Déjà vu again? Current market action looks increasingly like prelude to October 1987 crash: Greed & Fear

With the US bond yields on the rise leading to a subsequent sell-off in US markets, Christopher Wood, global head of equity strategy at Jefferies, in his latest Greed & Fear report pointed out that the current market action looks increasingly like the prelude to the October 1987 market crash.

"The potential similarity with what occurred in October 1987 is that the historic stock market crash was preceded by a big sell-off in the ten-year Treasury over the summer months. The 10-year Treasury bond yield rose by 203 bps from 8.2 percent on 17 June 1987 to 10.23 percent on 15 October 1987," the note said.

Similarly, the 10-year US bond yields have jumped to 4.8 percent, a 16-year high, from around 3.3 percent in May this year.

On October 19, 1987, the Dow Jones Industrial Average plummeted by 22.6 percent in what later became known as Black Monday.

“The other salient point to note is that when the S&P 500 subsequently collapsed by 28.5 percent in four days, and by 20.5 percent on October 19, 1987, alone, the Treasury bond market staged a classic flight-to-safety rally in the context of a then-dramatic decline in the 10-year Treasury bond yield. The 10-year bond yield fell from a peak of 10.23 percent on October 15, 1987, to 8.72 percent on October 26, 1987,” Wood said.

The interesting point now, as per Wood, is to wait and watch whether treasury bonds would behave in a similar fashion.

He argues that excessive reliance on government bonds as collateral can reduce incentives to screen and monitor borrowers while raising aggregate leverage. It also said that the widespread use of government paper as collateral raises liquidity risks in a risk-off event.

"This in turn raises the issue of the declining liquidity in the treasury bond market which Fed officials have been warning about of late, as also discussed here last week. Such an outcome, where the “risk-free” status of Treasury bonds is questioned, even if only temporarily, may seem to many an extreme event. But in GREED & fear’s view it is no longer far-fetched to think about, as is also evidenced by the fact that such a paper has been written," he stated

Wood further pointed out that the near-term impact of Greed & Fear’s still-anticipated Fed fudging of 2 percent inflation target will confirm that Treasury bonds, and most likely all other Group of Seven government bonds, are in a bear market, as has been Greed & Fear’s view since early 2020.

He believes that this bear market view of Treasury bonds is supported by the breaking of the trend line in the long-term chart of the 10-year Treasury bond yield, going back to the beginning of the 1980s.

Going ahead, he advises investors to keep an open mind on whether the continuing weakness in Treasury bonds reflects growing supply concerns. The real acid test will only come if Treasury bond prices fail to rally on bearish economic data, such as a sudden collapse in payrolls or, for that matter, a stock market crash. And that, clearly, has not happened yet, said Wood.

Portfolio

The report also reviewed the performance of Greed & Fear’s various long-only portfolios. It should be noted again that all the portfolios have not been allowed to own cash since inception.

It highlighted that the long-term performance of its Asia (ex-Japan) thematic portfolio has been “satisfactory”. Since inception at the end of Q3 2002, it had risen by 2,804 percent in dollar terms, on a total-return basis, as of the September quarter, compared to a 511 percent increase in the MSCI AC Asia (ex-Japan) index and a 695 percent increase in the S&P500.

This means the portfolio has risen by an annualised 17.4 percent since inception, compared with an annualised 9.0 percent increase in the MSCI AC Asia ex-Japan index and an annualised 10.4 percent gain in the S&P500, it informed.

The portfolio declined by 2.3 percent last quarter on a total-return basis, compared with a 3.2 percent decline in the MSCI AC Asia ex-Japan index. It is up 4.4 percent year to date, compared with a 0.1 percent decline in the benchmark.

The portfolio remains 49 percent invested in India, with 18 percent exposure to China and another 10 percent allocated to Taiwan and Korean technology. There is also a 10 percent allocation to energy, resources, and gold. The portfolio remains primarily geared to the long-term domestic demand story in India. It should be noted again that the stated performance of the absolute-return portfolio is on a total-return basis, mentioned the report.

The India long-only portfolio, launched on 1 July 2021, rose by 13.3 percent in US dollar terms last quarter on a total-return basis, compared with a 2.9 percent gain in the MSCI India benchmark. It is now up 26.5 percent year to date, compared with an 8.3 percent gain in the benchmark. As a result, it is now outperforming since inception, rising by 32.1 percent, compared with a 13.3 percent increase in the MSCI India index and a 15.5 percent gain in the Nifty, it further highlighted.

Moving away from regionally orientated equity portfolios, a global long-only equity portfolio was introduced on 19 January, 2023. It began with a 66 percent weighting in Asia Pacific of which 23 percent comprised India. The portfolio is up 0.4 percent since inception in US dollar terms on a total-return basis, compared with a 6.5 percent gain in MSCI AC World.

The portfolio declined by 2.3 percent in US dollar terms in 3Q23, compared with a 3.3 percent decline in the MSCI AC World. This followed a 6.9 percent gain in 2Q23, compared with a 6.3 percent increase in the MSCI AC World. So, the portfolio has marginally outperformed in the past two quarters. The portfolio is now 68 percent invested in Asia Pacific with a 26 percent exposure to India.