Five Years After The Crash, Wall Street and Main Street Again Seem : Out of Touch
Five years ago this week the great stock market crash of 1987 reverberated around the globe, setting off an economic . . . non-event.
If history had kept to Wall Street’s tearful script, a serious recession--or even a 1930s-style Depression--should immediately have followed the unprecedented 508.00-point, 23% plunge in the Dow Jones industrial average to 1,738.74 that Monday, Oct. 19.
As eminent investment strategist John D. Connolly mourned to a Times reporter that panicked afternoon: “What we have is an economic crisis of international proportions.”
What we had, in fact, was a case of Wall Street projecting its own irrational, computer-powered mood swings onto the population as a whole. Stocks lost nearly a quarter of their value in just six hours, but to the average uninvested American viewing the relatively robust economy of the time, things seemed quite OK nonetheless.
And in 1988 and 1989, as the economy continued to expand, the stock market fully recovered its 1987 losses--ultimately accepting that the crash was an embarrassing case of Wall Street being totally out of touch with Main Street reality.
Five years later, the great irony is that Wall Street again seems dangerously out of sync with the true mood of the country. But this time the situation is reversed. While the majority of Americans view the economy as seriously depressed and the future as foreboding, stock prices overall remain near historic highs.
If consumers are an accurate barometer once more, the stock market must come down, say Wall Street’s bears. Their bullish counterparts argue the opposite, that Americans’ mood will soon improve to match stocks’ optimism.
One side or the other absolutely has to give, because this split is defying the maxim that in the long run “the stock market is supposed to be a reflection of the growth of the economy,” notes Andrew Midler, manager of the $4.4-billion Fidelity Growth & Income stock mutual fund in Boston.
Since the recession that began with Iraq’s grab of Kuwait in August, 1990, the consumer confidence index compiled by the Conference Board research firm in New York has plunged from 101.7 to 56.4 as of September--indicating a national confidence level only half that of the benchmark year of 1985.
As the presidential election campaign has so well magnified, many Americans are convinced that the economy is mired in a severe state of slow- or no-growth that threatens their jobs and their children’s future prosperity.
Investors, however, have refused to accept the gloomy outlook projected by average consumers. Financial markets’ attitude toward the economy since the Gulf War ended in winter, 1991, has been one of seemingly infinite patience: Stock prices have soared based solely on the expectation that robust economic growth will soon resume--and with it, higher corporate profits.
The Dow Jones industrial average, at 3,174.41 now, is down 7% from its all-time high of 3,413.21 set in June. But it still is 21% higher than at the end of 1990 and 46% higher than at the end of 1988.
Meanwhile, though corporate profits have improved this year from 1991’s recession levels, they still are below 1988 levels as measured by earnings of the blue-chip Standard & Poor’s 500 companies.
The result of this divergence between stock prices and underlying profits is that the S&P; index now is valued at a lofty 18 times its expected 1992 earnings per share. Historically, each time that price-to-earnings ratio reaches 18, it then falls back in one of two ways: Either earnings rocket, or stock prices plunge.
Charles Allmon, whose Chevy Chase, Md.-based investment firm Growth Stock Outlook Inc. manages $350 million for clients, believes that investors’ patience with the earnings side of the equation is about to run out. Sometime in 1993, he says, Wall Street will realize that consumers have it right--that the debt-burdened U.S. economy will grow meagerly at best for the next several years, and likewise corporate profits.
That will be true no matter who is President, Allmon argues, because the government’s power to influence the economy is limited by the massive $4-trillion federal debt.
The slow economy “is finally going to wear investors down,” Allmon says. As they lose hope about significant profit and dividend growth in their companies, they will become sellers of stocks instead of buyers, he says--ultimately driving the Dow index to as low as 1,500, a 50% drop from here.
What are Allmon’s credentials? At age 71, he has seen plenty of market cycles. But it’s also worth noting that he has been bearish since just before the 1987 crash. While he got his clients out of the market ahead of the crash, he missed the huge profits in the 1988-89 rally that followed.
In contrast, many other investors who stayed in stocks during the crash or re-entered the market afterward have profited handsomely. That experience appears largely responsible for Wall Street’s steadfast patience with stocks over the last two years despite the morose economy: Investors have come to believe that any severe drop in stocks is a buying opportunity--because since 1987, all have been.
In effect, investors’ constant vigil over a repeat of the Oct. 19, 1987, collapse has virtually guaranteed that it can’t happen, many analysts say. That was demonstrated again on Oct. 5, when a new flash of worry about the economy kicked the Dow down 105 points in the morning. By afternoon, buyers swarmed back into the market, and the Dow closed off a mere 21 points for the day.
“Everyone has the crash in the back of their minds,” says Bryan White at Newport Beach-based Collins Associates, a major adviser to institutional investors.
