Another October Stock Market Surprise?

By: Andy_Sutton

I have been asked countless times in the past month why it is that share markets seem to have a difficult time navigating the autumn months. Obviously, there is a healthy amount of fear regarding the next 29 days, as the memories of last year are still firmly intact. Yesterday’s 203-point drop in the Dow Jones Industrials Average has done nothing more than rekindle those sour memories. While the question ‘Why October?’ is largely rhetorical in nature, we can certainly take a look at history for some potential causes for the blowups.

Not helping our prospects for avoiding another October surprise is the fact that almost nothing has been done to rectify the underlying problems facing the US economy. Plenty has been spent to bailout various enterprises, but until a healthy, unsubsidized demand for goods and services exists at the consumer level, we will continue to spin our wheels. A fantastic example is the cash for clunkers program. The massive infusion of subsidies did manage to increase auto sales, but now that the program has ended, we’re heading right back to where we were before. This is evidenced by Ford’s US auto sales immediately dropping 5.1% after C4C was terminated.

The Panic of 1819

The panic of 1819 was the first stoic example of the boom-bust cycle in the nascent United States.  Oddly enough, this panic, and the crisis in which we are currently embroiled have striking similarities even though they occurred nearly 200 years apart. For starters, the panic of 1819 was a direct result of internal factors rather than external ones. Occasionally, a crisis in a nation can happen because of someone else’s doing. This one was mainly due to the rampant spread of private bank notes of varying quality and value thanks to runaway inflation caused by borrowing for the War of 1812. Oddly enough, the panic of 1819 resulted in many of the same things we are seeing today: foreclosures, unemployment, bank failures, and significant slowdowns in both agriculture and manufacturing activity. This crisis is important because it is the country’s first example of a homegrown crisis and really determined the anatomy of many subsequent events. Essentially what happened was a boom of sorts, which resulted in malinvestment, financial and economic dislocations, and the decay of underlying fundamentals followed by a severe correction of the imbalances to restore economic and financial order.

However, there was another interesting twist in many of these early panics, and it had to do with our money itself. One of the characteristics of early banks in the US was to offer paper bills that were redeemable for specie (metallic) money. Redeemability was a huge factor in the confidence in the paper bills. Unfortunately, analogous to today’s Fed, these early banks had the propensity to print and circulate bills far in excess of the amount of specie they had on deposit making them susceptible to bank runs. Many of the early panics in the new United States were caused because banks got greedy and overstepped their boundaries. Sound familiar? The more things change, the more they stay the same. Unfortunately, when these bank runs occurred, the banks would merely run to the government who made the rather foolish decision to suspend specie payments on bank notes, effectively ripping off the holders of the bank notes. Incidentally, as a result of the panic of 1819, unemployment in Philadelphia, for example, reached near 90% and almost 2000 workers were put into debtors prisons. In addition, displaced and unemployed workers lived in tents outside the city. I am sure this irony is not lost on anyone who has seen some of the tent cities around America as a result of runaway foreclosures.

The important point underlying many of the panics of the 19th century was the fact that they were rooted in the monetary system and/or the economy in general. This paradigm shifted with the advent of share markets and the panics oftentimes transitioned from monetary and economic panics to stock market crashes and then to a hybrid situation from 1929 through the start of World War II.

The Crash of 1929 – October 24-29, 1929

I am not going to rewrite the chronology and factors surrounding the Great Depression. For anyone who is interested, they can Click Here to read an article entitled ‘Anatomy of a Disaster’ from last fall. This crash was the first well-defined example of a stock market crash and a significant economic contraction happening simultaneously. Not surprisingly, this is where the history books usually get it wrong. They oftentimes assert that the market crash caused the Great Depression. Nothing could be further from the truth. The economic boom of the roaring 1920’s had run its course leaving (as in prior examples) financial and economic dislocations, overleveraged consumers, and a general feeling the boom would last forever. The mountain started shaking in the summer of 1929 and by autumn, panic gripped the markets resulting in a 2-day 23% sell-off in the DJIA. By the middle of November 1929, the DJIA had lost 40% of its value. What happened next is crucial to understanding what is happening right now. The market then made a valiant attempt to rally, bringing back many investors from the sidelines as the Dow mounted a furious charge into 1930. However, the rally didn’t stick, conditions worsened, and by the time 1932 rolled around, the venerable index had lost 89% of its value. It would take 25 years for the Dow to recover that lost value in nominal terms. If you think this cannot happen again, then you are incredibly naïve.

The Crash of 1987 – October 14th - 19th, 1987

In financial folklore, the crash of 1987 is one of those events that cannot generally be explained since there were no obvious dislocations. P/E ratios were high, but not extreme, investors were not grossly overleveraged, and the economy was comparatively healthy. There have been many theories about financial raiders cashing in on the sudden decline, and given what we’ve seen recently, the idea of someone triggering a crash for their own benefit doesn’t seem too far out of the realm of possibility. The interesting thing about the 1987 event was the recovery time. On a percentage basis, the loss was massive – 31% in 5 days for the DJIA. Yet it took just a tad under two years for the index to fully recover in nominal terms.

What was rather poignant about the ’87 crash was the response. This was the event that gave rise to the shadowy President’s Group on Working Markets, lovingly referred to as the Plunge Protection Team. In addition, various circuit breakers were placed in the markets to halt trading if certain conditions were met:

After the invocation of trading curbs and the President’s Working Group, investors seemed to be lulled into a sense that the markets could never again drop significantly. That has certainly not been the case, and in case anyone is counting, the events are becoming larger and closer together. In 1997 and 1998 we had the Asian crisis and the Russian default, followed by Long Term Capital Management. The new century was ushered in by a vicious bear market thanks largely to overvalued Internet stocks. That bear market ended in 2003 and was followed by a steep nominal recovery in share prices only to see markets fall apart once again after the late 2007 top.

In summation, given everything we know about the underlying economic fundamentals, and the nature of bear market rallies; it certainly won’t be much of a surprise if we have another horrendous October. And if the first day is any indication, it could be a long month.

By Andy Sutton
http://www.my2centsonline.com

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. His firm, Sutton & Associates, LLC currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar. For more information visit www.suttonfinance.net

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