Who will get hurt from the next stock market crash? Not just investors…

Summary: There is an exception to Saturday’s post, which said that a stock market crash would have only minor economic effects on America. Just as an oil crash hurts oil producing regions, such as Texas, a stock market crash hurts areas that produce stock certificates. Printing this “paper” is the most profitable part of the San Francisco Bay economy, putting it in the cross-hairs for the inevitable crash.

Stocks Crash

Sector crashes often harshly affect industries and regions even when the national impact is minor or even beneficial. An oil bust hurts not just oil exploration and production companies, but also regions focused on that industry (e.g., Texas) — while helping everybody else. Similarly a stock market crash will hurt companies that trade stocks (brokerage firms) and those that print stock certificates (Tesla Motors) — and areas that manufacture stock certificates, like the San Francisco Bay Area.

Silicon Valley and the entire Bay area form a 21st century version of a gold rush. Money floods in and fortunes are made — but instead of exporting pretty rocks it exports papers promising future riches. This should be obvious by now. I walk through the details in these posts…

These industries will not disappear, any more than finance did after the 1970s crashes, or the oil industry did after the 1980s bust. But the people in these industries and the areas in which they cluster will suffer from the fall to Earth (except those people at the top, and those who got in early).

The fall can be quite far. Here’s the price graph of the iShares Nasdaq Biotechnology Index (Symbol IBB), as it rose from $80 to $340 in five years. Try not to see the bubble when you look at it (that requires an investment professional’s eye). Do not ask how many of its 145 constituent stocks are profitable. The ETF’s profile is here.

IBB index

What will happen after the crash?

The venture capital industry will evaporate, except for its long-experience super-competent core. The bursting bubble will thin the herds of biotechs, social media companies, and other bubble industries. Bankruptcies for the unprofitable while the survivors reorganize to produce cash flow and profits instead of glitzy investor presentations and clickbait headlines. That means layoffs, and wage freezes for the rest — which slowly ratchet real wages back to normal.

It will force evolution of the cultures at some corporations. The New York Time’s expose about Amazon reveals how the management squeezes its white collar workers (it doesn’t mention the sweatshop working conditions in its warehouses). Only its insanely hot stock price makes that possible, as workers toil for the chance to profit from investors’ greed — more so than their wages. Amazon’s price to earnings ratio crashing to 30 (after it’s forced to generate consistent profits) will end that game — and reintroduce the 40 hour workweek.

When a regional economy breaks, its real estate prices usually crash as well. San Francisco has been one of two great beneficiaries of the debt supercycle since 1982. The result of its field of dreams burning will not be pretty. For its history see “Recessions, Recoveries & Bubbles: 30 Years of Housing Market Cycles in San Francisco” by Paragon Real Estate Group (click to enlarge graph).

Case-Shiller: San Francisco home prices from 1984

A real estate crash in a hot property market begins a second wave of decline for the affected region. Since this is America, people walk away from their mortgages (“jingle mail” for the banks) and seek new opportunities elsewhere. Prices will drop far. Not to those of Buffalo or Iowa City, but to those of a premium urban center (much like Oz, the Emerald City, after people take off their green glasses).

Homes for sale

Conclusion

This is a cycle, not the apocalypse. Boom-bust cycles are an inherent aspect of free market systems. Sometimes government policy restrains them. Sometimes — like now — it magnifies them. By 2115 it will be a footnote in the history books.

The important matters are helping people affected (minimizing the pain), not making the downturn worse (e.g., the Fed NOT raising interest rates), and learning to better manage these cycles. Investors being less gullible is a good first step. Only fools allow insiders to blow two bubbles in 20 years.

(5) For More Information

For more about the bubble see Wolf Richter’s website, such as “No Growth, No profit, No problem” (17 July 2015).  Please like us on Facebook, follow us on Twitter, and post your comments — because we value your participation. Updates to this post appear in the comments. See all posts about bubbles, especially these…

To support the FM website project please hit the tip jar (on top of the right-side menu bar). Your help makes this possible.

(5) Great books about bubbles

Extraordinary Popular Delusions and The Madness of Crowds
Available at Amazon.
Manias, Panics and Crashes
Available at Amazon.