Managers of large pension funds, for example, can be divided into two camps, White says. “The ones who stayed in the market (since ‘87) are running pension surpluses. The ones who got out are being forced to add more money to their funds,” he says, because by forsaking stocks they lost out on the appreciation needed to keep pace with retirees’ rising benefit requirements.
Yet even as they have been conditioned to buy into any steep market decline, investors large and small also have revealed an increasing unease about being wrong. One measure of that unease is the soaring use of “put” options on individual stocks this year.
A put gives its owner the right to sell a stock to another investor at a set price sometime in the near future. The opposite of a put is a “call,” which is the right to buy a stock at a set price.
For a number of reasons, call options usually predominate. So when the use of puts rises sharply, it’s a sign that more investors are convinced the market is about to dive. By using puts, investors can bet outright on a market decline or hedge their portfolios against the losses they’d incur in a decline.
The Cincinnati-based Investment Research Institute, which tracks option trading, says the put-to-call ratio on individual stock options at the Chicago Board Options Exchange now is 64%--meaning there are 64 puts outstanding per 100 calls. That ratio has risen consistently all year, and at the current level is the highest since it hit 68% in October, 1990.
There is a certain irony to this barometer of investors’ caution, however, because put volume is frequently a contrary indicator: Investors often flock into puts just as the market is about to rally.
In fact, Allmon and other bears don’t contest the idea that a big market rally may lie immediately ahead, perhaps in pure relief at the election’s conclusion, no matter who wins. After one last hurrah, however, Allmon sees the “politics of disillusionment” emerging to rule the stock market in 1993. The realization will hit hard, he says, that there is no quick fix for the economy, nothing to spark the kind of profit growth that Wall Street demands.
The great surprise in all of this, Allmon says, is that investors will come to recognize the bear only gradually--and after it’s too late. While many investors have protected themselves against a rapid market decline through short-term options and futures hedging games, those techniques are of little use against a sustained, old-fashion kind of bear market, says Charles Biderman, a Santa Rosa, Calif., investment adviser who publishes a newsletter called Market Trim Tabs.
“I see it as a long bear market, lasting a couple of years,” Biderman says, with the Dow losing 33% to 66% of its value.
To those who say it can’t happen, Biderman merely points to Japan’s devastating market decline, a classic bear market that will be 3 years old on Jan. 1. Since Dec. 31, 1989, Tokyo’s Nikkei stock index has lost more than half its value, from 38,916 then to 17,369 now, in a decline that has mostly been orderly but relentless.
The underlying cause of Japan’s slide has been an erosion of investor confidence in the future, analysts note--which is exactly what U.S. consumer confidence statistics seem to be telegraphing here.
How do the stock market’s bulls reply to the bear case? Forget the Tokyo comparisons, they say, because Japan was a “bubble” economy that burst; asset values in the United States never reached the same inflated levels, they note.
The bulls’ major argument against a sustained bear market, however, is simply the belief that the economy will indeed improve in 1993, and with it consumer confidence.
“We know the election is going to be behind us soon,” says Roger Engemann, whose Pasadena-based Engemann & Associates is a major growth-stock investor. “It’s time to roll,” he says, noting that both consumers and businesses have spent much of the last two years paying down debt and bolstering their finances.
J. Richard Walton, chief investment officer at brokerage Wertheim Schroder Investment Services in New York, offers another reason why the bear case may be overblown: If slow economic growth means low interest rates as well, stocks will continue to win by default, he says.
Aging baby boomers have no choice but to invest now for their retirement and their children’s education, Walton notes. So far this year, stock mutual funds alone have attracted $49.4 billion in new investment, already surpassing last year’s full-year record of $38.3 billion. Much of that comes in via 401(k) plans and other retirement plans that didn’t exist even five years ago.
Though as consumers they may feel lousy about the future, as investors many individuals understand that the stock market offers the highest returns of any investment over the long run, Walton says. For that reason, he says, “I think a lot of people are going to keep averaging-in to stocks,” buying on a regular basis regardless of the market’s gyrations--just as they’ve been doing since the 1987 crash.
Charles Allmon doesn’t argue with that strategy. He believes that the Dow will reach 6,000 by the year 2000, rewarding investors who take the long view.
The problem, he says, is that “there’s a Grand Canyon between here and 6,000” in the form of a long bear market--one that will probably do to most investors what all bear markets have done before, which is drive them out in agony at exactly the time they should be buying.
Five Years Later, A New Crash: This Time, It’s Confidence
Do consumers see the future more clearly than Wall Street pros? In 1987, while stocks plummeted confidence in the economy remained high--foretelling a fast market recovery. Now the situation is reversed: Confidence has plunged, but stocks haven’t followed.
Source: Conference Board
While Some Investors Bet On Another Fast Market Drop. . .
A rising volume of stock “put” options this year illustrates investor bearishness. Put options are bets on falling stock prices; call options are bets on rising prices. So a higher ratio of puts to calls indicates more investors expect a market decline.
Source: Investment Research Institute
