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Summary

  • The current markets don't mirror past market crash prone markets.
  • Extreme levels of optimism aren't present in the markets.
  • A wall of worry is being climbed, not a celebration of euphoria.

Last year I wrote an article about possible black swan events developing in China. While technically "black swan" events are impossible to predict, that hasn't been the case historically. There were plenty of warning signs going into the 1907, 1929, 1987, 2000 and 2008 crashes. In fact, one common denominator gives rise to one of the most difficult points I have to continually refute in my conversations with friends and family. All 5 major stock market crashes in the past 110 years occurred under Republican administrations. Republicans are 5 for 5 when it comes to being on watch when a crisis hits.

However, history actually shows that the U.S. economy, stock prices and corporate profits have generated stronger growth under Democratic administrations than Republican ones.

The best stretch of market performance since 1900 occurred in 1993-2000 under Bill Clinton, who saw the S&P 500 rally an average of 19.9% per year during his presidency, S&P said.

For Republicans, the strongest market action occurred from 1981-1992 when the S&P 500 climbed an average of 13.5% each year under Ronald Reagan and George H.W. Bush.

To me, that kind of statistic makes sense. In order to have a major crash, you have to first have extreme optimism pushing the stock market and economy into the "irrational exuberance" danger zone. Republicans love free markets, they love market solutions and they don't typically view income inequality as an evil as long as the income equality is the result of economic freedom.

Republican "Teddy" Roosevelt was in office during the Panic of 1907. Roosevelt's predecessor was Republican William McKinley, a staunch capitalist and a favorite of "big business." He campaigned on a platform of economic prosperity and sound monetary policy.

the wealthy Ohio industrialist Marcus Alonzo Hanna. In the general election, McKinley faced William Jennings Bryan, who ran on a platform attacking the gold standard and supporting the coinage of silver as well as gold. Touted by Hanna as the "advance agent of prosperity" and the protector of America's financial interests in contrast to Bryan's radical policies

Teddy Roosevelt wasn't as friendly to business as President Harding, and ushered in the "trust busting" era. During the Panic of 1907 however President Roosevelt took a hands off approach, and relied upon banker J.P Morgan to resolve the issue. That event however set in motion the forces that would ultimately result in the creation of the Federal Reserve in 1913.

The 1929 crash ended the "Roaring 20s" immortalized by books like The Great Gatsby. Calvin Coolidge's Republican predecessor Warren Harding ran on a post-war peace and prosperity theme of a return to "normalcy," putting in place the foundation of the "Roaring 20s." Once in office Republican President Calvin Coolidge cut taxes and embraced laissez faire capitalism.

Calvin Coolidge (1872-1933), the 30th U.S. president, led the nation through most of the Roaring Twenties, a decade of dynamic social and cultural change, materialism and excess... cleaned up the rampant corruption of the Harding administration and provided a model of stability and respectability for the American people in an era of fast-paced modernization. He was a pro-business conservative who favored tax cuts and limited government spending. Yet some of his laissez-faire policies also contributed to the economic problems that erupted into the Great Depression.

The economy and stock market exploded for a decade. By 1929 President Coolidge was no longer in office, and Republican President Herbert Hoover had taken charge. The US economy had faced a financial panic just 22 years earlier in 1907, but this time there was no J.P. Morgan at the helm. Herbert Hoover made a mistake that was later repeated in 2008, that being the inability of some conservative leaders to accept that free market principles do not apply to the banking system. The banking system enables the free market to work, the banking system is like oil to an engine, without the oil, everything freezes up. That reluctance to get the government involved in the banking crisis, and his failure to spur the infant Federal Reserve into action, triggered the Great Depression.

Hoover's response to the crisis was constrained by his conservative political philosophy. He believed in a limited role for government and worried that excessive federal intervention posed a threat to capitalism and individualism... "Prosperity cannot be restored by raids upon the public Treasury," he explained in his 1930 State of the Union address.

While he was dead on with his belief that "raiding the Treasury" wasn't the solution, he failed to understand that the Federal Reserve isn't the Treasury, and performing its role as "lender of last resort" is essential to calm a financial panic. Emergency liquidity loans aren't the same as fiscal policy spending. They are apples and oranges, and yet we will see that lesson was still not understood 80 years later in 2008.

