By
Peter Schiff
:
Twenty five ye ars 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
don't 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 80's, investors had hoped that these gaps
would come under control. But as Ronald Reagan's second term wore
on, those hopes faded.
From 1982 to 1986, the U.S. trade deficit had expanded475% fro m
$24 billion to $138 billion. Most economists blamed the trend on
the dollar gains in the early 1980's, which had apparently made
U.S. products uncompetitive. As it was assumed that a weakened
dollar would solve the problem, in 1985 th e 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 nation's $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.
Today's twin deficits now add up to more than 13% of current GDP
(twice the level of 1987). But today's 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 don't exist.
When America's creditors wake up, particularly those foreign
governments now shouldering the lion's 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.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
See also
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Returns
on seekingalpha.com