to raise rates.

Regardless, it's another good reason to avoid over-valued US markets in favour of less over-valued ones like Europe. MoneyWeek regular Jonathan Compton picks out some of his favourite eurozone stocks in the next issue of MoneyWeek magazine, out on Friday. If you're not already a subscriber, get your first four issues free here.

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.