Dow Pullback: Do Past Corrections Predict the Future?

Summary

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WSJ Your Money Briefing: Dow Pullback – Do Past Corrections Predict the Future?

Date: February 13, 2018
Host: JR Whalen
Guest: Greg Ip, Chief Economics Commentator, The Wall Street Journal

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Episode Overview

This episode tackles the February 2018 stock market pullback, examining whether past corrections—specifically those in 1987, 1998, and 2007—can predict future trends. Host JR Whalen and guest Greg Ip discuss the roots of previous downturns, why this correction feels different, and what patterns (or risks) investors should watch as the market becomes rocky again.

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Key Discussion Points & Insights

1. Comparing 2018’s Decline to History

• 2007–2008 (Great Recession):

  • Trigger: “The market drop was a symptom of much more severe underlying problems in the economy. Essentially, you had trillions of dollars of badly underwritten mortgages…” — Greg Ip [01:17]
  • Difference: Current (2018) pullback isn’t signaling “severe economic fragilities.”
  • “When I look at the market downdraft we've experienced in the last few weeks, it doesn't seem anything like 2007 or 2008.” — Greg Ip [01:46-02:05]

• 1998 (Asian/Russian Crises, LTCM Collapse):

  • External Trigger, Not U.S. Economic Weakness:
    • Turmoil was driven by Asian financial crisis and Russian default.
    • Market affected by the collapse of Long-Term Capital Management hedge fund.
    • “It was worrisome and scary, but in the end it did not tell us about anything special about what was going on in the economy itself. And indeed, once that was out of the way…the economy turned out to be fine.” — Greg Ip [03:14-03:29]

• 1987 (Black Monday):

  • Market Structure, Not Fundamentals:
    • Portfolio insurance strategies exacerbated the drop, with little underlying economic weakness.
    • “What really provided the fuel for the stock market crash was a strategy called portfolio insurance…big investors [were forced] to sell into the falling market.” — Greg Ip [04:26-04:46]
    • Some similarities today: complex investment strategies that rest on recent assumptions (e.g., low volatility, inverse stocks/bonds relationship) unraveled under stress.
    • “These are strategies which have assumed that the very low level of volatility that we've seen for some years now would continue.” — Greg Ip [05:05]
    • “Volatility has gone up. Stocks and bonds started moving together instead of in opposite directions.” — Greg Ip [05:20-05:27]

2. Structural Market Risks vs. Fundamental Economic Risks

• Greg Ip emphasizes that much of the recent volatility stems from “market dynamics as opposed to changing perceptions of what's really going, going on in the economy.” — Greg Ip [05:49]
• Points out the difference between technical/structural selloffs (2018, 1987, 1998) versus economically driven selloffs (2007–2008).

3. The “Stability is Destabilizing” Phenomenon

• Reference to economist Hyman Minsky: “Stability can be destabilizing because he had observed that over time, when you have long periods of market calm, it sort of encourages people to believe that risk has gone away.” — Greg Ip [06:35]
• Long stretches of low volatility cause risk underestimation and complacency; eventually, volatility snaps back.

4. Central Bank Policies and Future Risks

• 2010s: Market calmed by central bank (Fed) intervention (low rates, bond buying).
• Now, the perception that central banks always intervene is changing:
  • “If we're in a world now where there is more upside risk to interest rates, if stocks and bonds start moving together more often, if volatility returns to just historic levels…that's a collection of sort of changes to our assumptions that need to be priced into markets.” — Greg Ip [07:24-07:40]
• Possible outcome: Lower overall stock market valuations, more volatility.
• “None of us are smart enough to know exactly how that's going to shake out or when that's going to shake out.” — Greg Ip [07:44-07:47]

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Notable Quotes & Memorable Moments

• On 2007–2008:
  “That was a tip of a serious iceberg.” — Greg Ip [01:46]

• On 1987’s Market Dynamics:
  “Once the market started to go down, the formulas underlying these strategies required big investors to sell into the falling market.” — Greg Ip [04:43]

• On Today’s (2018) Market:
  “What you're observing to some extent are market dynamics as opposed to changing perceptions of what's really going, going on in the economy.” — Greg Ip [05:49]

• On Complacency and Risk:
  “If you think there's never going to be a recession, you're willing to pay more for stocks or for houses.” — Greg Ip [06:47]

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Timestamps for Critical Segments

• 2007–2008 vs. 2018: [01:17–02:18]
• 1998 (LTCM & Asian Financial Crisis): [02:30–03:29]
• 1987 (Black Monday, Portfolio Insurance): [03:29–05:49]
• Current Market Assumptions Shifting: [05:49–07:47]
• Hyman Minsky & Destabilizing Stability Discussion: [06:32–07:47]
• Expectations for Volatility Ahead: [07:47–08:06]

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Tone & Closing

• The conversation is analytical, measured and matter-of-fact, designed to assuage panic and provide historical context.
• Final advice: Investors should not expect markets to return to the complacent, low-volatility years; adjusting assumptions is key.

