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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
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 expanded 475%from $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 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 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.
Peter Schiff is the CEO
and Chief Global Strategist
of Euro Pacific Capital, best-selling author and host of syndicated
Peter Schiff Show.
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