27 thoughts on “Who will get hurt from the next stock market crash? Not just investors…

  1. In 20 years we have seen the following bubbles:

    • -Asian currencies/debt (late 1990s)
    • -Dotcom (late 90s)
    • -Real estate (mid 2000s)
    • -CDOs/CLOs (mid 2000s)
    • -Petroleum (mid 2000s; echoed in early 2010s)
    • -Precious metals (early 2010s)
    • -China (2008-2015)
    • -Unicorns (2015)
    • -Fixed Income Debt (1982-?)
    • -The one we don’t know about yet

    I may be missing some, but as best I can count this is more than two.

    1. John,

      I was speaking of stock market bubbles in America (“we” at the FM website means Americans; see the masthead). Also, bubble is technical term. It doesn’t refer to “stuff varying in price.”

      • “CDOs/CLOs” were a financing mechanism, part of the real estate bubble — but not a bubble in any meaningful sense.
      • Price volatility in oil and gold resulted from normal commodity cycles. They’re common as dirt due to hard commodities’ inflexibility of supply, small stockpiles, and volatile demand.
      • To call the price change in oil after 2010 a “bubble” is silly.
      • Nations are not assets. China in 2008 – 2015 can have bubbles, but not be a bubble.
      • Unicorns?
      • The Asian currencies were not a bubble in any usual sense of the term.
      • That there was an investment bubble in the East Asian nations in the late 1990s is somewhat definitional.

      No, we don’t have bubbles without knowing about it. People can deny the bubble, that’s is a possible bubble is always discussed.

    2. My personal definition of bubble is a runup in the value of an asset class materially above the equilibrium level of value for that asset class that is funded by leverage that cannot be sustained when the value of the asset class returns to or drops below its equilibrium level.

      As an asset class CDOs but probably not CLOs definitely fit that definition and the collapse of their value created great pain. The short term effect of the collapse in CLO values decimated the M&A market in 2007-2008. Even if the long term value was still there, they were held in weak hands.

      I partially disagree on oil. The 2008 peak was in great part debt and speculation driven. The recent echo fits more with a normal commodity cycle. The oil peak and collapse were a major contributor to the 2008 crash. Gold was clearly a speculative bubble as there is no intrinsic value. Not sure how debt driven, however, so I’ll concede that one.

      The entire Chines economy appears to be a debt driven bubble if you look at it as an asset class so i won’t concede that one.

      Unicorns refers to the fact that prior to the recent crash there were 113 privately funded venture backed companies, most with no profits and some with little or no revenue that were each valued over $1 billion. We don’t yet know how much debt was involved, but i can almost guarantee that there has been a lot.

      I stand by there being more than two bubbles material to the U. S. economy in the past twenty years.

    3. John,

      “The 2008 peak was in great part debt and speculation driven.”

      No, it wasn’t.

      (2) I supposed you could call each aspect of the real estate bubble its own bubble, but that’s absurd. It was one event, expressed in different ways.

      (3) To call a nation a bubble is silly. Yes, China has some bubbles. No, it’s not the whole economy or even the largest part or largest driver.

      (4) The pre-public valuation bubble in new companies is just another aspect of the stock market bubble.

      You see so many bubbles because you don’t look at the underlying forces which create them: e.g., US real estate in 2005-2008, stocks 2011-2015 (the dates are somewhat arbitrary). As I have often said, “bubble” has become a term almost without useful meaning — the “stop” button in the analytical process.

    4. John,

      “I stand by there being more than two bubbles material to the U. S. economy in the past twenty years.”

      I was referring to two stock market bubbles in the US in the past 20 years. Since I said there was a real estate bubble, that shows that I believe there was more than two.

    1. Tice,

      Thanks for the link!

      As for the advertising-supported internet — I suspect we’ll look back on this as a quite daft craze. How can an $800 billion market cap industry (peak, including pre-public companies) be supported by ads most of which are hated by viewers, and which they shut-off as quickly as possible? Why would advertisers pay for these?

      What happens when ad-blockers become more common? I wonder if the whole scaffolding of the ad-supported industry will crash.

  2. Well these movements in the Market lately were not a Crash. It’s not long enough nor deep enough. What we get is the fortune tellers on both the buy side and the sell side telling us what to do, i.e., talking their Book.
    Noise. And all it produces in the minds of regular people is confusion and reinforces their idea that they cannot understand the Market and also cannot trust the people with their money.
    There is a lot of money floating all over looking for yield in all areas financial, not just the Market.
    Risk is a funny Animal. Will take much more than this episode to startle and deeply alter the current frenzy(ies).
    IMO, anyway for what that’s worth.

    Breton

    1. Breton,

      Nothing unusual has happened yet in the U.S. stock market. Yet the combination of high valuations and slow economic growth (both domestic and global) make a crash quite likely.

