Investors may not be out of the woods just yet, despite the recovery of stock prices from their recent lows on February 8. In fact, some analysts and investment managers are seeing disturbing parallels with the 2007-08 financial crisis, Yahoo Finance reports. That's worrisome, since the bear market of 2007–09 lasted 517 calendar days and knocked 56.8% off the value of the S&P 500 Index (SPX), per Yardeni Research Inc. At the close on February 12, after gains on two consecutive trading days, the S&P 500 was 7.5% below its record high on January 26.
The Investopedia Anxiety Index (IAI) continues to register extremely high concerns about the securities markets among our 27 million readers globally, outweighing low levels of worry about other economic and financial matters. A new risk for 2018, and thus a new source of anxiety, has come from so-called "short-vol" trading strategies that fell apart in recent weeks. (For more, see also: 6 Forces That May Push the Stock Market Even Lower.)
The 2007–08 Crisis
"Part of what brought down the stock market [last week] was very symptomatic and very similar to what happened in the financial crisis. Secured [securitized] products, leverage and complexity combining to form a selloff. When you look at 2008 a lot of it was there," says Aaron Kohli, interest rates strategist at BMO Capital Markets, in remarks to Yahoo Finance.
In 2007, there was a subprime mortgage meltdown, as a housing price bubble began deflating. Banks were hit by increasing defaults and delinquencies on home mortgages, especially those that began to exceed the declining values of the underlying properties. Complex debt instruments carved out of home loans began to crater in value, such as mortgage-backed securities (MBS) and collaterized debt obligations (CDOs).
This imposed huge losses on the holders, both individual investors and major financial institutions. Then the dominoes started falling, as big financial institutions faced insolvency and could not meet obligations to each other. For the first time, the concept of counterparty risk entered mainstream discourse, and a massive government bailout of leading financial institutions under the TARP program eventually was necessary to prevent systemic financial and economic collapse.
The Federal Reserve and other central banks around the world then pursued a policy of aggressive quantitative easing, pushing interests down to zero (or even into negative territory), to prop up the prices of financial assets, and to stimulate the economy. As in 2018, 2007 began with a strong economy and upbeat U.S. economic outlook. However, by the end of 2007, partially due to the subprime crisis, the economy was in what has come to be called The Great Recession, which lasted into 2009.
Dangers in 2018
In 2018, the unraveling of risky "short-vol" trading strategies tied to the CBOE Volatility Index (VIX) accelerated the recent stock market selloff. After more than a year of historically low volatility, a growing number of speculators began making what they had come to believe were can't-miss bets using futures and options. When volatility as measured by the VIX shot up unexpectedly, these highly-leveraged schemes produced huge losses, and traders scrambled to raise the capital necessary to cover these losses, adding to the selling pressure on stocks.
Today ordinary retail investors can choose from more than a dozen ETFs linked to the VIX, Yahoo Finance reports. Many of these products are highly leveraged, meaning that their value can swing wildly, Yahoo adds. Just as with various complex debt instruments and derivatives in 2007–08, individual investors have piled into these new products with little, if any, understanding of the full risks. Yahoo might have added that even investment professionals seriously underestimated the risks of complex new products in 2007–08, adding to that crisis.
A particularly notorious example today is the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) from Credit Suisse AG. It lost 92.6% of its value on February 6 alone, and Credit Suisse plans to liquidate it on February 21, at close to a total loss for most investors, Yahoo says. Also, as in 2007 with MBS and CDOs, the leading rating agencies have not been issuing warnings about the dangers of these volatility-linked products, Yahoo adds.
Since 1980, the MSCI All-Country World Index has recorded at least a 10% decline two out of every three years on average, per research by Charles Schwab & Co. Inc. cited by The Wall Street Journal. The maximum dip so far this year has been 8.4%, dividends included, from the high on January 26 to the low on February 8, suggesting a further decline this year, per both sources. Meanwhile, the S&P 500 fell by 10.2% over that same period.
Despite all this, the optimists point to worldwide economic growth and corporate profit growth that remain solid. However, even long-term bulls such as Michael Wilson, chief U.S. equity strategist and chief investment officer at Morgan Stanley, acknowledge that today's high equity valuations will be hard to maintain in the face of rising interest rates and inflation, the Journal adds, raising the odds of further pullbacks in stock prices. (For more, see also: Why Stocks Won't Crash Like 1987: Goldman Sachs.)