Monday, October 22, 2012

25 years ago, on another Monday in late October, the financial world seemed to disintegrate in a heartbeat. Though the 205 point drop in the Dow last Friday (the technical anniversary of the 87 Crash) was somewhat reminiscent of its 108-point drop on Friday, October 16, 1987, the real action in 87 was on the Monday that followed. And while this Monday is not nearly as black, it is important that we use the opportunity to recall the circumstances that nearly sent the stock market into cardiac arrest.

While there were technical reasons that allowed the snowball to gather so much mass, it was major economic problems that started it rolling. Those issues remain to this day, but have grown much, much larger. But while they terrified the market 25 years ago, they dont rate a second look today. Whether investors have gotten wise, or merely oblivious, is the question we should be asking.

Though most simply remember the 1987 Crash as one panicked selling day, Black Monday was just the largest drop in a string of bad days. On the Wednesday before, the Dow sold off 95 points (then a record) and dropped another 58 points on the Thursday. On Friday the selling got worse, with the Dow setting another record with a 108 point drop. After thinking about it over the weekend, investors decided to preserve what remained of their gains by selling on Monday. Unfortunately, everyone got the same idea at the same time.

It is true that the Crash was in some ways a technical phenomenon. As of August of 1987, stocks had surged 75% from January 1986, and 40% from January 1987. After such an upswing, it was inevitable that investors were on edge. Rather than taking profits, many on Wall Street instead hedged their positions using the new, and largely untested, trading programs that were designed to put a floor under losses if the markets turned south. But when the selling came in waves, the machines went into overdrive. Selling begat selling and an automated rout ensued. When the dust settled, the Dow was down 22% in a single day.

If that was all there was to the story, we would be left with a neat cautionary tale about the folly of placing too much faith in machines. But that is a distracting sideshow. In truth, the market was spooked by concerns over international trade and government debt, which then became known as the twin deficits. After widening earlier in the 80s, investors had hoped that these gaps would come under control. But as Ronald Reagans second term wore on, those hopes faded.

From 1982 to 1986, the U.S. trade deficit had expanded 475% from $24 billion to $138 billion. Most economists blamed the trend on the dollar gains in the early 1980s, which had apparently made U.S. products uncompetitive. As it was assumed that a weakened dollar would solve the problem, in 1985 the leading western democracies and Japan announced the Plaza Accords to systematically push down the dollar against the Japanese yen and the Deutsche mark. By 1987, the plan had succeeded devaluing the dollar 51% against the yen. But by the second half of that year it became apparent that the Plaza Accord had failed in its real mission to cut down on the U.S. trade deficit. Despite the plunging dollar, the deficit expanded that year by another 10% to $152 billion.

At around that time, the U.S. government budget deficits also became a major concern. Everyone remembers Ronald Reagan as a small government champion, but many conveniently forget that he presided over a significant expansion in government spending. Federal deficits rose 199% from 1980 ($74 billion) to 1986 ($221 billion). Although the deficit came down to $150 billion in 1987, many were frustrated that it remained stubbornly high by historic standards.

As early as August of 1987, concern over the twin deficits, which together accounted for 6.4% of the nations $4.76 trillion GDP became critical. Given the prior run up in stocks, this was enough to convince many investors to head towards the exits. Before Black Monday (October 19), the Dow had already declined 18% from its August peak.

When we look back at those events from the current perspective, it almost seems comical. Government deficits now approach $1.5 trillion annually and annual trade deficits exceed $500 billion. Todays twin deficits now add up to more than 13% of current GDP (twice the level of 1987). But todays investors are largely untroubled. Oftentimes news of a falling dollar and wider deficits will spark a stock rally, and the issues barely rate a mention in a presidential debate.

Are investors today simply more sophisticated than they were then? Have they lost an irrational fear of deficits? To the contrary, I believe that we have arrived at a point where money printing and government stimulus has replaced manufacturing and private sector productivity as the foundation of our economy (see my lead commentary in the October 2012 edition of the Euro Pacific Global Investor Newsletter for more on this). As a result, most investors are now blind to the dangers of deficits. But that does not mean that they dont exist.

When Americas creditors wake up, particularly those foreign governments now shouldering the lions share of the burden, concerns over our twin deficits will return with a vengeance. As the problems now loom larger than ever, so too will the economic and market implications when the issues come to a head. Interest rates will surge and the dollar will fall. But the U.S. economy is not nearly as well equipped as in 1987 to withstand the stresses. Given the relative size of our imbalances, the manner in which they are being financed, and the diminished state of our manufacturing sector, higher interest rates and a weaker dollar will exact a much greater toll.

Despite this, I do not believe that the stock market is as vulnerable to another Black Monday. With the Federal Reserve so committed to its current course of quantitative easing, it seems to me unlikely that they will allow such a steep one-day drop. Also, with bond yields so low, domestic investors are currently presented with fewer attractive options. If anything, the next Black Monday is more likely to occur in the currency and/or bond markets, with safe haven flows moving into gold not treasuries.

Peter Schiffs new book, The Real Crash: Americas Coming Bankruptcy How to Save Yourself and Your Country is now available. Order your copy today.

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