The Ghosts of October 19

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The Ghosts of October 19
By Mark Skousen

Certain dates stand out in my life. One is October 19, 1987, the day the Dow Jones Industrial Average suddenly collapsed by 22%. That day is also significant because it happened to be my 40th birthday. Ever since then, I've been known as the "crash baby."

Most of my broker friends and investors were in a somber mood that Monday evening, stunned by the 509 point drop in the Dow. I was ebullient because by some fortune I sent out a "flash alert" on September 8, 1987, six weeks before the crash, telling my subscribers: "The coming credit squeeze could devastate the stock and bond markets; get out now! I advise you to sell all stocks and long-term growth mutual funds."

That evening, my wife had arranged a surprise birthday party. I had a lot of fun, but the party ended early as friends rushed home to check the financial news overseas.

Was the crash a portend of something more ominous, another Great Depression perhaps? After all, a similar stock market crash occurred in October, 1929, followed by the worst economic collapse in world history.

One of my technical trader friends was deeply worried. His trading system was based on moving averages of stock indexes like the Dow. At the New Orleans investment conference a month later, he showed a chart of the Dow with a "triangle" formation. He pointed to the triangle. "If the Dow breaks below the triangle formation," he warned, "the Dow could fall another 1,000 points or worse!"

I thought it was all a joke, but he was dead serious. He staked his reputation on his prediction. A few days later, the Dow started falling again, ominously below the point of the triangle. Yet, miraculously, the Dow never crashed. In fact, it rallied to new highs. My friend soon ended his newsletter, shamed perhaps by his failure to predict the next Great Depression.

As a macro-economist, I look at the economic fundamentals before making a prediction. And, in the case of the October, 1987, crash, the economic fundamentals looked to me to be largely sound. Business across the nation was doing well, both before and after the crash. The economy was growing, inflation was under control, and interest rates were relatively stable. So while I anticipated short-term trouble, I thought the long-term outlook looked good, and it wasn't long before I started recommending stocks again.

So why did the Dow Jones Industrial Average collapse by 22% on October 19, 1987?

Historians point to several factors, such as comments by the Treasury Secretary about a weak dollar and trade deficit, but I believe the crash can be blamed in large measure on an impulsive "Mr. Market" and the technical traders who encouraged mindless trading based on a line on a chart rather than business fundamentals. Too many investors were listening to my friend with the charts.

In the summer of 1987, telephone-switching between no-load mutual funds was all the rage, based solely on a technical charting system of a 39-week moving average. Mutual fund investing was extremely popular, to the point where you
couldn't go through a meal at home in the evening without a broker calling and telling you about the latest mutual fund. Few investors knew or cared about the companies the fund managers were buying. Just follow the line on a chart showing the mutual funds were moving higher. The brokerage business had become so successful that a book was released that year written by a Merrill Lynch broker entitled No Experience Necessary: Make $100,000 a Year as a Stockbroker (Simon & Schuster, 1987). How? By buying and selling mutual funds.

As a result, the market got way ahead of itself, with everyone following the same charts. Then when the price of the mutual funds went below their 39-week moving averaging, on the Friday before the Monday crash, everyone sold at once. The October 1987 crash was purely a technician's folly, and with the business fundamentals sound, the market quickly recovered within a few weeks.

As we celebrate the 20th anniversary of the 1987 crash, the media has recently asked me repeatedly this question: What factors could cause the stock market to collapse again? Or are we immune to another financial disaster?

Here is my answer: There are several potential financial crises out there that could cause the market to suddenly turn south. At the beginning of this year, I attended the American Economic Association meetings in Chicago, where I was fortunate to attend a luncheon with Fed chairman Ben Bernanke. He wouldn't take questions about current Fed policy, including interest rates, but he spoke volumes when he gave his formal talk to us at the luncheon. Ostensibly, the topic was "Central Banking and Bank Supervision in the United States," but reading between the lines, it was clear to see that Bernanke was worried about a financial storm ahead.

In his speech, he used the terms "crisis," "risk," "panic," "threats," "stress," and similar words at least 36 times.

Bernanke said that the Fed has set up a "crisis center" to handle potential global financial problems - to anticipate them, and to deal with them if they occur. What are the possibilities?

* A dollar collapse, like the one Paul Volcker suggested would happen in the next few years. (We're certainly moving in this direction.)
* A non-dollar currency crisis in Asia, Europe or Latin America (shades of the 1997 Asian currency crisis).
* A housing crash and foreclosure crisis (we suffered one this summer).
* A major terrorist attack on a financial center, such as New York, London or Tokyo.
* A sharp unexpected rise in inflation.

Bernanke revealed the various policy measures the Fed might take in response to a crisis: buying government bonds, providing overdrafts and other short-term credits to banks, facilitating currency swaps (to boost the dollar), and "securities lending," that is, lending money to institutions to buy stocks.

In sum, the answer is always the same: inject liquidity into the system to keep the stock market from collapsing. So far it's worked like a charm. Alan Greenspan applied this bailout policy several times during his 19-year tenure -- during the 1987 crash, and 1997 Asian currency crisis, the Y2K computer threat, and the 2001 terrorist attacks. (His new book "The Age of Turbulence" addresses all these events in detail.)

Bernanke had his first test this past summer with the mortgage credit crunch. The world's markets were on the verge of collapse on August 18 when the Fed intervened...by injecting liquidity.

But what if the same old medicine stops working, and the Fed injects liquidity, but the dollar and the stock markets keep on falling? There's only one protection: buy gold! And buy the products gold will buy. And that raises the specter of hoarding and the collapse of the world monetary system. And that leads to social unrest and...the institution of new emergency powers by the Federal government.