The recent yield curve inversion is just the latest signal that the markets and economy may be heading for a downturn. Inflation continues to surge even as the Federal Reserve has raised interest rates. Consumer confidence has tanked, with a recent Morgan Stanley survey showing that mall visits were down 14%, and two-thirds of consumers responded they were planning to spend less over the next six months. Like it or not, a recession could be on the horizon. As investors prepare for the potential downturn, it’s worth looking back at the last two recessions to understand what’s happening right now and why.
The Bubble Bursts
Many people may be inclined to look for similarities in the 2007 downturn, but a better starting point is the dot-com bust and the lead up to it. The internet changed almost every aspect of modern life beginning in the 1990s, and stock trading was not immune. With the advent of the internet, suddenly anyone could trade stocks almost instantly from almost anywhere. Suddenly, the ranks of day traders swelled as amateurs poured into the markets. These individuals were making trade after trade after trade, and during the boom years of the 90s — when anything with a .com at the end had a soaring valuation — they did very, very well. Right up until 2000, when the bubble burst.
The wild valuations of many of the dot-coms were unsustainable, and day traders who had become accustomed to a market that always went up — making it easy to make money — weren’t protected. When the bubble burst, roughly 90% of the day traders went out of business. For investors accustomed to a bull market who aren’t hedging, aren’t taking money off the table at regular intervals, and aren’t sticking to a plan for their investments, there are going to be issues when the market starts to move against them. The bursting of the dot-com bubble was followed by the September 11, 2001 terrorist attacks, a major geopolitical event which led the United States into wars in the Middle East and threw markets into further turmoil.
To compensate for the shock of 9/11 and the bubble bursting, interest rates were lowered, and many firms quickly moved into mortgages, which was one of the only areas that was doing well and making some money. The mortgage industry started to blow up, and firms levered up more and more and more to take advantage of it. This worked — until it didn’t. The whole thing came crashing down again in the fourth quarter of 2007, bringing on the collapse of Lehman Brothers and Bear Stearns and the Great Recession. The financial crisis was so serious that had the government not stepped in to stabilize things, it could have very easily led to a global depression. Even with government intervention, the Great Recession caused a great deal of pain, and it took years for markets and the economy to stabilize.
The Bubble Bursts Again
We’ve seen similar dynamics in recent years with the rise of meme stocks and retail investors riding waves on stocks such as Gamestop or AMC and various crypto trends. When the market was going up, these traders, making use of free platforms such as Robinhood, by and large did well. However, as the forces outside of their control have pushed the market into negative territory, many of them have piled up losses.
This time around, there have been twin bubbles. The first was in tech stocks, which led the market for years but have been a drag on the market in recent months. The second bubble was absolutely in crypto. Bitcoin’s all time high was over $68,000 in November 2021. Now Bitcoin is trading around $24,000. That’s a huge drop over a very short period of time, and it’s what happens when a bubble bursts.
And as in 2001, a major geopolitical crisis has coincided with the bursting of a bubble. Inflation, which was already raging in the wake of the pandemic, was thrown into high gear by Russia’s invasion of Ukraine and subsequent sanctions, disruptions in oil markets, and snarls in the global supply chain. Taken together, the combination of geopolitical events, inflation and the bursting of the crypto and tech bubbles is perfect to create a recession. Hopefully, the government will get things right this time around and avoid the sorts of problems that led to the financial crisis.
There’s nothing investors can do about inflation or geopolitics, but they can do things to protect themselves in the meantime. If they’re in a particular stock, it needs to be for its long-term growth story. In particular, investors need to understand why they believe in an investment and pay careful attention to whether those factors remain true. If the case for the investment changes for the worse, investors need to get out of it, regardless of their basis or what it costs them. This can be painful, but being strategic and disciplined — trimming positions on strength and sticking to your investment plan — is absolutely vital when conditions are difficult.
Have stories or advice from a previous recession? Share them with me on Twitter @CoachJoeMoglia.
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