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Summary prepared for listeners seeking depth and context on the February 2018 market correction, its drivers, and how (or if) historical corrections predict where we go from here.

Transcript

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[Radio Show Announcer]

This is yous Money Matters from the Wall Street Journal.

[JR Whelan]

Welcome to youo Money Matters. I'm JR Whelan in New York. February's stock market dive put Wall street in a tailspin, and it put some investors in a bind. But did it put us in a time machine? Wall Street Journal chief economics commentator Greg IP joins us from our Washington bureau to discuss which historical marker we should use to predict where the market goes from here. So, Greg, we could try to compare this year's steep market drop to a few sharp declines in the recent past. Let's start with the freshest in our mind, 2007 and the onset of what many call the Great Recession. Is that a legitimate fear of what this year's market drop could be portending?

[Greg Ip]

Most market drops have some kind of fundamental trigger to them, whether it's concerns about the economic outlook or concerns about inflation and interest rates. This one's no different at and that was the same in 2007. But what was special about 2007 was that the market drop was a symptom of much more severe underlying problems in the economy. Essentially, you had trillions of dollars of badly underwritten mortgages issued, and they were backed by housing prices that were too high.

[Interviewer]

So when you saw things like hedge

[Greg Ip]

funds run by Bear Stearns collapse or subprime lending start to implode, that wasn't just some isolated market event that was unsettling investors. That was a tip of a serious iceberg. When I look at the market downdraft we've experienced in the last few weeks, it doesn't seem anything like 2007 or 2008.

[Interviewer]

Yes, there's been a bit of a

[Greg Ip]

scare over inflation and interest rates, and that could indeed be a headwind to the market for some time to come. But I don't see the severe economic fragilities underneath the surface that we had 10 years ago.

[JR Whelan]

All right, so let's go further back to 1998. There was a lot of market volatility back then, and The Dow dropped 19%. But it wasn't the domestic economy that was spooking the market back then.

[Greg Ip]

Now, going into 1998, you had a lot of turmoil in the global economy. The East Asian financial crisis had been underway for a year. And in the summer of 98, all eyes were on Russia. They thought it was too nuclear to

[Interviewer]

fail, but fail it did.

[Greg Ip]

And that ricocheted into markets in the United States. Only with hindsight did we discover that a lot of that downdraft in the markets was being driven by one very large hedge fund called Long Term Capital

[Interviewer]

Management, which which had taken on very

[Greg Ip]

highly levered positions in a variety of markets, bonds and stocks, and was being forced to unwind those and essentially triggering fire sales of assets, putting huge stress on the markets. You had things like bond yields going haywire and not at all behaving like we were used to. It was worrisome and scary, but in

[Interviewer]

the end it did not tell us

[Greg Ip]

about anything special about what was going on in the economy itself. And indeed, once that was out of

[Interviewer]

the way, with a little bit of

[Greg Ip]

help from the Federal Reserve, which arranged a bank bailout of Long Term Capital Management, the economy turned out to be fine.

[JR Whelan]

And in your column you also take us back to 1987. And that year we saw a more dubious milestone. That was the stock market crash in which the dow lost about 23% of its value. That year. Concerns included rising bond yields, inflation, and how a newly seated Federal Reserve chairman might pull the trigger on interest rates. That sounds a lot like today, but you say not a fair comparison. And don't let that comparison keep you up at night.

[Greg Ip]

There are similarities and differences with 1987, and let's start with the similarities. Even though we think of the bear market as being all about Black Monday,

[Interviewer]

the decline in stocks had actually started

[Greg Ip]

weeks, if not months earlier. Interest rates had been rising. The Fed had raised the discount rate quite sharply. In September, there was a fight between Germany and the United States about the

[Interviewer]

value of the dollar. And there had been a lot of froth related to leveraged buyouts, which is

[Greg Ip]

starting to come undone.

[Interviewer]

And so the market was kind of primed for fundamental reasons to give up

[Greg Ip]

some of its gains.

[Interviewer]

But what really provided the fuel for the stock market crash was a strategy called portfolio insurance. And I won't bore you with the details, but the gist of it is that we had very large multi billion

[Greg Ip]

dollar positions built up in the market

[Interviewer]

that once the market started to go

[Greg Ip]

down, the formulas underlying these strategies required

[Interviewer]

big investors to sell into the falling market.

