Stock Market Reversals Can Cause Recessions Too

Howard Marks offers a dollar for anyone who can identify the cause of the collapse of the bull market and tech bubble in 2000.

My submission here – and I’ve covered this before, most recently in April of last year…

It was a Barron’s article, published over the weekend leading into Monday, March 20th. That was the top for the Nasdaq Composite (the rest of the market – aka “Old Economy” stocks had already begun selling off as no one wanted anything non-dot com).

The article was called “Burning Fast” by Jack Willoughby and it may have been the most important piece of investment journalism ever up until that time. The cover looked like this:

I still remember reading it.

Willoughby attacked the unprecedented craze for profitless companies in a very shrewd way and framed the entire concept in a way that no one else had thought to do. Almost all of the skeptical journalism surrounding the bubble up until then had been focused on valuation – but investors didn’t care about valuation at all. The internet was poised to change the world (that part we were right about), and anyone worried about valuation just didn’t get it.

The Barron’s piece took a different approach – they focused on the cash burn rates at these companies and it completely flipped the market sentiment around these names, pretty much overnight. Willoughby effectively created a deadpool and the mentality went from “Gotta catch ’em all” to “Who is going to die first?” It was truly remarkable. The way Willoughby set up timetables for when over a hundred newly minted companies would run out of cash was the thing that shook everyone out of their stupor long enough to press a different key than the Buy button.

Here’s a PDF of the Barron’s table.

What’s funny is that he gave Amazon 10 months to live at its current cash position / burn rate. Okay, so that one was wrong, but almost every other company on the list is long gone.

That was the catalyst. That Monday, Microstrategy, a “B2B” web company announced an accounting problem after the close and its stock was cut in half. I think it lost 150 dollars per share overnight. I watched it happen on a terminal. The wheels were in motion and the panic had begun. The term “burn rate” was on everyone’s lips. That was the top.

Sentiment can flip that fast, and when that turn happens, high-concept stocks with insane burn rates don’t stand a chance.

Everyone knew the dot com stocks were overvalued or trading based on nonsense metrics, and we knew it for a long time. But not many people had considered that the companies would run out of money and go out of business. Concerns about valuation turned into concerns about survival, which was a different story. Willoughby’s article changed the whole conversation and, overnight, it was like someone had flipped a light switch on and we all woke up at once, blinking, rubbing our eyes…and selling with both hands.

What makes this apropos to today is the idea that, while there is no recession in sight economically, a stock market reversal could certainly cause one. After all, it was the early 2000 reversal in growth stocks that caused the recession then. So much capital expenditure and consumer spending was being fueled by equity gains that when the gains went away so did all the demand in the real world. It wasn’t the first time that speculative market activity spilled over into the economy with disastrous consequences, and it won’t be the last time.

In the early 1900’s, we had stock market-driven recessions all the time, annually in fact, but they were called panics. As in “The Panic of 1903”, “The Panic of 1904”, “The Panic of 1905” and on and on. We were an agrarian society and, each fall, gold had to be moved to small banks around the country so that farmers could borrow enough to bring in the harvest. They’d pay the banks back with the proceeds from selling their crops, and the banks would send their surpluses back to New York City, where it would be invested in bonds and stocks. But if the bond and stock market didn’t cooperate that winter and speculative bets failed to pay off, then come spring planting season the gold would be late in coming back. This would result in anxiety, followed by panicking followed by bank runs. Which would then, circularly, put additional pressure on Wall Street as even more gold was being sucked back out of stocks and bonds to meet the withdrawals at local banks. (Read Roger Lowenstein’s book on the founding of the Federal Reserve to understand this period better.)

A violent reversal in stock prices now could absolutely tip the nation into recession, despite there being no signs of recession at the present moment.

Since Jesse Livermore was trading those early 1900’s panics each year, I’ll give him the second to last word. “There is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.”  

Sometimes markets are a leading indicator, and sometimes they actually cause changes in the economies they are meant to reflect. George Soros calls this reflexivity. It’s a thing.

Sources:

Latest Thinking (Oaktree)

Contra Einhorn (TRB)