Monday, October 15, 2007

Black Monday: Can It Happen Again?

By andrew Bary

It's fitting that as the 20th anniversary of the ferocious 1987 stock-market crash approaches, most major U.S. equity averages are at or near record levels, and many markets in the developing world at boiling points.

-- The prevailing view on Wall Street is that the monumental drop on Oct. 19, 1987, when the Dow Jones Industrial Average plunged 508 points -- 22.6% -- on then-record volume, won't be repeated. There's good reason for the widespread optimism. But, then again, Wall Street seemingly is always optimistic until something goes terribly wrong. Not that the bulls don't have some good arguments. The Dow's drop on Oct. 19, 1987, was unprecedented, and hasn't come close to being equaled since then.

The largest percentage decline in the current decade was 7.1% on Sept. 17, 2001, and the biggest drop in the past two years was 3.3% on Feb. 27, 2007. Even the historic 1929 crash, while deeper, broader and longer-lasting, didn't produce a one-day downdraft as vicious as 1987 did. The Great Crash included a 12.8% one-day loss on Oct. 28, 1929, followed by an 11.7% slide the following day and one of 9.9% on Nov. 6. So, the 22.6% drop 20 years ago was truly a statistical outlier.

In fact, to the extent that Wall Street looks back at that disastrous fall day in 1987, it's probably to scoff with amazement that investors were foolish enough to dump stocks on what turned out to be one of the great buying opportunities. By the end of that year, the Dow had regained 11 percentage points of its loss. And by Dec. 31, 1988, the DJIA was almost 25% higher than it was at the end of Black Monday.

One reason that monster declines are less likely now is that investors recognize something that they didn't in 1987: The Federal Reserve is on their side. When the markets were rocked this summer by fears about the economic impact of the subprime mortgage crisis, the central bank hesitated initially, but then did what Wall Street demanded and has come to expect: It provided liquidity and cut short-term interest rates. Helped by the Fed, the Dow has eclipsed its July peak of 14,000, ending Friday at 14,093, up 13% this year. And tech-share strength has powered the Nasdaq, which is up 16%, to 2,806.

The stock market is no bargain now, but it's not as richly valued as it was in 1987, when the crash ended a five-year bull run that had tripled the Dow. The trailing price/earnings ratio on the Standard & Poor's 500 index stood around 22 on the eve of the crash, versus about 18 today. More importantly, interest rates now are much lower, which enhances stocks' relative appeal. In contrast, Treasury bonds were in a deep bear market 20 years ago. On the morning of the crash, the yield on benchmark 30-year bonds hit 10% -- more than double their current 4.87%. Short rates then were close to 7%, versus 5% today.

"The stock market has never been as overvalued before or since" the crash, says Tom McManus, chief equity strategist at Banc of America Securities. "Stocks have a much more stable foundation of valuation now than in the summer of 1987." In hindsight, it's amazing that the market went on a tear in 1987, rising by more than 40% to its August peak, when bond prices were crashing.

The U.S. economy is stronger now than it was in 1987, and Wall Street matters less globally, making stock markets abroad less vulnerable to shocks in the U.S. Globalization was still years away in 1987. Russia then was part of the communist Soviet Union, and much of Eastern Europe was under Moscow's thumb. China was emerging from the economic instability that lingered well after Mao's death, while India was captive to socialist policies that had prevailed since its independence in 1947.

"I don't think there's a chance that the market can go down 22.6% in one day" now, says Byron Wien, the chief investment strategist at Pequot Capital Management in New York. "There is too much liquidity and too many buyers to cause a cascade like that."

Technology has improved, too.

McManus, then working in the equity-trading division at Goldman Sachs, recalls how the New York Stock Exchange was so swamped with orders that some trades couldn't be completed for hours. Often, it was even unclear whose orders were being filled when trades did get done.

Computer systems sophisticated enough to smoothly handle trades and record-keeping were only beginning to be used by the markets in 1987. Information also was less available to investors than it is today. The Internet didn't exist, and cable TV wasn't widespread. There was no CNBC or Bloomberg Radio.