[Greg Ip]

And so it accelerated downwards.

[Interviewer]

And I Think why that's similar to today.

[Greg Ip]

And something to keep in mind is

[Interviewer]

that we have similar sort of complex

[Greg Ip]

strategies in the market. They're probably not as big and they're

[Interviewer]

not as dangerous, but they have a similar kind of character. These are strategies which have assumed that the very low level of volatility that

[Greg Ip]

we've seen for some years now would continue. There are strategies that assume that bonds and stock prices would move in opposite directions as they have for the last 10 years.

[Interviewer]

They're strategies that have assumed essentially that the world will behave as it has for the last 10 years and the last few weeks.

[Greg Ip]

A lot of those assumptions have proven wrong. Volatility has gone up. Stocks and bonds started moving together instead of in opposite directions.

[Interviewer]

And as investors who put on very large positions in the stock and bond

[Greg Ip]

markets discovered that relationships are changing, they

[Interviewer]

need to get out of those positions and once again they sell into a

[Greg Ip]

falling market and therefore it takes on a character of its own. And that is a bit like 1987.

[Interviewer]

Now, the degree of the decline is

[Greg Ip]

much, much smaller today.

[Interviewer]

But the similarity is that what you're

[Greg Ip]

observing to some extent are market dynamics as opposed to changing perceptions of what's really going, going on in the economy.

[JR Whelan]

And we're going to talk more about the volatility and the stability in the market in just a moment. We're speaking with chief economics commentator Greg ip and you're listening to your Money Matters from the Wall Street Journal. Welcome back, everybody. So, Greg, the current US Economy doesn't give Wall street really strong reason to worry, as was the case in 2007. But if we see a return to buying of stocks and the market run up in the Dow, we could reference a legendary economist you quoted in your story. Stability is destabilizing. So a future pullback could be simply the reason and the result of the run up itself.

[Interviewer]

Well, Hyman Minsky had said stability can

[Greg Ip]

be destabilizing because he had observed that over time, when you have long periods of market calm, it sort of encourages people to believe that risk has gone away and therefore they can take bigger positions.

[Interviewer]

To take one very simple example, if

[Greg Ip]

you think there's never going to be a recession, you're willing to pay more for stocks or for houses.

[Interviewer]

And in the last 10 years we've had a significant disappearance of volatility. And that's largely because central banks have been so resolute about keeping interest rates

[Greg Ip]

low and doing things like buying bonds every time there's a threat to the economy.

[Interviewer]

And what might be changing is that perception that central banks will always, always

[Greg Ip]

sort of err on the side of delivering more sort of monetary morphine to the economy.

[Interviewer]

And that might be a sea change

[Greg Ip]

right now that people really need to get their heads around.

[Interviewer]

Because if we're in a world now

[Greg Ip]

where there is more upside risk to interest rates, if stocks and bonds start moving together more often, if volatility returns to just historic levels, never mind unusually

[Interviewer]

high levels, then that's a collection of sort of changes to our assumptions that

[Greg Ip]

need to be priced into markets.

[Interviewer]

And it could mean that the stock

[Greg Ip]

market needs to be lower and possibly

[Interviewer]

quite a lot lower. And none of us are smart enough

[Greg Ip]

to know exactly how that's going to shake out or when that's going to shake out.

[Interviewer]

But it does suggest that the coming year, if this narrative of higher inflation

[Greg Ip]

and interest rates takes hold, it could continue to to be a rocky year

[Interviewer]

as people adjust to the fact that the stability of the last decade turned

[Greg Ip]

out not to be a permanent feature.

[JR Whelan]

Well, it's a good reason to follow economics and Wall street coverage in the Wall Street Journal. That's chief economics commentator Greg ip, joining us from our Washington bureau. Greg, thanks so much for being with us.

[Greg Ip]

Thanks for having me.

[JR Whelan]

And thank you for listening to youo Money Matters. I'm JR Whalen in New York for the Wall Street Journal.

[Small Business Owner]

Access to affordable credit helps me pay my employees, but I don't really need it.

[Retail Industry Representative]

Inflation is killing me, but who cares? Big retailers are making record profits. That's why we support the Durbin Marshall credit card bill.

[Small Business Owner]

See banks and credit unions help small businesses make payroll. This bill would cut the vital resources

[Retail Industry Representative]

they need while increasing megastore profits. They deserve it, don't they?

[Advocacy Group Spokesperson]

Tell Congress, stop the Durbin Marshall money grab for corporate megastores paid for by the Electronic Payments Coalition.