      Our inability to see this is another example of our unwillingness to learn from experience or clearly see the world, which is the great theme of the FM website.

    2. Breton,

      (1) “What we get is the fortune tellers on both the buy side and the sell side telling us what to do”

      What you describe is the free market in action (i.e., you have this quite backwards). People want confident predictions, therefore the financial industry supplies that product. If you want vendors to provide what clients need but don’t want, you need a very different system.

      (2) “talking their Book. Noise.”

      Talking their book is, strictly speaking, a different phenomenon — where people’s expressed views match their holdings. Stock market strategists and stockbrokers are not bullish because they personally own stocks — or because their firms own stocks — but because doing so is good for business. It’s usually correct (~80+% of the time), which is the way to be without knowledge of the future when you don’t have chips on the table.

      (3) “all it produces in the minds of regular people is confusion”

      Evidence for this? In 30+ years that’s not what I see. People pay for assurance, they get it, most believe it.

      (4) “reinforces their idea that they cannot understand the Market and also cannot trust the people with their money.”

      That would be good sense. But in fact neither is as widespread as it should be.

  3. Happened upon your site via Wolf Street.

    This article is brilliant. The allusion to the Gold Rush and equating printing stock certificates to mining gold is priceless. John Maynard Keynes would be amused.

    You are correct, this is a cycle and as in the Gold Rush those selling the supplies to the miners will be the ultimate winners.

    The miners always migrate to the next Great Thing…and the cycle repeats.

  4. “Mood getting worse on Wall Street”, Bloomberg Business, after Mkt Close today. Huh? Come on….the Mkt is down a mere 9.3 % and it is all doom and gloom. Noise to confuse and fill pages. This is no crash.
    Call me when Payments and Settlements are weakening and stalling.
    The Central Banks are woefully weaker perhaps in policy responses. The Economies are not as vibrant as they wish us to believe, perhaps. But if a 9% drop after this long bull run is a crash? Goodness. What is seemingly evident is people expect a never ending rise?
    Man this Capitalism, please stop crying. :-)

    Breton

    1. Breton,

      “Huh? Come on….the Mkt is down a mere 9.3 % and it is all doom and gloom. Noise to confuse and fill pages.”

      I have said this hundreds of times, and (God willing) will do so hundreds of times more. When you find yourself dismissing as foolish the assessment of highly paid professionals, you should assume you are ignorant and wrong until proven otherwise. Investment professionals use highly reliable analytical tools to assess what’s happening now. They provide useful assessements of risk of future movements (which is different than predictions of future movements).

      “This is no crash”

      Next time you fly, ask the pilot to spray-paint the cockpit windows and instruments in black. After all, why bother? The instruments might show a serious problem, but it’s not yet a crash. And you need no pilot’s license, window, or instruments to determined that the plane has crashed!

      The rest of your comment is equally silly, but anyone who believes they’re so much smarter than the people quoted by Bloomberg is probably beyond help. Good self-esteem, however!

  5. You really believe this is now a Crash?
    Ok
    Thx for the insight. It is a lot easier to not deal with the comments and to just say “your silly”?:-0 Its your Blog.
    Crash it is.
    Assessment of risk so noted and also noted as NOT future predictions? And I will dismiss all your writing about who will get and is getting hurt in this Crash as you really didn’t mean to “predict”, right? Just assessing the current and future movement and so noted. Awaiting the Pilot’s announcement of the Crash Trucks on the runway.
    Hand waving accompanied by deeper concern.
    Chastised and educated.

    Breton

    1. Breton,

      “You really believe this is now a Crash? Ok”

      I said nothing remotely like that. If you are going to make stuff up, please do it elsewhere.

      Our tools shows a combination of extremely high valuations, rapidly weakening stock market dynamics, slowing of the U.S. and world economies, and instability in the currency markets — against a background of historically unprecedented global interest rates at zero or even below.

      Negative interest rates! When I first suggested that might happen, commenters went berserk. Incredulity, just like yours today.

      A combination of any *two* of those would be disturbing. It doesn’t take Lord Keynes to see that all of these add up to a situation that could spiral out of control in a heartbeat. There are many ugly historical precedents.

      It is the equivalent of a control room where the machinery still works, but is making odd noises — and the room smells of smoke.

      The people Bloomberg quotes know all this. They know lots more than you, although they might lack your awesome self-confidence.

    1. Breton,

      “your assessment that right now we have crashed?”

