Saturday, October 20, 2007

To Market, To Market

Eerie thing about the stock market: you almost feel like it's a repetitve cycle, and that you've been here before at some point:
NEW YORK (Reuters) -Caterpillar Inc.'s warning that the housing slump was infecting the wider economy sent U.S. stocks tumbling by the most in more than two months on Friday, in a drop that was made more unnerving as it marked the 20th anniversary of the 1987 market crash.
It was twenty years ago yesterday that the biggest market crash in American history occurred, kicking off nearly fifteen years of economic instability and multiple recessions, saved only by the miracle of Bill Clinton's tax hikes and economic policies.

But that's a different story. Let's read tea leaves today:
Leading up to the "Black Monday" rout on Wall Street, a massive budget shortfall, falling dollar and burgeoning trade deficit clouded the horizon for the U.S. economy, even as the Dow hit a string of record highs.

Sound familiar?

Since the start of this decade, the U.S. budget has swung from surplus to deficit, the dollar has slid to record lows and a huge hole remains in the trade balance -- only now it's nearly twice as big compared to the overall economy.

Transcripts from the Federal Reserve's meeting a month before the 1987 crash show similar issues were on the minds of policy makers.

Investors were also concerned, particularly after a bond market rout in the wake of a precipitous drop in the dollar during the two years leading up to the October 19, 1987, crash.

"Eventually the dollar broke and that crushed the bond market," said William O'Donnell, head of U.S. interest rate strategy and research with UBS in Stamford, Connecticut.

So you have the issues of timing (mid-October) and the economic preface in place. You also have a Bush in the White House (Reagan, at least, listened to his economic advisers, rather than decide things for them). This might not be very pretty to watch, to put it diplomatically.

That's not to say that this is a slam dunk certainty that the markets are poised to tank. By some measures, the stock market is actually undervalued, which means there's plenty of upside left, if you buy that scenario.

I think differently, however, and believe that using 20 year old measures when so much has changed in the marketplace is silly. For example, investors now have access to much more immediate trading based on much more immediate information, and since earnings reports this quarter have been pretty ugly (look at what Catepillar's report did yesterday), to say the market is "undervalued" is likely wrong, especially if people don't "feel" that it is.

And feel counts for so much in stock trading. In a perfect market, people would make rational decisions based on perfect information that they felt they could trust.

We have neither of those, and it's a self-reinforcing cycle of mistrust and irrationality.

The most eerie similarity between this week (and upcoming week) and Black Monday is this: In 1986, the United States economy began shifting from a rapidly growing recovery to a slower growing expansion, which resulted in a "soft landing" as the economy slowed and inflation dropped. The stock market advanced significantly, with the Dow peaking in August 1987 at 2722 points, or 44% over the 1986 closing of 1985 points. On October 14, the DJIA dropped 95.46 points (a then record) to 2412.70, and fell another 58 points the next day, down over 12% from the August 25 all-time high. On Friday, October 16, the DJIA closed down another 108.35 points to close at 2246.74 on record volume.

If you look at the American economy and in particular, the New York Stock Exchange over the past two years, you'll see that you can pretty much fit the curve into the above paragraph with little error.

In 1987, in one day, a billion dollars was lost in the American economy. A drop of similar proportion today would result in the loss of tens of billions, perhaps more.

That's going to hurt, because while the markets have grown five-fold, the US economy has barely doubled in the past twenty years, after accounting for inflation.

The law of gravity applies here, and while I don't expect a 14,000 point drop in the Dow, I also don't rule it out over the long haul. It is only human hubris that makes us think we can suspend the laws of physics and finance.