The optimists also note that the U.S. probably now has one of the least overheated stock markets in the world. Since the start of the current bull run in early 2003, the Standard & Poor's 500 is up about 90% -- impressive, but still the smallest gain among major markets, according to Birinyi Associates.

Despite all this, a decline of 1987 proportions, while unlikely, isn't impossible.

After the crash, the New York Stock Exchange implemented circuit breakers designed to prevent another meltdown. Under current rules, the market shuts down if the Dow industrials fall 2,700 points, or nearly 20% at its current level. Specifically, the rule stipulates that if the benchmark average drops 2,700 points prior to 1 p.m., the market closes for two hours. If a 20% decline occurs between 1 and 2 p.m., trading halts for an hour. If the 20% swoon occurs after 2 p.m., trading ends for the day. Furthermore, the maximum daily decline permitted is 4,050 points. A drop of that magnitude would shut the market for the rest of the day, regardless of when it occurred. The current circuit breakers haven't come close to being tripped.

Still, the optimists' case has some big flaws.

What could precipitate a 1987-style setback?

The leading candidate is a major geopolitical shock. A U.S. attack on Iran, for instance, could drive oil prices past $100 a barrel, lead to wholesale liquidation of dollar assets by Middle Eastern investors and destabilize the region by drawing powers like Russia into the conflict. That, in turn, could set off a financial crisis by prompting wholesale liquidation of stocks by leveraged hedge funds and other investors, while putting enormous stress on the leveraged balance sheets of major banks and securities firms. Such a catastrophe could be worsened by the trillions of dollars of derivatives that Berkshire Hathaway CEO Warren Buffett has called "financial weapons of mass destruction."

Meanwhile, top executives at Goldman Sachs and elsewhere have referred to August's market setback as a 100-year flood or a 20-standard-deviations event -- a fancy way of implying that it was a statistical fluke unlikely to recur. Dislocations in the mortgage and leveraged-finance markets emerged, hammering stocks by nearly 10% over a few weeks and battering a group of big quantitative equity funds that suffered declines of as much as 30%.

What happened in August, however, was no extreme event. The setback in the junk-bond market was mild compared with what happened in 2002. If a geopolitical shock erupted in a period of market instability, the Street would have to deal with some real financial trouble.

It's worrisome that the best and brightest on Wall Street consistently underestimate the odds of market-jarring events because this suggests that the financial community isn't well-prepared for a true 100-year flood.

"Why is it every year or two, we seem to experience 100-year events? When people talk about a 100-year flood, it's another way of saying that something bad happened and they didn't expect it," says Rick Bookstaber, a former hedge-fund manager for FrontPoint Partners and the author of the recently published book, A Demon of Our Design. It argues that the risk of a true financial crisis has risen in recent years, despite efforts to reduce that danger.

"As the markets get more complex, leveraged and interconnected, they become more crisis-prone," Bookstaber asserts. Advances in engineering, he argues, have made the physical world a safer place, but financial engineering has increased dangers for investors.

For instance, the leverage used by hedge funds and financial institutions can create the potential for a cascading decline, because price drops can lead to forced selling. The selling then can feed on itself and infect unrelated markets. That's just what happened when the Long-Term Capital Management hedge fund collapsed in 1998. And despite the often-heard theory that the major stock markets are decoupling, there seems to be a growing correlation among them when prices drop. The growing influence of hedge funds and other leveraged investors may account for that.

Bookstaber has some experience with financial mayhem -- he was one of the original practitioners of portfolio insurance, a supposedly benign hedging strategy that turned out to be one of the main causes of the '87 crash.

The idea behind portfolio insurance was that institutional investors would sell stock-index futures during market declines to limit their losses. When the Dow fell 10% over the week before the crash, portfolio-insurance triggers were tripped, causing heavy sales of S&P 500 index futures on the morning of Oct. 19. This drove the futures to a discount to the underlying index. Arbitrageurs then bought futures and sold individual stocks, deepening the market losses and turning a bad day into a terrible one.

