Odds of a crash are higher than you think
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Stock-market crashes are rare, statistically, but the odds today are dramatically higher than 'normal.' Ask yourself how you'll handle it.
By Bill Fleckenstein
7/12/2004
What are the chances of a stock-market crash? On July 3, Neil Cavuto asked me this question on his Fox News business program. Though the medium of television dictated a "sound-bite" reply, the subject does not lend itself to pat answers. What's helpful, instead, is a lesson in "crash math," which I'll try to provide.
When I say "crash," people usually think of the Oct. 29, 1929, or Oct. 19, 1987, stock market crashes, i.e., a one-day event, but I don't mean just that. My working hypothesis always has been that a market dislocation needn't necessarily happen in one day, but could happen over a series of days. I prefer the term "dislocation" (or, to borrow a phrase from the commodity markets, a "market repricing"), since it's less likely to cause people to immediately think of the 1929 or 1987 crashes.
A big dislocation is rare indeed
You can estimate how rare a dislocation ought to be. Looking at the S&P 500 index ($INX) monthly data since 1973 (I only use monthly data here to make the calculations a little simpler), you'd find that a month where the market went down, say, 14%, like it did in August 1998, was approximately a 3 standard deviation move. A month where the market dropped as it did in October 1987 would be about a 4.5 standard deviation move.
To put those numbers in perspective, a 3 standard deviation move is roughly 1 out of 740 observations, a 4 standard deviation is 1 in 31,600, while 4.5 standard deviation is a staggering 1 out of 294,000. The minutiae of the math that could get us to different numbers totally misses the obvious, main point: Crashlike moves are very rare.
I bring this subject up because I believe the risks are far higher now than "normal" (which is the point I tried to make last weekend on "Cavuto on Business"). However, to say that the chance of a crash-like event is far higher than normal doesn't really mean much if you don't know how likely it is in the first place.
A 1-in-5 chance?
When pressed, I told Neil I thought the chance might be as high as 1 in 5. Well, compared to the statistics I've given you, 1 in 5 is a gargantuan number, but I don't know if 1 in 5 is the right number. One in 10 would still be a giant number, as would 1 in 20, relative to "normal." I have no idea what the true probabilities are -- because they are not knowable. Everyone who looks at the potential causes of a dislocation, which I'll get to in a moment, will arrive at different conclusions.
However, what I don’t think is debatable is that the possibilities are far higher than most people would think (if they ever even thought about it). Folks need to factor the possibilities into their investment strategies, or think through the possibilities and dismiss them, should they come to that conclusion. With that preface aside, let me move on to what I think are the ingredients necessary to cause a market dislocation.
Speculation: yeast for a crash cake
First, you need a fair amount of speculation in order to extend a market in a large enough way to make it "crashable." We obviously had that in 1987. Once you say that we had enough speculation in 1987 and compare that with today, it's clear to me that we have enough speculation now and then some. If we just look at the P/E of the S&P 500, it's about the same now as then.
However, the earnings quality is arguably far lower and less stable (i.e., earnings are potentially overstated today, thanks to compensation in the form of options not being expensed). In addition, I could list a whole host of speculative ideas that today sport multibillion-dollar market caps, whereas back then, by my observation, speculative ideas were still measured in the multimillions.
Structures that make dislocation possible
Then, more important than speculation, and the instability caused by it, you need a structure that is crashable. That was really the key in 1987. We had a structure called portfolio insurance that caused people who might ordinarily be inclined to sell not to sell. As long as the market didn't drop by a certain pre-established amount, they all just sat on their hands.
When the market started to drop by the predescribed amount, say 3% to 8%, they all sold (via their money manager) at the same time, and that's how you had everybody pounding the exits all at once. We experienced speculation, but the structure was more important than the speculation.
We can't know if today's structure is more crashable than 1987's. We know we've got 8,000 hedge funds, plus or minus, most of which have hair-trigger fingers. We know we've got 7,000 or 8,000 mutual funds, most of which will allow redemptions on a phone call -- which, to me, makes the structure more crashable.
