Could markets crash again?

Discussion in 'Financial Cents' started by Jonas Parker, Oct 23, 2007.

  1. Jonas Parker

    Jonas Parker Hooligan

    USA Today has an interesting article at:

    20 years later, could markets crash again?

    By John Waggoner and Adam Shell, USA TODAY
    NEW YORK — Wall Street loves its sayings. Buy low and sell high. Don't fight the tape. Don't try to catch a falling knife.
    A useful one now might be one that historians often trumpet: Those who forget the past are doomed to repeat it.
    COLUMN: Let's review what we learned from '87 Crash
    Twenty years ago Friday, the U.S. stock market suffered its worst one-day drop ever: the Crash of '87. The Dow Jones industrials plunged 508 points, or 22.6%, as waves of selling swamped the New York Stock Exchange. It was a market dislocation so intense that some pundits predicted another Great Depression.
    The dire predictions turned out to be wrong. But while one-day declines of that magnitude are extremely rare — one study says crashes are likely to occur once every 75 years — the Black Monday anniversary has prompted Wall Street to wonder: Can such a swift loss of wealth occur again?
    A legitimate question. Markets now have many similarities to just before Black Monday. Surging oil prices. A slowing economy. Stocks near records in an aging bull market. Volatility on the rise.
    When it comes to financial panics, you can never say never. But most Wall Street experts stress that crashes are low-probability events. A cataclysmic crash, they say, is usually the result of many financial stresses converging at once — and one big dollop of mass hysteria. New regulations, better technology and more proactive central bankers make major financial dislocations less likely. Still, it's hard to predict when and if the market will derail. Given the history of financial panics and the tendency of market psychology to change from bullish optimism to flat-out fear virtually overnight, crashes might never be eliminated from Wall Street's vocabulary.
    The big one
    Not many people on Wall Street today were working there in 1987. But for those who were there for the free fall, the memories are vivid.
    The crash was breathtaking in its sheer, devastating size: An equivalent plunge today would rip the Dow down nearly 3,200 points. A record 604 million shares traded on the NYSE that day, choking the system from the outset.
    A third of the 30 stocks that make up the Dow didn't open for the first hour because sell orders swamped buy orders. "It was worse than hell," says Jim Rutledge, a retired NYSE floor specialist. The selling cascaded throughout the day. As bad as the ticker looked, the situation was far worse: Trades were executed and recorded as much as an hour late. "Information dried up," Rutledge says. "We were still living on the tape, and the tape was so far behind, it was useless."
    Computerized trading programs kept dumping more stocks onto the market as it plunged. The losses intensified as traders, worried that regulators would shut the market down, scrambled frantically to get out of their positions. Nearly half the Dow's loss happened in the last hour of trading.
    "What was most surprising to everyone was how liquidity disappeared," says James Stack, editor of InvesTech Market Analyst, and one of the few advisers to get his clients out of the market before the crash. "If you wanted to sell a stock, there were no buyers."
    The Dow's final 508-point loss wasn't finally tallied until long after the market closed. Money manager Frank Cappiello waited around his office until 7 p.m. to see how the market closed. Depressed, he went home to call Roy Neuberger, founder of the Neuberger & Berman funds, one of the few people he knew who had worked on Wall Street during the 1929 crash. If anyone knew what would happen, Cappiello figured, it was Neuberger. But Neuberger called him first. "Frank," Cappiello recalls Neuberger saying, "You're a smart fellow. What do you think will happen tomorrow?"
    The big fear — that it would be 1929 all over again — proved unfounded. Stocks plunged early on Tuesday, Oct. 20, then began to rebound in the afternoon, thanks in part to news of U.S. companies announcing plans to buy back their own battered shares — and a sense the market would survive. Although there were several rocky days after the crash, the market bottomed in December and hit new highs within two years. In contrast, the Dow took almost six years to recoup its losses from the 2000-02 bear market.
    Out of the blue
    To this day, economists and market historians debate what sparked the Crash of '87, despite a massive investigation by a presidential commission, as well as numerous independent research efforts.
    One peculiarity of the crash — and of nearly all declines of 10% or more — is that no single news event drove the selling. The market almost never collapses during a big news event. When President Kennedy was assassinated, the Dow fell 3%. The Dow fell 3% the first trading day after the Japanese attack on Pearl Harbor, and 7% after the Sept. 11 terrorist attacks.
    Mark Hulbert, editor of the Hulbert Financial Digest, points to a study that looked for news triggers the day of the 50 largest percentage drops in the stock market. "They came up empty-handed," he says.
    But the 1987 crash did confirm that big, devastating meltdowns have several points in common:
    •The market makes huge gains beforehand. The Dow soared 44% from the start of 1987 through its Aug. 25, 1987, peak. The Standard & Poor's 500 index had climbed 265% the five years ended August 1987, assuming reinvested dividends. In contrast, the S&P 500 has gained about 92% the past five years.
    The run-up to the 1929 crash was even more spectacular: The Dow surged 345% in almost six years.
    •Market euphoria reigns. The public doesn't usually focus on the stock market — unless it's skyrocketing. The public's attention was focused on Wall Street in 1987. Tom Wolfe's book The Bonfire of the Vanities, which chronicled Wall Street excesses, was on the best-seller list. And Wall Street, the Oliver Stone movie in which the fictional Gordon Gekko immortalized the line, "Greed is good," was in the works during the crash and premiered in December 1987.
