If you think stock market volatility is bad now, just wait for next year


Andy Xie says the current market volatility is the result of a battle between optimistic mobile internet-led investors and monetary policy. Liquidity tightening will, however, eventually burst the bubble

Stock markets have of late dropped about 10 per cent from the peak. If you think that’s bad, you ain’t seen nothing yet. What happened is small beer. A real collapse is much worse. In 1997/98, the Hang Seng Index fell by over 70 per cent in a year. The S&P 500 did something similar in 2000 and 2007. The current stock market bubble is much greater than on those three occasions. When the real crash comes, it will be worse.

We live amid the greatest bubble in human history. This is the culmination of a series of successive bubbles over the past four decades, based on US dollar printing. People clearly never learn. After one bubble based on a wacky idea pops and wipes out a generation, another generation is sure to come along and embrace another bubble with a new wacky idea. Homo sapiens must be hard-wired to love bubbles.

Every bubble is based on monetary excess. This one is no different. US Federal Reserve chair Janet Yellen refused to raise interest rates from zero despite the country having a normal economy for years, hoping to heat up the US labour market.

Because labour is globalised, the Fed has essentially been heating up the whole world. Hence, the monetary excess had to be incredibly large for the US labour market in particular to warm up. This is the source of the fuel for the biggest stock market bubble in history.

When the market falls, people ask why. “What goes up must come down” isn’t good enough. “What was the last straw?” curious people ask. The rising US bond yield was the trigger this time. Then some crazy leveraged Exchange Traded Fund (ETF) that bet on calm markets forever went belly up, amplifying panic. But none of this would have happened if the market was at normal valuation. When the market is the most expensive in history, it doesn’t take much to cause a rumble.

When a bubble peaks, it usually pops. But, sometimes, it fades away gradually. It took Japan’s Nikkei nine years to bottom out. The Japanese property market is still deflating 25 years after its peak.

A quick burst usually follows a banking crisis. This happened in 1997 in Asia and 2008 in the US. When the government keeps the banking system liquid no matter what, as was the case in Japan, a bubble could deflate gradually. Considering how central banks have been nursing and protecting bubbles, there could be enough liquidity and confidence for this one to fade away rather than pop.

The current sell-off points to another scenario that could burst this bubble. The ETF that bet on low volatility had a big impact on the sell-off. It suggests that there is tonnes of leverage in the market through structured products, especially ETFs. When the storm hits, they have to unwind, which could trigger waves of sell-offs. The 1987 market crash was due to something similar. The current one, however, is much bigger. When the real burst comes, a 50 per cent collapse would be kind.

Another factor that would make this market pop rather than fade is the US budget. The latest budget points to a US$1 trillion (US$7.8 trillion) deficit for the foreseeable future. That means the dollar interest rate will be high. Japan kept interest rates at zero after its bubble began to deflate, because its domestic savings were funding its ballooning fiscal deficit. The US depends on foreign capital for its blowout deficit. The high dollar interest rate means that the bubble must expand or pop.

The current turbulence is not likely to lead to the immediate demise of this bubble, because the greed momentum is still strong. Any bubble, in addition to liquidity, needs something shiny to capture popular imagination.

Mobile internet is the perfect shiny thing. Most grown-ups have become phone zombies, willing guinea pigs for mind manipulation, which the internet-based business model works on. But this market sell-off has not been led by the internet.

Rather, every rebound is led by the internet. The mass hysteria is still intact. It will fight against tightening liquidity again and again. The battle between the two will cause several sell-offs this year such as the one we are now seeing.
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The popular infatuation with mobile internet will fade soon. The decline in Facebook usage is a sign of things to come. The internet-based model thrives on misinformation and deception. But the internet boom will burn itself out. People will eventually wake up to the reality that to get on the internet is to get ripped off. That will be a driver behind the bubble bursting.

Tightening liquidity will eventually kill greed. The US budget has sealed its fate. The ballooning fiscal deficit in a peaking economy means that the US bond yield will keep rising, even if the Fed drags its feet on raising the policy rate. The 10-year bond yield may reach 4 per cent in one year. That would be enough to pop the bubble.

The market wobbles in 2018 are just tremors. The big one will come in 2019.

Andy Xie is an independent economist

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