Wall Street firms like to talk about their tolerance for risk and their willingness to provide liquidity. But these financial behemoths are highly leveraged, sometimes having just one dollar in equity capital backing every $30 of assets. Their holdings include tens of billions of dollars of illiquid securities. In reality, if disaster strikes, the financial giants might be sellers of assets and seekers of liquidity.

A big problem with leverage is that it can force investors to sell just when markets are most depressed and opportunities are greatest. The U.S. mortgage market arguably is as attractive as it has been in several years, but a leveraged investor like Thornburg Mortgage (ticker: TMA) can't take advantage of it. It was a forced seller of mortgages in August because lenders wanted their money back.

Few investors are positioned as well as Warren Buffett, who has $40 billion of cash at Berkshire Hathaway and can await opportunities. Berkshire's liquid balance sheet may be getting more recognition in the stock market because Berkshire Class A shares (BRK-A) Friday hit a record and now fetch $127,100, up 15.6% this year.

Yes, there are enormous pools of liquidity in the world, including more than $5 trillion of reserves held by global central banks, more than $1 trillion of that by China alone. There also are an estimated several trillion dollars of so-called sovereign wealth funds run by the likes of the Persian Gulf states, Singapore and Norway. But how much, if any, of these funds would be deployed during a crisis is unknown. How they're used could help determine the depth of a crisis.

Geopolitical risk, especially the danger posed by Iran, has been discussed by Niall Ferguson, the noted financial historian and Harvard professor who was profiled in a Barron's cover story this year ("Wake-Up Call," March 12).

Given the hawkish view toward Iran by some officials in the Bush administration and the unpredictability of the Iranian regime, the odds of a U.S.-Iran conflict aren't trivial -- although the ability to wage war against Iran is questionable, given the U.S. armed forces' deep involvement in Iraq. Iran has long been an irritant to America. In fact, one factor in the 1987 crash was the uncertainty caused by a U.S. attack on Iranian oil platforms that Washington said had been used to attack an American tanker.

Ferguson has argued that the repercussions of a U.S.-Iran conflict could cause a repeat of what happened after the onset of World War I -- an extended shutdown of major equity markets. To him, the World War I situation shows just how fragile liquidity can be. Financial markets were blind to the coming of war in 1914 until it had virtually begun. The markets now might be ignoring the growing danger in the Middle East.

Another obvious risk is a Chinese economic slowdown or financial crisis. It's notable that the biggest decline in the Dow this year -- 416 points on Feb. 27 -- was a direct response to a sharp selloff in the Shanghai market. While China still probably isn't big enough in the world economy to prompt a market crash, it certainly could contribute to one.

Liz Ann Sonders, the chief investment strategist at Charles Schwab, cites several parallels between the economic and financial backdrop in 1987 and now, including a weakening dollar, rising oil and commodity prices, inflation fears, a long-standing economic expansion, an elevated stock market, a relatively new Fed chairman, rising protectionist sentiment and a lengthy span since the last 10% market correction.

Perhaps the most alarming similarity bears on the dollar, which has been under pressure against the euro, pound and Canadian dollar.

Prices of key commodities have surged this year, with gold hitting $750 an ounce, its highest level since 1980. U.S. financial authorities aren't publicly talking down the dollar, as Treasury Secretary James Baker did to harmful effect just before the 1987 crash. Henry Paulson, the current Treasury secretary, keeps reiterating that a strong dollar is in the national interest, but few in the currency markets think he means what he's saying. Instead, they see Washington tolerating a weak greenback because it stimulates exports and should help trim America's record trade deficit.

The U.S. may be playing a dangerous game, because the depreciating currency might be taxing the patience of world central banks that are seeing the value of their huge dollar-denominated holdings erode. While a run on the buck -- and a sharp market setback -- are possible, it doesn't appear to be in the interest of big dollar-holders like China, Russia or the Middle East nations to precipitate a collapse in the currency.

The odds of a meltdown probably are low, but they're not so remote that investors shouldn't emulate Buffett by maintaining liquidity. Giddy markets should inspire caution. And the markets -- as they were in 1987 -- are giddy now.


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