Again in 1989, I raised the possibility of another stock-market crash, unbelievable with less than two years having elapsed since the 1987 Crash... investors' memories can be so short sometimes.... and this was fulfilled by the October 1989 minicrash when the UAL buyout failed. (In 1989, the "circuit breakers" installed since the 1987 Crash did work to some extent, and there was no market meltdown.)
And why do I see the possibility that another stock market crash might happen later this year (or maybe sometime in 1996)? Because I see the prerequisites for one falling into place. And some of these prerequisites are:
A hostile Federal Reserve. The Federal Reserve has been raising interest rates since October 1993, and the pressures for it to keep raising rates.... namely, a booming economy, inflation in the pipeline, and a weak dollar.... remain in place. Yet stocks (excluding very interest-rate-sensitive ones, which have correspondingly tanked) have ignored the Fed's tightening in their rush to all-time highs (for the weighted averages).
Compare this to other pre-crash periods: In late 1928, the Federal Reserve began tightening, and short-term interest rates peaked at almost 20% in the spring of 1929, but stocks kept soaring into September 1929. Both in 1987 and 1989, stock prices continued to rise as interest rates climbed. In 1987, it took 10% short-term rates and a touch of dollar mismanagement to kill of the stock market. 1989 was an oddball year, in which stocks did very well in spite of a hostile Fed and the minicrash; the bear market didn't appear until 1990.
The current blowoff by the Dow very much resembles the April-to-August 1987 blowoff. Most stocks peaked in the spring of 1987, but the Dow had tacked on an additional 16% by late August.... representing, to date, the most extreme divergence of the Dow to the overall market preceding a crash. If we were to take, say, Dow 3950 (from either January 1994 or late 1994) as representative of when most stocks peaked, a similar move in 1995 would carry the Dow to about 4600 before peaking.... a level from which a crash would be a virtual certainty. (Don't look now, but we're more than halfway there.)
Valuation at historical extremes. Stocks.... meaning the investment-fund managers who buy them.... tend to chase earnings. It never seems to occur to these dodos that something might go wrong, and that a company's earnings might not expand at the current rate forever. Usually it is a macroeconomic change.... such as a recession.... that lowers earnings and brings on the waves of disappointment. But it also happens many, many times with individual companies which report lower-than-expected earnings.... and the analysts go off and rewrite their projections.... and the stock prices hit an "air pocket".
The current price-to-earnings ratio of the Dow (about 16) is not greatly different from what it was at the market peaks in 1929, 1968/69, 1987 or 1989; the mistake was in projecting that earnings would expand indefinitely at the current rate.... "permanent prosperity" in 1929, "soft landing" today. (A little quiz: When was the most recent great buying opportunity for stocks? In 1982, when the Dow's P/E was infinite.... that is, the companies were losing money.)
More significant are stock prices in relation to fundamental value.... that is, the assets and earning power of the underlying companies. This is accurately reflected by price-to-book value (more than three times) and dividend yield (about 2.6%), both now at historically extreme levels which have signalled past market peaks.
Terrible technicals. The current rise of the stocks making up the popular averages has most "technicians" scratching their heads. Now I've never been one for using technical indicators as absolutes, because each major market move seems to throw in a new and unanticipated twist that changes the rules. But I do sit up and take notice when I see extreme divergences, because these are invariably characteristic of market peaks. The most extreme divergence currently is in the advance/decline line (for any market; pick one) which, taken by itself, says we are still in a bear market. Essentially, the weakness of this indicator tells us that the "new highs" are being achieved by fewer and fewer stocks; and if you look at the unweighted market averages (such as the Wilshire 5000) you will find they have recovered only to the levels of last summer. In effect, we are being warned that the money managers.... who do not buy "unweighted averages", but buy only stocks in companies big enough to take the influx of cash without driving the stock prices into the stratosphere.... are all concentrating their purchases in the same few companies; and this frequently is a symptom of a market peak.
Another divergence is the behavior of utility stocks (and bonds) which are by no means telling us that the peak in interest rates has been reached; rather, the utilities, which almost always reliably point the way for future moves in interest rates, seem now to be signalling that further increases lie ahead. (The best interpretation you could give is that we are at, but not past, the bottom.) And rising interest rates are not bullish for stocks, although there are times, such as the past few months, when stocks don't seem to pay attention.
