Why Market May See Risky Stock ‘Melt Up’ Like Late 1990s

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Many investors and market watchers welcomed the Federal Reserve‘s recent announcement that it would be more restrained in its approach to future interest rate hikes. Others worry that this will create a speculative bubble, or “melt up,” in stock prices, similar to the situation in the late 1990s that ended with the Dotcom Crash of 2000-02. Critics note that the aggressive policy of monetary easing pursued under Alan Greenspan, Fed Chairman at the time, did not have a noticeable impact on the economy, but instead fueled inflated stock prices that inevitably crashed.

“The interesting thing about this period is that officials largely ignored the macro data they were seeing. Despite a ‘very tight’ labor market and ‘no discernible deterioration in the economy’, the FOMC believed they were heading off an important risk,” observes Dario Perkins, managing director of Global Macro at U.K.-based research firm TS Lombard, in a note to clients as quoted by MarketWatch.

Are Stocks Melting Up?

(Gains From Dec. 2018 Lows to Close on Feb. 11, 2019)

Source: Yahoo Finance

Significance For Investors

Perkins predicts that the Fed may cut rates in the second half of 2019 as U.S. exports weaken and delayed effects of previous rate hikes take full effect. However, he does not see a U.S. economic recession on the horizon, and believes that the global economy actually may strengthen into 2020, which would prompt the Fed to tighten once more in response.

Looking back at 1998, Perkins notes that, “like today, many parts of the world were in distress.” In response, “the FOMC shifted from a tightening bias to an emergency rate cut in a manner of weeks.” The principal effect; he says, was a two-year melt up, or sudden surge, in stock prices that eventually led to the so-called Dotcom Crash, in which the S&P 500 dropped by 45% and the Nasdaq Composite plummeted by 78%.

Perkins expects that a surge in stock market volatility will spur the Fed to cut rates even before any indications emerge that the U.S. economy is slowing considerably. Just as there was a supposed “Greenspan Put” that existed in the late 1990s and early 2000s, he believes that a “Powell Put” is expected by many investors today. That is, he anticipates that the market is anticipating swift action by current Fed Chairman Jerome Powell to prop up stock prices by boosting liquidity and cutting interest rates if they are on the verge of plummeting.

Robert Burgess, an editor for Bloomberg Opinion, writing in January, saw a 2019 melt up that is even stronger than that during the opening weeks of 2018, which ended with a sharp correction. Bond yields have dropped in the face of more dovish rhetoric from the Fed, raising the likelihood that the huge cash balances built up by nervous investors in the fourth quarter of 2018 may start flooding back into stocks. However, after seeing a net $11.3 billion flow into equity mutual funds and ETFs, both domestic and international, in the week ending Jan. 9, 2019, the following three weeks experienced a net outflow of $15.0 billion, per the Investment Company Institute (ICI).

Looking Ahead

The decision by the Fed to back off on rate increases probably has extended the life of the bull market. However, the historic experience cited by Dario Perkins raises the specter of an unhealthy melt up that may end badly.

Source: Investopedia

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