Wall Street Is Crash-Proof (Almost)
“Never underestimate the size of a panic, nor the power of the politician.”
-Harry D. Schultz
Today, October 19, is the 30th anniversary of Black Monday. That day in 1987, the Dow Jones Industrial Average fell more than 500 points, or 22.6%. It was the worst one-day decline in stock market history, before or since.
I was lucky enough to anticipate this “first-class catastrophe,” as one historian calls it. Six weeks before, I sent out a special alert to my Forecasts & Strategies subscribers with the headline “Sell all stocks.”
October 19 also happened to be my 40th birthday. But few of my friends on Wall Street were smiling at the party my wife put together. One broker friend had a $5 million margin call and wasn’t sure if his customer was going to make it. (He eventually did.)
It was a day that made grown men cry. Imagine if the Dow fell more than 5,000 points in a day, wiping out trillions in stock values. You’d cry too.
Can it happen again?
In 1954, the free market economist (who went on to win a Nobel prize) Milton Friedman presented a paper in Stockholm, Sweden, titled “Why the American Economy Is Depression-Proof.” He rejected the Cassandras of the day who were predicting another Great Depression.
He argued they were wrong for three reasons: the adoption of federal bank deposit insurance, the growth of the welfare state and the Federal Reserve’s willingness to bail out the banking system with easy money.
For decades, he was right. But then came the financial crisis of 2008, when the economy came within a week or two of total collapse. Another Great Depression was averted, but just barely. Instead we got the Great Recession and a long, painful recovery, as well as Dodd-Frank and Obamacare.
In sum, the American economy may be Depression-resistant, but it’s not Depression-proof. It’s always possible for the American people to lose faith in its highly leveraged fiat monetary system.
Obstacles to a Full-Blown Crash
Is the stock market crash-proof? The 1987 crash was largely the result of newly created institutional financial instruments such as portfolio insurance that mindlessly sold stocks short.
The quick action of the Fed under Chairman Alan Greenspan stopped the bleeding the day after the crash. The stock market has prospered ever since, although it has suffered several severe bear markets since (especially 2000-2002 and 2008-2009).
In some ways, the institutional leveraged factors are still at work. At the Dallas MoneyShow, I learned that 90% of all trades are computer-generated. Only 10% are made by individual stock pickers.
Once the market turns, the sell-off could be severe. A bear market can easily get out of control in a global laissez-faire market economy with few capital controls between nations.
However, investors should not discount the power of government to intervene to keep a full-scale rout from happening. After the 1987 crash, the Securities and Exchange Commission imposed circuit breakers that stop trading when the market drops by a certain percentage.
Under rules in place since 2013, marketwide circuit breakers kick in when the S&P 500 Index drops 7% (Level 1), 13% (Level 2) and 20% (Level 3) from the prior day's close. These breakers halt trading for 15 minutes or longer.
The federal government can also intervene in the stock market to keep it from collapsing. After the 1987 crash, President Ronald Reagan signed an executive order creating the Working Group on Financial Markets, also known as the Plunge Protection Team.
It was active in the 2008 financial crisis, although it said it did not buy stocks directly. Germany has a similar agency called the Federal Agency for Financial Market Stabilization.
Given these restraints, I am of the opinion that a stock market crash à la 1987 is highly unlikely, and I have avoided predicting a crash ever since 1987. That’s not to say that bear markets are somehow outlawed. And the most recent crisis won’t be the last.
Is the Stock Market Overvalued?
Many economists and analysts, including Robert Shiller and Mark Hulbert, think the market is vastly overpriced. They base this conclusion on traditional measures such as the price-to-earnings ratio, dividend yield, price-to-book, price-to-sales, the cyclically adjusted price-to-earnings ratio (CAPE) and the Tobin Q ratio.
CAPE is Yale Professor Robert Shiller’s favorite index. It measures the price-to-earnings ratio of the U.S. stock market over a 10-year period. It shows stocks are almost as expensive as they were in the late 1990s and 2007. In both cases, stocks eventually collapsed.
The Tobin Q ratio compares the market capitalization of stock indexes (such as the S&P 500) with corporate earnings. It comes to the same conclusion as the CAPE Index... stocks are expensive.
Yet as Pomona Professor Gary Smith points out, Shiller and other Wall Street bears fail to take into account historically low interest rates. The chart below compares earnings for stocks with long-term interest rates.
When you look at this chart, you can conclude that stock prices are not overvalued and could move higher.
That’s why I remain 100% fully invested. Of course, there are bound to be corrections along the way. In case I’m wrong, I do recommend using stop orders around 20% below current prices.
Good investing, AEIOU,
Thoughts on this article? Leave a comment below.
P.S. The above quote from Harry D. Schultz is taken from my book The Maxims of Wall Street, which contains more than 800 valuable quotes on bull and bear markets, crashes and panics, fundamental vs. technical analysis, gold bugs, contrarian investing, and many short stories and anecdotes.
Maxims is now in its fifth edition. Alex Green says it’s a classic, Warren Buffett considers it his favorite quote book, and Dennis Gartman has it on his desk to quote from it in his monthly newsletter. Maxims makes a great gift to friends, relatives, brokers and clients.
Copies are available for only $20 for the first copy, and all additional copies are only $10 each. I autograph each copy and pay the postage. (For orders outside the U.S., add an additional $15.) To order your copies, call Harold at Ensign Publishing toll-free at 1.866.254.2057 or go to https://miracleofamerica.com.
Photo credit: Roger Hsu, Flickr. Used under a Creative Commons license.