I know that many "technicians" who have commendable long-term track records, and who have preserved their clients' assets in downdrafts as well as made money when stocks are climbing (Jim Stack and Marty Zweig immediately come to mind, as well as fundamentalist Geraldine Weiss) have been caught completely flatfooted by the latest market surge. (The track record of your humble servant, the crafty contrarian, is not much better; my portfolios and retirement funds are heavily in cash and becoming more so, and on my recommendation only the young are following the current market surge.) These people have lived through major bear markets and know the devastation they can wreak; can the same be said of the plethora of twentysomething or thirtysomething hotshot fund managers who currently populate the canyons of Wall Street?
There is one major factor in favor of a continuing bull market: demographics (the baby-boomers saving for retirement), which seem to point to higher stock prices to about the year 2005, when the older boomers actually retire and the demand for financial assets will start to decline. But that doesn't mean we can't have some nasty corrections in the meantime, when valuations get out of whack.
The current blowoff bears resemblance to parts of all of the previous major market peaks. In 1929, it was thought that hard times would never happen again; and even after the 1929 Crash, few people had an inkling of the Depression that lay ahead. (Relax; Fibonacci and Elliott-wave theorists to the contrary, I do not feel we are at the cusp of some "grand supercycle". In an era of paper money, world economies are unlikely to fail on a large scale until their governments fail.) I also see a strong resemblance of the current period with 1968/69, when stocks subsequently deflated, then went to sleep for a decade. It seems inconceivable today that people might actually lose interest in stocks and that money would start draining away from stock mutual funds; but my recollection is that this was equally inconceivable in 1968, yet it did happen.
The current period also bears some resemblance to the "Nifty Fifty" period of 1972/73, when institutional buying was concentrated in a small number of "one-decision" blue-chip stocks. (In case you've forgotten, the "one decision" was when to buy, for one would never have to sell. But when the selling finally did come, boy, did those overpriced stocks ever deflate!) The equivalent today is buying those stocks picked by computers as undervalued on a relative basis, or chasing momentum, or doing whatever else the computers predict will make money; but the sum of these strategies favors putting money into the large-cap stocks, the kind that make up the Dow and the weighted market averages.
But the strongest resemblance I see to the current period is the blowoff in the Dow that occurred from April to August 1987, preceding the 1987 Crash. (How quickly we forget!) This does not mean that a crash is inevitable, but the odds of a crash rise sharply when such a large divergence takes place, simply because "the market" has further to fall to reach fair value when the inevitable correction does arrive; and, because the paper profits which disappear are correspondingly larger, people are more prone to panic in the plunge.
Currently "fair value" for stocks is about DJIA 2800; which means that, ultimately, either short-term interest rates will decline, or stocks will decline, for the risk/reward ratios of stocks versus cash to return to equilibrium. The current 53% overvaluation of stocks (a similar level of overvalue preceded the 1987 Crash) will not persist forever. But, as in 1987, it would be foolhardy of me to predict to just what extreme the herd can inflate stock prices before the market runs out of gas, and the (in my opinion) bear market reasserts itself.
What the history of prior crashes does tell us is that the market is unlikely to peak one day, then tumble into the abyss the next. Typically, we don't enter "crash country" until the averages have declined about 15% from their peaks; then there will be enough disillusioned investors, wanting to get out at any price, to panic. So my "crash watch" is very early, still too early to assess the odds of one happening.... but I'll keep tabs on it.
If and when a "crash" does come, it is unlikely to look like prior crashes because of the so-called "circuit breakers" that have been installed to keep the computers from melting the market down. My own opinion is that if enough people are panicking, the collars are unlikely to make much difference; the markets will simply close, according to the formulas, as the number of now-illiquid investors who are panicked rises exponentially. No matter how unpleasant 1987 was for you, at least you could sell out at the very bottom if you wanted to, because the markets were open. I doubt that any "cooling-off" period created by forcing the markets closed would be so; more likely, John Q. Public would be exceedingly unhappy that he was allowed to buy stocks as they were going up.... maybe even at the peak.... but now was prohibited from selling as prices tumbled.... and market closure would only serve to increase the level of panic. And (unlike 1987) such a change in the rules of the game could cause investors to abandon their mutual funds (what's left of them) and bring on a long period of stagnant or declining stock prices.
But my own opinion is merely that we are watching the herd instinct at work. Success breeds success.... up to a point.... and rising stock prices attract ever more new investment funds in a self-reinforcing spiral, until finally the flow of money slows, then stops.
I'm not very good at predicting when a mania will finally wind down; being a cautious soul, too many times I have been trampled by the herd in its mad dash forward. But I would urge you, like me, not to be lulled by the siren song of those who declare, "Don't worry; there is no cliff ahead of us".... because there is.