Jim Jubak - hx of 1929 crash, etc.
written some years ago
By Jim Jubak
In investing, history lessons are invariably painful. Are we about to receive one?
In October, an investor's fancy turns to crashes. Nine years ago, on October 19, 1987, the Dow Jones Industrial Average fell 508 points, or 22.61 percent, the biggest single-day slide in points and percentage in the history of the stock market. And October 1929 ushered in the most extended stock-market slump of this century. The Dow, which had peaked at 381 on September 3, 1929, would eventually fall to 41. It wouldn't match its 1929 high until 1954.
Of course, the market hasn't crashed in most Octobers, and this October the Dow, now fully recovered from its 7.5 percent spill of early summer, is poised to test its historic high of 5778. The current market rally -- which dates back to October 11, 1990, when the Dow stood at 2365 -- seems unstoppable.
That's exactly why investors ought to read up on the history of crashes now. Markets don't collapse when stocks are cheap. Crashes occur when stocks are at their most expensive -- and this market is expensive. For example, the dividend yield on the stocks in the Standard & Poor's 500 Stock Index stands at just 2.2 percent -- a record low since World War II.
But what causes a stock market to crash? It's not simply excessive valuation. If it were, stocks would have fallen through the floor in the fourth quarter of 1991, when the price-to-earnings ratio on the S&P 500 hit 26. Instead, the index climbed 26 percent that year and 5 percent in 1992.
Nor is bad news the key. It's impossible to find the big news events that set off the two great crashes of this century. Tragedies and traumas of every sort -- presidential assassinations, the outbreak of wars, major corporate bankruptcies -- have repeatedly failed to send markets into a tailspin.
Stock-market crashes aren't random events, however. They result from a complex interplay of the mass psychology of investors and the underlying fundamentals of the market. Pre-crash periods show common patterns of excessive optimism, a widespread use of borrowed money to buy stocks, and a gradual but largely unrecognized erosion of the foundations of the market. Exactly when the house will topple down the mountain can't be predicted, but the rough odds of a collapse can be estimated. We can, in fact, develop a scorecard to judge the “crash-worthiness” of today's market.
THE BLUEPRINT FOR A CRASH: 1929
Reading through the pages of the October 1929 Wall Street Journal is like watching an out-of-control car speeding toward a cliff. The Dow Industrials had spent all of September falling back from that September 3 peak. In the first two weeks of October, the market rallied, climbing as high as 353. Then, on October 15, the market showed renewed weakness when the weekly production numbers from U.S. Steel declined 7 percent. Rumors prompted heavy selling as the week ended in the then traditional Saturday session. For the week, U.S. Steel fell $21.75 and General Electric swooned $33.75.
The next week, only the pledge of $1 billion by a consortium of big banks to support stocks stopped the market from going into free fall. On October 24, a million shares traded in the first 30 minutes of the session. Sellers in big, liquid stocks, such as Radio Corp. and Montgomery Ward, couldn't find buyers, and prices dropped by $10 between trades. For the day, 12.9 million shares changed hands, easily breaking the record of 8.2 million.
On Monday, October 28, the Journal reported stock market passes crises, a headline that would soon seem cruelly mocking. Sell orders swamped the New York Stock Exchange immediately after opening. The support of the big banks couldn't stem the tide. The Dow fell a record 38 points.
The next day, the Dow resumed its collapse, falling another 30 points. By the closing bell, it had come to rest at 261, down 120 points (or 31 percent) from September 3. The carnage was sweeping. General Motors traded at $40, down from its 1929 high of $91.75. General Electric's stock price had been cut almost in half, from $403 to $222. What caused this crash? The bad news out of U.S. Steel certainly wasn't enough by itself to send the market tumbling. Earnings in general did not seem headed lower, and many signs pointed to a solid economic performance in 1930.
On October 3, for example, the Journal reported that capital-equipment manufacturers, such as railcar makers, predicted that 1930 would be an even better year than 1929. Chrysler reported shipping 17,000 more cars in the first nine months of 1929 than it had in the same period of 1928. A front-page story reported best september in typewriters and noted that typewriter sales were “generally considered an excellent indicator of business conditions.” A steady parade of companies predicted great earnings, and with earnings growing and the economy strong, stocks didn't seem expensive.
But stocks were expensive. A large number were trading not on actual earnings but on projected future earnings. Stocks were priced as if it were certain that 1930 would be another great year. For example, at its 1929 high of $403, General Electric showed a price-to-earnings ratio of 56.
