What the last three tightening cycles tell us about today
How different is this time?
Key points:
The dot-com bubble and the Great Financial Crisis (GFC) both experienced a bottom in most sectors approximately 800-1000 days after peak rates were initiated.
In both crises, a specific sector was identified as underperforming and lagged significantly behind others for an extended period.
Currently, we are about 160 days into our tightening cycle. If this cycle follows previous patterns, we may not see a true market bottom for another year.
Tightening cycles often reveal underlying economic issues. The Federal Reserve usually halts rate increases when a significant problem arises. In our case, this was marked by the collapse of SVB. More time is needed to identify the most vulnerable sector, with technology being a likely candidate, as suggested by recent layoffs.
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This post follows up on my last one, which averaged the returns of all sectors following the past three financial crises. A reader inquired about the performance of individual sectors during each tightening cycle. Below is a breakdown of these cycles, accompanied by some background. Although some points may seem obvious to seasoned observers, comparing and contrasting these crises is essential.
Starting with the dot-com bubble, the most notable aspect is the severe crash in technology, which remained stagnant for at least six years, barely breaking even. The reason for this significant impact on technology is clear: the dot-com bubble represented a period of easy money, during which technology stocks saw an extreme surge in price before the bubble burst.
This situation was partly due to inadequate regulation of tech stock promotions by brokerage firms. The surge in IPO proceeds highlights the intensity of this frenzy. Remember, an IPO allows a company to raise funds, often with a brokerage firm's support aiming to sell those shares. It's also crucial to consider recent years, where we see challenging times in the stock market. Profitability is a key factor here, as evidenced by the entry of numerous unprofitable companies into the market before the crash. A significant number of these companies were unprofitable, a trend that took a decade to peak. It's essential to recognize that some trends may take years to unfold, and current observations can be indicative of future outcomes.
Turning to the GFC, many remember it firsthand or saw their families affected. Its severity stemmed from systemic issues, exposing most of the economy. The financial sector is particularly noteworthy for its extensive reach across the economy. Lending and banking act as a critical link between savers and borrowers, underpinning our economic functioning. Companies also often roll over debt, using new loans to pay off existing obligations. However, when access to credit tightens, companies face significant funding problems because they can’t roll their debt over anymore. The financial sector's vulnerability has far-reaching impacts, which is why bailouts are often necessary.
The chart above begins at the peak federal funds interest rate, marking the economy's tightening phase. Observe that following peak rates, both crises required time to unfold in the market. However, the period of poor performance was relatively short-lived, lasting only a year or two. A key takeaway, perhaps unsurprisingly, is that sectors at the center of a financial crisis tend to remain impaired for an extended period and should be avoided for some time. One primary cause of this crisis was the debt burden that households started to take on.
The narrative is clear: financial institutions profited significantly by selling mortgages to many households that couldn't afford them. As defaults increased, financial services companies were the most impacted.
As defaults escalated, banks recognized their limited capacity to lend, consequently constraining the economy and precipitating a crisis. One thing I’d like to point out at this point is that there were warning signs. Processes were occuring that allowed stress to build up in the system. Keep this in mind as we shift our focus to the present scenario.
Since the onset of the current tightening cycle, most nadirs have already seemed to occur around 80-100 days, contrasting with the 800-1000 days after peak rates during the last two financial crises. Does this suggest a longer wait to reach the true bottom? Well, here’s the case that it doesn’t.
The dot-com bubble and the GFC primarily impacted specific sectors. Unlike these past crises, today's cycle doesn’t seem to be driven by a single struggling sector. The dot-com era was marked by extreme valuations, while the GFC arose from corruption and systemic failures in financial services. These factors led to more prolonged effects. However, the current high rates, spurred by inflation, do not result from systemic issues or investor behavior, implying a lesser deflation is needed from this 'bubble.' This assessment holds, considering that this 'bubble' partially originated from the Federal Reserve's lenient monetary policy post-COVID which didn’t last very long.
Contrarily, the argument for an impending recession points to the still-inverted yield curve. Specifically, the 10-year US government bond rate remains lower than the 2-year rate.
This situation arises when the Federal Reserve raises interest rates, leading to shorter-term bonds (like the 2-year) temporarily yielding higher than longer-term ones (like the 10-year). There's considerable debate about why this happens, but a common consensus is that the Fed often triggers a recession by using interest rate hikes as a blunt tool. Also, I’d like to point out that historically, it takes a few hundred days for a specific sector to emerge as particularly weak. During the dot-com bubble, it was approximately 160 days after peak rates for technology to become a troubled sector. For the GFC, it took around 390 days for the financial sector to clearly falter. If history is any indicator, we might soon see unhealthy sectors begin to emerge. Technology is a likely candidate, considering recent layoffs, but this may simply reflect over-expansion during periods of easy money. Now is the time to be searching for skeletons in the closet.