Nowhere to Hide

Investors don’t need to be told about the recent stock market crashes. The Dow Jones index is down 12.5% since early January. The S&P 500 is down 16.1% in the same period. The Nasdaq Composite is down an even more spectacular 26.5% this year. It lost more ground today.

This puts the Nasdaq solidly into a bear market (down 20% or more from an interim peak) while the Dow and S&P 500 are both in correction territory (down 10% or more from an interim peak).

The Dow was up slightly today, but the S&P was down again. On current trends, the S&P 500 may break into bear market territory in a matter of days with the Dow not far behind.

This collapse coming so soon after the market crash of March 2020 may surprise some investors, although this outcome was predicted in my last book The New Great Depression, published last year.

We could get into the reasons for the recent market swoon, like the Fed’s taking away the punch bowl, but the reasons almost don’t matter at this point.

What truly is surprising is that the stock market is not alone in its recent dismal performance.

The Great Crypto Crash

U.S. Treasury bonds, foreign currencies, gold and other commodities have all declined sharply side by side with stocks. There are good reasons for this, including the prospect of a recession that could cause stocks, gold and commodities to fall in sync.

Still, the market carnage doesn’t end there. The biggest collapse among major asset classes is in Bitcoin and other cryptocurrencies.

The price of Bitcoin has fallen over 55% since last November, when Bitcoin peaked at around $69,000. As I write this article, Bitcoin is trading at $29,647.

As is so often the case, gullible investors jumped in when Bitcoin was riding high. Now, 40% of all Bitcoin investors are underwater on their holdings. Like the saying goes, nobody blows a whistle at the top.

So much for Bitcoin being the new inflation hedge!

And the damage is by no means limited to Bitcoin. Huge losses have arisen in other popular crypto currencies such as Ethereum (down 57% over the same period), XRP (known as Ripple) and Solana.

Still, neither of those crypto collapses was the most spectacular. A crypto currency called Luna fell from $116.84 on April 5, 2022, to $0.0062 on May 16, an incredible 99.9% crash in less than six weeks.

That’s not just a crash, it’s a complete wipe-out. It just shows you how crazy speculative manias can become, completely unhinged from reality.

Contagion

The danger in these types of collapses goes beyond the losses to individual investors who happen to hold the coins. Such losses are indicative of a wider global liquidity crisis emerging. It’s a reminder of how deeply interconnected today’s markets are.

It comes back to contagion.

Unfortunately, over the past couple of years, the world has learned a painful lesson in biological contagions. A similar dynamic applies in financial panics.

It can begin with one bank or broker going bankrupt as the result of a market collapse (a “financial patient zero”).

But the financial distress quickly spreads to banks that did business with the failed entity and then to stockholders and depositors of those other banks and so on until the entire world is in the grip of a financial panic as happened in 2008.

Disease contagion and financial contagion both work the same way. The nonlinear mathematics and system dynamics are identical in the two cases even though the “virus” is financial distress rather than a biological virus.

As one market crashes, investors in other markets sell assets to raise cash and the collapse virus quickly spreads to those other markets. In a full-scale market panic of the kind we saw in 1998 and again in 2008, no asset class is safe.

Investors sell stocks, bonds, gold, cryptos, commodities and more in a mad scramble for cash.

Each Crash Is Bigger Than the Last

And unfortunately, each crisis is bigger than the one before and requires more intervention by the central banks.

The reason has to do with the system scale. In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses.

Today, systemic risk is more dangerous than ever because the entire system is larger than before. This means that the larger size of the system implies a future global liquidity crisis and market panic far larger than the Panic of 2008.

Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system and have much larger derivatives books.

To understand the risk of contagion, you can think of the marlin in Hemingway’s The Old Man and the Sea. The marlin started out as a prize catch lashed to the side of the fisherman Santiago’s boat.

But once there was blood in the water, every shark within miles descended on the marlin and devoured it. By the time Santiago got to shore, there was nothing left of the marlin but the bill, the tail and some bones.

The point, again, is that today systemic risk is more dangerous than ever, and each crisis is bigger than the one before. Remember, too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system and have much larger derivatives books.

The Fed Has No Answers

The ability of central banks to deal with a new crisis is highly constrained by low interest rates and bloated balance sheets, which exploded even higher in response to the pandemic. You see how much damage the Fed’s recent rate hikes and end of quantitative easing have caused.

The Fed’s balance sheet is currently about $9 trillion, which it’s just beginning to reduce. In September 2008, it was under $1 trillion, so that just shows you how bloated the Fed’s balance sheet has become since the Great Financial Crisis.

How much the Fed can drain from the balance sheet without triggering another serious crisis is an open question, but we’ll likely get the answer at some point.

The threat of contagion is a scary reminder of the hidden linkages in modern capital markets.

The conditions are in place.

But you can’t wait for the shock to occur because by then it will be too late. You won’t be able to get your money out of the market in time because it’ll be a mad rush to the exits.

The best description I’ve ever heard of the dynamic of a financial panic is, “Everybody wants his money back.”

We seem to be headed to that state of affairs at a rapid rate.

The solution for investors is to have some assets outside the traditional markets and outside the banking system.

Regards,

Jim Rickards
for The Daily Reckoning