The last stages of the rally -- its most speculative phase -- had been built on borrowed money. Broker loans to members of the NYSE reached an all-time high of $8.5 billion at the end of September, up from the 1926 low of $2.8 billion. (The total market value of NYSE stocks stood at $89.7 billion.) Much of the buying by individual investors was also financed on credit -- an investor could buy a stock on margin by putting up as little as 10 percent of the purchase price. It didn't take much of a drop in the market to make lenders nervous enough to ask investors for more collateral.
The pillar of cash that sustained those stratospheric prices had been weakening, even as the market moved higher in 1928 and 1929. Interest rates were moving up -- on August 8, the Federal Reserve Bank of New York raised its discount rate to 6 percent from 5 percent, the fourth hike in the discount rate since interest rates had bottomed at 3.5 percent in 1927. Those hikes had failed to end pressure on the dollar, however. Gold continued to flow out of the U.S., and foreign investors sold U.S. stocks and bonds rather than see the value of their holdings erode.
The market stabilized in the days after the crash and began to rally after a very rough spot in mid-November. But the seeds of a greater disaster had been sown. On October 28, the Journal reported that the Senate was likely to pass the Smoot–Hawley tariff bill by Thanksgiving. That bill's punitive duties on imports helped set off the worldwide collapse in trade that would be called the Great Depression.
BORROWING TROUBLE: 1987
Almost 60 years later, another expensive market sustained by borrowed money would fall more than 700 points in four days. The ostensible causes were again insufficient to explain the magnitude of the decline. On Wednesday, October 14, 1987, the Dow fell 95 points -- then the record point decline -- on news that the August trade deficit was an unexpectedly large $10 billion. Just as bad, from the point of view of investors, the House Ways and Means Committee agreed to changes in taxes that would put a damper on the mergers that had driven up stock prices. On Thursday, the Dow fell another 58 points. On Friday, a 108-point fall sent it to 2247. The market was down 17 percent from its August 25 peak.
On Monday, after a weekend spent thinking about the numbers, investors panicked. By 11 a.m. the Dow was down 206 points. By 3 p.m. it was down 300. Individual stocks went into free fall. Procter & Gamble went from $68 to $60 in 15 minutes. By day's end, the Dow had dropped 508 points, and 604 million shares had traded on the NYSE.
What had happened? Nothing more or less than a replay of 1929 with a modern spin. Valuations were again astounding. In August 1987, the stocks in the S&P 500 traded at 26 times reported earnings -- then a historic high.
Investors who couldn't rationalize purchasing stocks using conventional measures of valuation found creative justifications for their buy decisions. The boom in financial engineering (mergers, takeovers, buyouts, and the like) had led to a measure called breakup value. The key issue was no longer how much a company would earn, but what would it be worth if someone bought it with borrowed funds and then sold off its parts.
As in 1929, the valuations rested on borrowed money. The post-1929 reforms of the stock market now required an investor to put up 50 percent of the purchase price to buy a stock, but Wall Street had invented new forms of leverage, most significantly a derivative called an index future. Introduced in 1982, the S&P index future allowed an investor to purchase the market with one buy. The “future” part of this instrument -- the right to buy or sell a unit of the S&P 500 at a given price at a specific date -- enabled investors to make money if they guessed right about the direction of the market. If the market went down, of course, the price of the right to buy the index at a higher price could head rapidly toward zero.
Trading in these derivatives was leveraged in a way that made 1929 look tame. Investors didn't have to put up 50 percent -- 5 percent would usually do. Of course, that low margin meant that it took only a small fall in price to trigger a wave of margin calls.
Leverage wasn't the only source of easy money in 1987. Federal Reserve chairman Paul Volcker, who had vanquished inflation in the early 1980s, presided over a rapid expansion of the money supply -- it grew 12 percent in 1985 and 16 percent in 1986. Much of that money poured into equities because, with inflation conquered and interest rates just starting to climb, no investment appeared as attractive as stocks.
As it had in 1929, the Fed reversed course in the months before the 1987 crash -- delivering a one-two punch to the market by both diminishing the flow of cash to stocks and making the returns on alternative investments a little more attractive. Alan Greenspan replaced Volcker at the Fed in August, and on September 3, the Fed began to tighten: It raised its discount rate to 6 percent from 5.5 percent.
Huge budget deficits in the U.S. -- along with the Reagan administration's hostility to addressing that problem by increasing taxes -- had forced Greenspan's hand. Faced with a falling dollar, foreign investors were increasingly reluctant to buy the Treasury bonds necessary to finance the deficit. The flood of foreign money into the U.S. markets dropped in half. Raising rates was one way to keep foreign investors in the game.