Democrat President FDR followed President Hoover and attempted to get the economy out of its depression by "raiding the treasury." The result was to put "Great" in the title "Great Depression." The mistakes of FDR are also being repeated 80 years later, as excessive government spending has done little to re-invigorate the economy, and has largely just increased the debt.

"We have tried spending money. We are spending more than we have ever spent before and it does not work."..."I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises."..."I say after eight years of this Administration we have just as much unemployment as when we started. … And an enormous debt to boot!" Henry Morgenthau Jr. Secretary of the Treasury to President Franklin D. Roosevelt - and key architect of FDR's New Deal.

FDR's administration and the global economy was extremely disrupted by World War II, and set in motion a period where there wasn't another major crisis until 1987. One could argue the Nixon Watergate crisis was a financial crisis, but I won't because it was clearly a political and national crisis. The seeds of the 1987 crash were planted in the era of Democratic President Jimmy Carter, where America's standing in the world was hitting new lows, Iran was holding US hostages, OPEC controlled the US Economy, Russia was a major threat and invading Afghanistan, Japanese imports were reshaping the industrial landscape, there was a coming ice age, a 10 year supply of oil left and nuclear holocaust movies like The Day After were being shown in classrooms. Disco, stagflation, weakness, pessimism and gas lines defined the era.

America was hungry for a return to greatness, and Republican Ronald Reagan and his revolutionary "supply-side economics" and peace through strength full tilt "Morning in America" return to optimism agenda fit the bill. After taking the first 2 years to break the back of inflation, the economy and stock markets exploded. America went from being kicked around by Iran to effectively winning the Cold War. Lower taxes, lower regulations, lower gas prices, lower interest rates and yes greater spending on winning the Cold War paid huge dividends, returning American to greatness and restoring her standing in the world. Like the "Roaring 20's," extreme optimism set the stage for the 1987 crash. Global investors were extremely confident that they had an ally in the Whitehouse. He wasn't interested in redistributing wealth, he wanted to create it. His "rising tide lifts all boats" and "we'll grow our way out of the deficit" beliefs were the foundation of his "trickle-down" economics.

Effective monetary policy implemented by then Federal Reserve Chairman Alan Greenspan contained the damage from the 1987 crash, and America didn't even fall into a recession. Unfortunately, that lesson however was forgotten by 2008. The full benefit of Reagan's fiscal policy, while widely criticized while he was in office, had planted the seeds of prosperity that would grow to astonishing heights in the years that followed.

President Reagan was followed by Republican George H. Bush, who like Roosevelt and Hoover of the past, failed to continue the legacy given to them. President Bush did get to see the fall of the Berlin Wall symbolically ending the Cold War, and won the first Persian Gulf War, but he will be forever remembered for breaking his promise to not raise taxes, and the shallow recession that it caused. The fall of the Berlin Wall is largely credited to the successful fiscal and military policy of Ronald Reagan.

While the military and security benefits of the Reagan era were recognized almost immediately, the economic benefits were just starting to materialize. President Bill Clinton took office inheriting an environment of peace, prosperity and optimism like few president in American history. After his first two years of trying to socialize medicine, raising taxes and overall economic malaise, Americans had had enough. Republicans were given a landslide victory in the 1994 election. The market impact was swift and immediate.

The following logarithmic chart of the S&P 500 shows 2 "dog legs." A "dog leg" represents a shift in the slope, meaning that there was a fundamental event that altered the market's outlook for growth and earnings going forward. The post-War era had explosive growth aided by the tax cuts of President John F. Kennedy. That era was followed by the nightmare of the Vietnam War, OPEC oil embargos, Watergate, the Iranian hostage situation, stagflation and disco. President Reagan won office in late 1980, and by the end of 1982 was showing success in breaking the back of inflation/stagflation. The first "dogleg" is in 1982 with Reagan's victory against inflation. The markets exploded after that date, and rallied until late 1992, when the markets kind of flatlined with the election of President Bill Clinton. In late 1994, with the election of the Republican Congress, and President Clinton's Mia Culpa of "The Era of Big Government is Over," the second "dog leg" was formed.