Back in 1987, we did not have as much mutual-fund money in the market. A lot of money was run by dinosaur types like I used to be, managing individual accounts. Today, much more money is being managed more or less anonymously as OPM (other people's money), which causes higher levels of risk-taking.
Importantly, I also think that because of the market declines of the last couple years (before the recent 15-month rally), we've established a predisposition for people to cut their losses if the market heads down again -- something that wasn't present during the 2000-2003 market decline. People now know that stocks can go down, and go down a long way, so the precondition potentially exists for them to exercise their right to the 1-800-GET-ME-OUT phone call.
Lastly, in the structure department, we have trillions of dollars of derivatives, of which we have no knowledge of how they might work in a market meltdown. As a subset to that, we also have dynamic hedging on Wall Street, which might (again, unknowable) make the market more crashable. So, I would say we have more speculation now, but we had a structure in 1987 that was almost guaranteed to precipitate a crash. Whether today’s structure is powerful enough to trigger a dislocation or not is perhaps debatable.
What would the catalysts be?
Finally, you need a catalyst. Here I think the catalyst is far more powerful now than it was in 1987. I was managing money in 1987, and because of the climate I have described, I believed a crash was possible, which was a pretty radical thought back then. At that time, we had an inflation problem building, a belief that the Fed was behind the curve and a falling dollar. The fact that the dollar appeared to be breaking in an uncontrolled manner to the downside in October 1987 was the catalyst that allowed the speculation and the structure to create the implosion we saw.
Today, we not only have a Fed that is behind the curve, but, far more ominously, the Fed is trapped and unable to rescue the market. It's a variation of the theme I talked about recently in a speech I gave in New York (posted on my subscription site, fleckensteincapital.com) -- that the next time we see a downturn in the economy or the stock market, folks will realize that the Fed can't save them. If folks realize that the Fed can't save the day, that the stock market and economy are "on their own," and potentially heading south, that could easily foment panic.
The other potential catalyst now, as in 1987: The dollar is (potentially) coming unstuck, and foreigners could pressure the dollar, or, in other ways, get folks so sensitized to the macro problems that exist that they'd want to sell stocks, at roughly the same time. Most people do not realize that the decline in the dollar over the last two years has been bigger than the drop leading up to Oct. 19, 1987.
My gut feeling -- though there is no way for me to quantify it -- is that probability of a crash at some point in the next six months to a year is far higher now than in 1987. One subjective reason is that I just don't think it's possible for all the thousands of hedge funds and hundreds of thousands or millions of people who think they're talented enough to outwit the stock market -- and who believe they can play this game of speculating in an overvalued, dangerous stock market -- to get out whole.
My belief in the perversity of markets leads me to conclude that after 10 years or more of folks getting away with whatever they wanted, Mr. Market might just be ready to take some folks' money. What comes to mind are put sellers, who, euphemistically, win 99 times in a row but on the 100th time get wiped out. That's my vision of the stock market eventually taking back a lot of the paper wealth that's been created.
Yeah, but what can I do about it?
To sum up, just because the risks may be higher than "normal" does not mean that I think a crash-like event will happen. To believe that something would happen, you'd have to believe that the probabilities were at least over 50% and probably bordering on 75% or 80%. And obviously, just because the probabilities of an event may be higher than normal also does not mean that an event will happen.
Personally, as I often note, I am short stocks (mostly tech stocks), own gold and silver (as well as gold and silver mining stocks) and foreign currencies. I understand the risks I take, and I constantly monitor and adjust my positions as needed.
(Editor’s note: A small investor can buy FDIC-insured certificates of deposit denominated in foreign currencies from Everbank in St. Louis.)
Ultimately, you need to determine what’s appropriate based on your tolerance for risk and your own outlook. But to conclude that it's business as usual, i.e., a dislocation is an extraordinarily low-probability event, is liable to be costly.
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