Bears Locate a Template for a Crash

• U.S equities were making highs in January 1994.
• Emerging markets were rising parabolically into 1994. The Hang Seng index rose from 3,000 in 1990 to 12,500 in early 1994 while Mexico's IPC climbed from 700 to 2,900 in the same interval.
• In December 1993, complacency was copious. The VXO had declined from about 35 in 1990 to under 10 by year-end 1993.
• Bonds experienced a sharp rise in value as yields declined in 1990-1993. The 10-year U.S. note rose from about 84 and peaked at 106 in the third quarter of 1993. By January 1994, bonds were already beginning to falter.

A two-month drop of nearly 10% in the S&P 500 Index began at the end of January 1994. The emerging markets collapsed -- Hong Kong's market fell by a third and Mexico by an even greater amount. The bond market got schmeissed -- by year-end, the 10-year U.S. note had fallen 20 points, correcting the entire gain of the previous three years. Finally, the VIX fell back to 1990 levels, climbing from 9 to 24 in only two months.

To understand what could happen in 2007, it is also helpful to understand what conspired fundamentally back in February 1994 to take the world equity and U.S. bond markets down, and the volatility indices up. On Feb. 4, 1994, the market was spooked by a surprise hike in interest rates by the Federal Reserve. The mortgage markets went into a tailspin as bonds collapsed in price and rose in yield.

The already leveraged financial landscape was almost immediately littered with financial accidents: Orange County (California) went bankrupt and a venerable Wall Street firm (Kidder Peabody) collapsed, for example.

I can posit a number of similar developments in February 2007 that could result in history repeating itself, such as a surprise Federal Reserve rate increase, sovereign debt defaults (yesterday I mentioned Fitch's downgrade of Ecuador's debt), more aggressive moves by China to slow its economy, a financial accident in sub-prime lending or in the derivative markets, etc.

(Speaking of potential market-busting catalysts, it is interesting to note that the Chinese stock market dropped by 4% yesterday -- the largest one-day drop in seven months. Moreover, a Chinese official issued the government's first explicit warning about an overheated stock market by warning banks "to prevent personal loans from going into stocks.")