(click to enlarge)

Not only did the stock market form a "dog leg" as President Clinton embraced/triangulated/co-opted the Republican's "Contract with America," the 10yr interest rate that had been climbing throughout all of 1994, immediately reversed itself, and rates have never been higher since that election. That election ushered in a new trend of falling interest rates that remains in place to this day.

This following chart highlights the trend prior to and immediately after the election held in November/late 1994. Rates immediately reversed course and have fallen ever since. Anyone that thinks that understanding politics isn't important to investing simply needs to study the market impact of the 1994 election.

After the 1994 election, the seeds planted in the Reagan era started to blossom. The tech boom had its start in the Reagan capital gains tax cut era. Companies like Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO), Adobe (NASDAQ:ADBE), Oracle (NYSE:ORCL), Intel (NASDAQ:INTC) and Apple (NASDAQ:AAPL) all had their roots in the Reagan era, but were now reaching the size where they were driving the US and global economy. Al Gore proved Reagan's "supply side" economic theory valid to levels never dreamed of when he had a single line entered into the telecommunications deregulation bill of 1996 that allowed/preserved "commerce over the Internet," unleashing an Austrian "gale of creative destruction" like the world had never known.

to preserve the vibrant and competitive free market that
presently exists for the Internet and other interactive
computer services, unfettered by Federal or State regulation;

One year after the telecom deregulation bill of 1996 passed, Amazon (NASDAQ:AMZN) went public and the new supply-side economics world has never been the same. Unleashing the free-market on the internet set the investing world on fire, and out of it rose the Dot.com bubble, the inspiration for the "new metrics" that would re-write the rules for analyzing stock valuations. Companies like Pets.com reached unbelievable heights only to disappear overnight once the reality of "cash burn" metrics trumped the "new metrics."

Founded in 1998, Pets.com raised $82.5 million in an initial public offering in February...Despite these moves, the company's stock price has been mired below the $1.50 level for months.

Trading in Pets.com stock was temporarily halted Tuesday. When trading resumed, the price promptly plunged to 22 cents from 66 cents, a one-day decline of 67 percent. Volume topped 4 million shares.

After trading as high as $14 this year, the rock-bottom stock price values the entire company at about $6.4 million. The month before it went public, the company spent almost half that amount on 30 seconds of advertising during the Super Bowl.

Only 6 short years after the Republican victory in 1994, and 4 short years after the telecommunications deregulation bill, and 5 short years after the release of Windows 95 and Intel's (INTC) Pentium Pro Chip, the bubble burst. On April 3, 2000 judge Penfield Jackson released a verdict against MSFT, signaling the end of the "Tech Bubble" and peak of the Nasdaq 100, a level that hasn't been broken to this day.

By the time President George W. Bush had taken office in January 2001 the Nasdaq 100 had lost over 40% of its value.

(click to enlarge)

The bursting of the "Tech Bubble" was compounded by the corporate malfeasance discoveries in corporations like Worldcom and Tyco (TYCO) and even insider trading scandals that sent high profile celebrities like Martha Stewart to prison. Just when things looked like they may be settling down, America was hit with its worst terrorist attack in its history. America was put into a tail spin, and the markets didn't bottom until late 2002.

(click to enlarge)

Stimulative supply-side tax cuts, accommodative monetary policy and deregulation stopped the fall, and reversed America's course. Over the next 5 years the markets and economy exploded.

(click to enlarge)

Deregulation of the mortgage industry fueled economic growth, but it also planted the seeds for the next crisis. The push for affordable housing led to the securitization of mortgages and the decoupling of risk between the lender and the borrower. Suddenly banks could write loans for sub-prime borrowers, and not have to worry about taking the losses. No-Doc, Low-Doc, No-Income, No-Job-No-Problem loans were being made, many of them were with adjustable rates.

Democrats took the Congress in 1996, and immediately started to change the course of the Nation.

During the 2006 elections, House Democrats promised to take our country in a New Direction, that a Democratic Majority would bring the change that our country so desperately needed. House Democrats wasted no time and within the first 100 hours can now stand united to say that we have kept our promise to the American people.