Even as the market was crashing, however, Greenspan's Fed moved decisively to limit the damage. The Fed would provide whatever liquidity the markets needed, the policy makers announced. Reassured, the market bounced back 100 points the next day. By the end of the year, the Dow had rallied by nearly 150 points.
CRASHING IN SLOW MOTION: 1973
Even though crashes have underlying fundamental causes, they still seem inexplicable. How can the mass of investors move so quickly from euphoria to despair? And how is it that no one ever sees a crash coming?
Crashes happen so fast that they don't reveal much about the psychology of the crowd. It's much easier to understand the behavior of investors by looking at a long, drawn-out stock-market decline, such as that of 1973 and 1974.
The conditions in December 1972 should sound familiar. Valuations were at extremes. (McDonald's, to give a famous example, traded at 85 times earnings.) Inflation was accelerating. The underlying fundamentals continued to decay throughout 1973. Interest rates climbed. The Federal Reserve tightened the money supply. By November 1, the Dow had fallen 7 percent.
But most investors kept the faith. Many who could have escaped the true pain yet to come held on -- or worse, put even more money into the market.
They should have sold. In 1974, the dollar faced relentless pressure and fell against all the major currencies. In May, inflation rose at a 13.2 percent annual rate. On October 4, the Dow hit 585, the low point in this market. Since January 1973, it had fallen 467 points, or about 44 percent.
Psychologically, investors overvalue past performance -- they can't believe that what worked yesterday won't work tomorrow. Despite all the negative signs, investors hated to abandon the rally that had driven the Dow past 1000 at the end of 1972. In October 1974, the psychology worked the same way: No one who had been through the past 18 months wanted to buy equities. The Dow would not see 1000 again until November 1980.
DON'T LOOK NOW...
Measured against these meltdowns from the past, how do things stand in October 1996? How likely is this market to crash? And how should you approach it, knowing what you now do about your own investor psychology?
First, watch valuations carefully. Currently, valuations are high, but they aren't yet alarmingly high. The price-to-earnings ratio on the S&P 500 stocks reached 19.5 on August 14, up from 17.17 a year earlier.
But valuations could easily reach scary levels. Although earnings will almost certainly grow for the rest of this year and in 1997, at this point in the economic cycle they won't grow very fast. Earnings growth rates peaked in the first half of 1995.
That wouldn't be a big problem except that analysts and investors are probably still overestimating future earnings. In August, Standard & Poor's calculated that earnings would grow by 10 percent to 12 percent in 1996. Wall Street analysts, by S&P's estimates, were still predicting 19 percent growth. If earnings disappoint in 1996 and then grow even more slowly in 1997, look out.
Second on your watch list should be interest rates, which have inched upward for much of 1996. The market would probably shrug off a single Federal Reserve increase, but two could spell trouble if investors take that as a sign the Fed has lost control of inflation.
Third, watch the dollar. The buck has climbed against other currencies, such as the yen, for 13 months, but it may be about to reverse course. Why? Because the U.S. trade deficit is still accumulating at a rate of $10 billion to $13 billion a month. The dollar has shrugged off the pressure, but that is largely because foreign investors have been buying U.S. Treasurys.
The flow of foreign money has leveled off recently. If foreign investors become convinced that the dollar is set to fall, they will be less likely to buy U.S. bonds, and that could send U.S. interest rates up. Watch the exchange rate. If the dollar falls below 100 yen, it's a bad sign.
Even though the conditions for a crash aren't in place, investors should still take some simple steps to reduce the risk in their portfolios. Those with a low tolerance for risk or an imminent need for cash should move some money to the sidelines. Reduce the leverage in a portfolio to make sure you aren't forced to sell if the market turns down. Also, review less obvious forms of personal leverage, such as credit-card and home-equity-loan balances. This might be a good time to pay them off by taking some stock-market gains.
It's better to take these elementary precautions now than to wait until we're convinced that this market has turned downward. Although we want to believe otherwise, we are near the end of a market and economic cycle. As growth slows, valuations are headed down. The exciting stories that have fueled this market -- the Internet and telecommunications deregulation, for example -- are very tired. Cycles don't have to end with a bang to do damage to the underprepared investor.
The ratio of risk to reward is moving against investors. The potential upside return from this market is uncertain, and downside risk is higher than it was a year ago. So don't buy on future earnings. Don't pay for stories. Don't chase hot stocks. And don't forget history |
