Investor Education: Credit Default Swap (CDS)
A Credit Default Swap (CDS) is a financial instrument that allows investors to protect themselves against the risk of default on a particular debt. CDSs were regularly discussed during the 2008 financial crisis, with many swaps hitting new highs amid uncertainty surrounding the banking and insurance industries. This article, written by Reuters in September of 2008, gives a glimpse into all the unfolding events and CDS's role in that.
Read our overview of CDS here!
The Way Speculation Ends
Q1 is in the books. For the first quarter of 2023, the S&P 500 was up about 7%, and the Nasdaq was up about 16.8%.
The Nasdaq’s Q1 return comes after a 2022 return of -33.1%. So in the first quarter after a 2022 most investors in the tech-heavy Nasdaq would like to forget, the index has retraced over 1/3 of what it lost last year.
We’ve made the case in this newsletter before that history often rhymes, and that studying stock market history is important in helping one position for the unpredictable future.
The run in the Nasdaq during Q1 reminds us of the period from November 1929 to March 1930, when the stock market retraced almost half of its steep losses in the crash that began in October 1929, and left the market down only about 20% from its previous peak.
That recovery gave some people hope that years and years of speculation had ended with a brief crash and that all was back to normal.
But as those who have studied that period know, the real pain was just getting started, and the market wouldn’t bottom until the summer of 1932, at a level 89% below its 1929 peak.
No time is the same. Central banks and governments get more involved in things these days—although they were plenty involved back then as well. The companies and industries in which people both invest and speculate during one era change in the next era
But people’s reactions to the ups and downs of making and losing money are generally the same. In a boom and bust cycle, greed turns to worry, which turns to hope, which turns to fear, which ultimately ends in despair.
Writing about that stock market crash from an earlier time, John Kenneth Galbraith wrote the following in his book The Great Crash 1929:
“As already so often emphasized, the collapse in the stock market in the autumn of 1929 was implicit in the speculation that went before. The only question concerning that speculation was how long it would last. Sometime, sooner or later, confidence in the short-run reality of increasing common stock values would weaken. When this happened, some people would sell, and this would destroy the reality of increasing values. Holding for an increase would now become meaningless; the new reality would be falling prices. There would be a rush, pellmell, to unload. This was the way past speculative orgies had ended. It was the way the end came in 1929. It is the way speculation will end in the future.”
We have no idea what the future holds. But we do observe that speculation still seems to be healthy. While many of the old stories that drove major parts of the speculative boom in 2021—like SPACs or non-technology companies pretending to be technology companies—have lost their luster, new things have taken their place. (Maybe you’ve noticed just a few articles on A.I. over the last few months?)
In other words, in the cycle above, we’ve progressed from greed to worry and are now in the hope stage—hope that the new stories will drive new returns, and hope that central bankers know what they’re doing.
Whether the investing public eventually turns to fear and despair if this cycle of high valuations ends like previous ones—over multiple years and much lower lows—is anyone’s guess. But, as always, we encourage investors to know what they own and why they own it.
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