Like all of you, I too am a student of the ongoing market. I find reasons to be a contrarian and so I've written from that perspective. I am wondering what conditions we are creating and where they will lead us. My particular interest, since I do anticipate a very serious correction or worse, is whether we are creating conditions that lead to one or both of what I consider the worst American stock market crashes.
The Crash of 1929
Let's begin with the crash of 1929.
(1) "With stocks skyrocketing in price…. the Federal Reserve Bank was [has been] very accommodating…. It expanded the money supply and lowered interest rates. In this loan-friendly environment, brokers, amateur investors and even banks were leveraging everything on margin to get more of the action. The buying glut caused prices to break away from the fundamentals and sent them soaring." This is certainly true today
(2) Consider "the buying glut caused prices to break away from the fundamentals and sent them soaring [italics mine]."
As the G20 recently warned: "Finance ministers from the Group of 20, which includes the United States, the U.K, the European Union and China, warned at their latest meeting that financial markets may be headed for a slump. 'Downside risks persist, including in financial markets,' the group said in a statement from Cairns, Australia. 'We are mindful of the potential for a build-up of excessive risk in financial markets, particularly in an environment of low interest rates and low asset price volatility….' Since the market bottom in 2009, the S&P 500 has risen by about 200%, while overall U.S. economic output has only risen by about 20%. Stock prices relative to earnings are above historical averages. Many top investors have been predicting a market correction for months [italics mine]."
(3) Focusing again on "the buying glut caused prices to break away from the fundamentals and sent them soaring," is also a warning from the BIS (Bank of International Settlements), the world's oldest international financial institution, urging policy makers to begin to normalise rates, which clearly our FED is at least considering. "The risk of normalising too late and too gradually should not be underestimated," the BIS said. The VIX, a measure of US market volatility known as the "fear index," is at a seven-year low. [The VIX did momentarily abandon its seven year low, but it has returned into the realm of utter complacency since the October scare has faded into ancient history.] Growth has disappointed even as financial markets have roared. "Overall, it is hard to avoid the sense of a puzzling disconnect between the markets' buoyancy and underlying economic developments globally [italics mine]," the BIS said in its annual report.
(4) Finally, there is the issue of whether "amateur investors and even banks were [are] leveraging everything on margin to get more of the action." That is a very complex question but the following graph is a way of pointing out the degree to which investors are on margin:
Graph from the home page of Alex Dvorkin.
The first paragraph, (1) above, is from an historical economic description of what led to the crash of 1929. While there are dissimilarities, the similarities are a bit discomforting and verge on the ominous. I didn't want to say that at the opening since the similarities do sound very contemporary.
And then along came 1987
The second crash on which I wish to focus is the one that lingers in my memory, the crash of 1987. As an historical economic site tells us: "This was the crash that everyone expected but could not justify because of the work of the U.S. Securities and Exchange Commission, which is the governing body President Franklin D. Roosevelt ordered after the depression. The SEC - which was established for the prevention of further crashes and fraudulent practices that had infected the stock market - was doing a fine job after the war and finally coaxed tentative investors back into the market in the sixties. The SEC, however, could take investors to the proper information but couldn't make them think…. [as] institutional investors and large mutual funds [were] increasing their dependency on program trading…."
I don't want to suggest that investors were or are unthinking or that we are any less reliant on program trading than we were in 1987. But there we were: expecting a downturn and we got our money beaten out of us. In terms of crashes, this was a much worse market crash than 1929. As the historical description tells us, "the amount the market declined from peak to bottom: 508.32 points, 22.6%, or $500 billion lost in one day. The largest one-day percentage drop in history."
What seemed to make the market drop so quickly was computerized trading. Again, as we read, "as people began the mass exodus out of the market, the computer programs began to kick in. The programs put a stop loss on stocks and sent a sell order to DOT (designated order turnaround), the NYSE computer system. The instantaneous transmission of so many sell orders overwhelmed the printers for DOT and caused the whole market system to lag, leaving investors on every level (institutional to individual) effectively blind. Herd-like panic set in and people started dumping stock in the dark without knowing what their losses were or whether their orders would execute fast enough to keep up with plummeting prices. The Dow plummeted 508.32 points (22.6%) and 500 billion dollars vaporized."
Some of you who experienced this amazing crash may remember that some market-makers abandoned their trading desk. We would not expect such chaos to happen ever again in our markets. Our computer systems and back-up systems are much more powerful and sophisticated. On the other hand, we do have high-frequency trading that moves stock orders at a speed that was only imaginary in 1987. The market world is still fraught with uncertainty.
Can't we just go up and away? Not according to Buffett and Schiller
Can't we just keep going up? DOW: 27000; NASDAQ: 7200; S&P: 3000? Anything of course is possible. But I don't think any of us believe that these numbers indicate realizable values, or at least not in the foreseeable future.
Two stock gurus, Warren Buffett and Nobel Prize-winning economist Robert Shiller, clearly warn that we are in dangerous territory. "Buffett judges value by calculating the ratio of total market value to gross national product (GNP), and the lower the ratio the better. 'A good time to buy stocks is at 80%, Buffett has stated, while he becomes cautious at 100%,' the article states. The total market value-to-GNP ratio now stands at over 120%," not a good time from Buffett's perspective to purchase stocks. Meanwhile, Robert Shiller notes that the "cyclically-adjusted price-to-earnings ratio stands at 26, or roughly 50% higher than its historical average."
A correction is coming and we all know it. The analogues to 1929 are ominous. The safety-nets to avoid another 1987 may be offset by high-frequency trading. We'll just have to watch and see. One thing for sure, the market will change, each day it is open, beginning at 9:30AM.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author has calls on VIX, TVIX, and UVXY.