During their "first 100 hours" they promised to go after "Big-Oil," a policy that would have tremendous unforeseen and unintended consequences.

We will energize America by achieving energy independence, and we will begin by rolling back the multi-billion dollar subsidies for Big Oil.
H.R. 6, "Creating Long-Term Energy Alternatives for the Nation Act." passed 264-163, Jan. 18th, 2007

The attacks on "Big-Oil" immediately reversed the downtrend in fuel prices.

The higher oil prices then drove inflation higher.

The higher inflation drove interest rates higher, triggering many highly leveraged households to default on their mortgage loans.

In late 2008 Secretary Hank Paulson made the ill-advised decision to allow a "too big to fail" bank to fail, triggering the worst global financial crisis since the Great Depression. A couple of months later President Obama got elected running on a campaign of "Hope and Change."

During the Obama Administration the stock market has recovered, but the economy is anemic, uncertainty has corporations holding record levels of cash and unemployment is stubbornly high. While the stock market is at or near an all time high, it largely got there through cost cutting, low interest rates and stock repurchases. The stock market and economy are far from being considered symbols of optimism. With rates as low as they are, the Graham and Dodd Matrix would predict a much higher multiple for the stock market. With AAA Corporate Bond Rates at 4.45% and the S&P 500 P/E approximately 20, the Graham and Dodd Matrix suggests that the markets are discounting about a 5 year earnings growth rate of about 7%. Hardly a rate associated with extreme optimism. The S&P 500 is only 300 points or 20% above the level reached in 2000, and rates were much higher in 2000. Gold, an index of fear, still trades above $1,200, rates are still low for good reason and there is plenty of fear and anxiety in the geopolitical arena. Now simply isn't the typical environment for a "black swan."

Reviewing the above market crashes, the common denominators are:

1) Extreme optimism and hope for the future tend to lead the crashes. The markets have to first climb to the high ground before they can stumble.

2) Technological advancements like the auto, electricity, phone and the Internet often lead the optimism.

3) Political change often leads the market crashes. 1929, 2000 and 2008 all occurred either in the first year of an administration or at the very end of a second term.

4) Financial crashes combined with a banking system collapse tend to be the deepest and longest. Hopefully 2008 will teach out leaders in Washington to ignore the angry mob and do what is right, no matter how politically unpopular.

5) Financial crashes that are followed by failed fiscal policy also tend to be deep and long. Hoover, FDR and Obama all tried Keynesian solutions and they all failed/are failing. GW Bush and Reagan used supply-side fiscal policy and the recoveries were relatively quick and robust. Prior to the crash of 2008 unemployment was 4.4% in early 2007 and economic growth was 4.9% in early 2006. The crash of 1987 was contained to the stock market and didn't really impact the overall economy.

The take home message for investors is that the current market isn't the kind of market that is consistent with past market crashes. It lacks the extreme valuations and optimism. This market is climbing a wall of worry, and while it does have an above average P/E, it is during a period when interest rates are extremely low. If interest rates were to rapidly increase going forward, the markets would be at risk, but they are not currently.

When I started writing this article I intended to write about strategies to protect against "black swans" but a fellow Seeking Alpha contributor beat me to the punch. Eric Parnell wrote "The Four Horsemen of the Stock Market Apocalypse" which basically covered the topic that I intended to. He highlighted 4 strategies to protect a portfolio from a sudden downturn. The "4 Horsemen" were:

1) Cash

2) Long-Term Treasuries

3) Gold

4) Volatility

I agree with all 4 of those solutions, and would add an additional one.

5) Market Neutral Positions

Bottom line, the above strategies are ideal for preparing for a financial "apocalypse," but in my opinion the current market simply isn't consistent with past crash prone markets. There is no excessive hope or optimism, and nothing in the near-term is likely to change. Fiscal policy focused on redistribution, regulation and higher taxation instead of growth, deregulation and tax cuts isn't gone to get the markets excited.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Full Disclaimer and Disclosure Click Here.

Source: Black Swan Events: How To Protect Your Portfolio When It Is Needed