      Second lie. Your comments are now moderated.

      As for the NYT article, market p/e’s are a very basic metric. Sector p/e’s are more useful, plus metrics less easily manipulated than earnings (price/revenue, price/cash flow). Also important are knowledge of flows: who is buying? Now the bid comes from stock buybacks (largely funded by borrowing) — which will immediately evaporate during an economic slowdown.

  6. I don’t see a single bubble in the chart you show. I see a 32 year (actually MUCH longer!) secular bull market that has enriched anyone who invested in it for the long haul without too much leverage. As a Napa Valley resident who is geographically engulfed in this “bubble” as much as someone on Nob Hill–and as one without a dog in this fight as I don’t invest in property–I think you’re suffering from Digital Envy. I hate the Silicon Valley culture & economy. I can relate. But until the machines they’re inventing take over, these social irresponsibles are the overlords. Today’s crappy San Mateo County 1 million dollar condo will sell for 2 million in 2025 and 3 million in 2035 (inflation adjusted). Your bubble call is decades early on this one.

    1. John,

      If you believe earnings are irrelevant, and that dreams are substitutes for earnings, then you are correct.

      Since that is not so…. this is just another bubble. Not as large as the greats, like the 1840 British RR bubble — hence it’s likely small macroeconomic effects — but a bubble still.

      Also, you do not see it here because this post discusses effects of the bubble. See the posts in the For More Information section.

    2. John,

      “32 year bull market – actually much longer”

      No, it is only a 32 year bull market. If, that is, you ignore the 12 year 1997-2009 plateau (containing a wild ride). The rise was in large part a result of the massive rise after 1982 in public and private debt.

      The 18 year 1964 -1982 period was another plateau containing a wild ride.

      You think it was longer than 32 years due to the inflation illusion, which makes assets rise in nominal terms. More accurate is to look at real values. The Dow Jones was flat (with a wild ride) from WWI to 1950. Then came a steep climb to the 1966 peak — sliding back down to that WWI value again in 1982 — an almost 3/4 real loss from 1962 (made worse by high taxation of phantom capital gains).

      That is the risk in stocks: one or two decades with zero returns in nominal terms, and sometimes massive losses in real terms. The long return in stocks has been from dividends, which is why today’s low dividend yield so greatly increases the risk.

  7. Larry Summers warns that rough waters lie ahead

    Summers is one of the top economists of our time. I recommend attention to this: “The Fed looks set to make a dangerous mistake” by Larry Summers in the Financial Times: “Raising rates this year will threaten all of the central bank’s major objectives.”

  8. Background to Summers’ warning

    Excerpt from a valuable article by Brad DeLong (Prof Economics, Berkeley):

    Remember: the last four times the Federal Reserve has started raising interest rates, it has had no clue where the economic vulnerabilities lie:

    In 2005-2007, neither Greenspan nor Bernanke had any idea how fragile mis- and un-regulation had left housing finance and the New York money-center universal banks.

    In 1993-1994, Alan Greenspan had no clue how much of an impact what he saw as small policy moves would have on long-run financing terms — but fortunately he shifted policy and stopped raising interest rates in midstream (over the protests of many on his committee).

    In 1988-1990, Alan Greenspan had no clue how much of an impact it would have on the balance sheets of southwestern S&Ls. The federal government had to give three months of total Texas state income to Texas S&Ls and their depositors who had been chasing high yields in order to clean that up.

    In 1979-1982, Paul Volcker did not realize that raising interest rates would bankrupt not only Latin America but also leave Citibank and others as zombies — things that were bankrupt, and that ought to have been shut down, but that were allowed via promises of government rescue if necessary to earn their way out of bankruptcy over the next five years.

  9. A warning from one of our time’s most successful investors

    From the Financial Times. Ray Dalio is the head of Bridgewater, a $200bn hedge fund group — the world’s largest, and one of the most successful.

    In a note to clients on Monday afternoon he predicted that the “next big Fed move will be to ease (via QE) rather than to tighten” due to global debt levels, the Chinese ructions and turbulence in emerging markets as a whole. “While we don’t know if we have just passed the key turning point, we think that it should now be apparent that the risks of deflationary contractions are increasing relative to the risks of inflationary expansion because of these secular forces,” he wrote.

    “Our risk is that they could be so committed to their highly advertised tightening path that it will be difficult for them to change to a significantly easier path if that should be required,” he added, in the note seen by the FT.

Leave a Reply