    Many argue that it is the swing from mass euphoria to despair that triggers crashes. "The market's trends derive from the mood of the investing herd, which trends and reverses according to its own internal dynamics," says Robert Prechter, president of Elliott Wave International, perhaps the most celebrated of those who got investors out before the crash.
    •Sharp downturns precede the crash. Selling cascades occur for a variety of reasons, including an inability to deal with losses, notes psychiatrist Ari Kiev. Fear is a trigger. "It gets scary when the market starts going down, down, down," says Kiev, author of the upcoming book Mastering Trading Stress. Uncontrolled emotions also amplify the need to get out. "The mind-set just changes dramatically. Catastrophic thinking occurs. People get in the mind-set of doom," he says.
    The market had been sliding since late August, but it fell a total of 10% the three days before the crash. Says University of California at Berkeley finance professor Mark Rubinstein: "When those declines happened, there were a lot of people who started to think about it over the weekend who concluded, 'This is not the kind of market I want to be in.' "
    •Financial innovation backfires. Institutional investors touted "portfolio insurance" as a way to immunize themselves from huge losses. In theory, offsetting positions in the futures market could keep your portfolio from getting clobbered. But in the chaos of the crash, many portfolio insurance schemes didn't work as planned. Instead, they acted as a trigger to sell when prices were in free fall, exacerbating the losses.
    Can it happen again?
    "A crash is a very rare event," says Richard Russell, editor of Dow Theory Letters. "The odds are always slim, but they do occur." The odds of a meltdown like Black Monday are long — but not as long as might be predicted by financial models, Hulbert says. A 2003 paper by professors Xavier Gabaix, H. Eugene Stanley, Parameswaran Gopikrishnan and Vasiliki Plerou, put the odds at once every 75 years.
    Are there similarities between now and 1987? Sure; 1987 was also a pre-election year. Economists then were worried about an economic slowdown. In 1987, the dollar was weakening, and corporate deals were red-hot.
    But the differences are far more important, Russell says. In October 1987, the Federal Reserve had just finished a round of rate increases that left the key federal funds rate at 7.50%. In contrast, the Fed cut the fed funds rate a half-percentage point, to 4.75%, last month.
    What's more, many of the problems that fed the panic on Black Monday — overwhelmed trading systems, faulty communications and a lack of circuit breakers to halt trading — have been addressed in the past 20 years, says Richard Ketchum, head of regulation for the NYSE, who was head of market regulation for the Securities and Exchange Commission in 1987. "You have dramatically enhanced capacity, better technology, better communication," he says.
    Today, average NYSE volume is 1.76 billion shares, vs. the then-record 604 million. Similarly, 585,000 orders were placed during the crash; today, 155 million orders are processed daily. By year's end, the NYSE wants to handle 64,000 order messages a second, vs. 95 messages in 1987.
    Then there are the circuit breakers. The market stayed open all day on Oct. 19, 1987. Today, for a 2,700-point, or 20% drop, trading would be halted for two hours if it occurred before 1 p.m. and an hour if it happened between 1 p.m. and 2 p.m. The market would close if a 20% drop occurred after 2 p.m.
    "The beauty of the circuit breakers is it gives traders time to take a breath and get a better understanding of what's going on," says Ketchum.
    But panics have a way of short-circuiting the market's best-planned defenses. Peter Schiff, president of Euro Pacific Capital, offers one scenario with the power to prompt a meltdown: "If we wake up one morning and learn that: Overnight, the value of the dollar has plunged 15% to 20%; prices of U.S. Treasury bonds have plummeted, pushing yields up 3 or 4 percentage points; and commodities, such as gold and oil, skyrocket." In essence, he says, investors should fear anything that indicates a serious movement away from dollar-denominated assets, or something big that would change the investment equation in a matter of hours — such as news hinting at a serious recession.
    A geopolitical crisis, forced selling by overleveraged investors or a meltdown in Wall Street-created products, such as derivatives, could also cause a panic.
    Still, a 22.6% drop today is unlikely to occur in a single day, says Schiff. "Maybe the Dow goes down 1,000 points per day for a week. Boom. Boom. Boom."
    One thing is clear: You can't plan a portfolio around a megacrash. "Could it happen? Sure. Should I bet my portfolio on such a rare event? No," says Liz Ann Sonders, chief investment strategist at Charles Schwab. Most crashes occur after excesses. So don't be greedy. Scour your portfolio for big winners, be it in Chinese stocks, oil or emerging markets, and trim those positions before markets tank, she says. Also, the 1987 crash turned out to be a great buying opportunity. Says Sonders: "After the calamity, start to add, add, add."
    Waggoner reported from McLean, Va.; Shell from New York
  2. Clyde

    Clyde Jet Set Tourer Administrator Founding Member

    So, in summary -- Liquidate and be ready to consolidate and reinvest.....not what the market would want to see
  3. spamghod

    spamghod Monkey+++

    One warning about gold and other PM's, in a big crash, the price of gold and other PM's will initally plummet. That's because everyone is selling whatever they have that is liquid to cover their liabilities. That's also the time you back up the truck and load up with your liquidity. After the initial plummet, gold will rubber band back to MUCH higher than it was before.

    The only stock I plan to own (not that I'm an expert on the market) are gold and silver mines. Historically, they were some of the few stocks that did well after the crash in 1929. Other stocks came back, but it took years to do so. I believe (among others) discusses this.
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