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An Internet reader wants to know why I think the odds of a stock-market crash have risen so sharply in recent months. A fair question.... and the answer, I think, is akin to why a small rowboat will tip over when everybody in it sits to one side.... namely, it is unbalanced.
My primary measure of "balance" is the valuation and yield of stocks in relation to historical norms and the competing yield on "risk-free" investments such as money-market funds. Stocks can remain overvalued for long periods of time, as they did in the late 1960s, but such long periods of overvalue generally do not exceed 30% to 35% of overvaluation. From these levels, bear markets can begin, but crashes seldom occur. But, in my judgement, once the level of overvalue climbs above 35%, the odds of a future stock-market crash begin to rise sharply, until they "max out" at about 60% of overvaluation.... that is, greater levels of overvalue will not appreciably add to the already-high odds that a crash will occur.
Even though I make it sound mathematical, this is really judgmental.... the level of overvalue is merely an attempt to measure a psychological extreme, the extent to which a "feeding frenzy" has taken place, and to what extent everybody is leaning to one side of the boat. By comparison, stocks were about 60% overvaued at the peak prior to the 1929 Crash, just as they are today; about 55% overvalued prior to the 1987 Crash, and 45% overvalued prior to the 1989 minicrash (a crash which was, in my opinion, aborted by the so-called "circuit breakers").
But what is mathematical is a powerful trend that statisticians call "regression to the mean"; namely, if stocks have yielded an inftation-adjusted return of about 5% for the past 100 years, that unless the structure of American society changes drastically, they are likely to do so in the future, and the double-digit returns of the past decade-plus are an anomaly awaiting correction.
Crashes will occur when the feeding frenzy has been so extreme that a shift in opinion by only a small percentage of the players results in a large change in price. The 1987 Crash quickly dropped prices to "fair value" with less than 3% in value of stocks on the New York Stock Exchange traded.... suddenly, the sellers accustomed to high prices could no longer get them, the buyers waited for prices to go even lower, and the previous buyers who had bought at high prices (the "bagholders") instantly turned into sellers wanting to bail out before their losses became larger. (Should you think that this is impossible in the current market, go back and look at the trading of technology stocks on July 18, 1995.)
Automation has also made crashes more likely because it has speeded up the rate at which people can panic.... or more accurately, act on their panic.... and the speed at which modern crashes can occur only feeds the level of panic. The 1929 Crash really stretched out over two weeks; first, the professionals panicked, with the public panic arriving the following week. The 1987 Crash took place mostly over two days, with the public panicking over the weekend prior to the crash, and acting on that panic through electronic transfers of funds.
One of the subjective measures of the extremes to which a feeding frenzy has gone is the level of complacency preceding the crash. You will hear a lot of "this time it's really different", or, "there are no bears to be found", or "it's a perfect world (for investing)". At the monthly PIG meetings I've made no secret of my feeling that stocks are likely to crash. One of the professors said, if they do, the Federal Reserve will step in with liquidity, just as it did in 1987, and stocks will soon recover, so a crash is no big deal.... and this from an economist. Now, that's complacency!
Lately there have been proposals to enlarge the ranges of the "circuit breakers", those levels at which program trading is suspended or at which the stock markets are shut down. I have previously said that a future stock market crash would more likely be a complete shutdown because of the circuit breakers; if they are changed, a future crash will instead look more like 1987, where the markets remained open but liquidity disappeared. The difference is about the same as the difference between death by electrocution or poisoning; the outcome is the same. When all the money managers decide, at once, to be the first out the door before the decline hits, the panic will be upon us and stocks will freefall; will it really matter whether or not you can trade them?
First, we have a general rule here; never buy the first release of anything, because it's likely to be "buggy". Second, we have a major investment in our existing PC software and insufficient people to go around upgrading all our PCs, so they are likely to be replaced by attrition.... that is, as they become obsolete. Third, our PCs talk to mainframes, and the mainframe manufacturer is much slower updating its software than are the makers of PC software. For example, my office PC uses two flavors of networking software, one for talking to mainframes and the other for managing communications hubs, and it will probably be at least a year before I see releases of these programs that are Windows 95-compatible.
So, I can see Windows 95 being very popular when shipped with new PCs packaged with compatible applications software, but I think the corporate world, and the public, may drag its collective feet in upgrading existing systems. And if the sales of Windows 95 and related software do not meet analysts' expectations, then for the technology stocks (and maybe for the market as a whole).... watch out below!
Japan's central bank has been facing similar criticism for being "too tight" with money and allowing its M2 money supply to remain stagnant. Though Japan appears to have been "pushing on a string", as our Federal Reserve tried to do in the 1930s, modern theory says that if you push a little harder, and pump enough fresh money into the pipeline, M2 will rise and the economy will recover.
So Japan's central bank has decided to do just that.... and one thing is guaranteed: that the purchasing power of the yen will decline. Will this allow debts to be paid back with cheaper yen, thereby abating the debt liquidation, and put Japan back on the path to recovery? Currency debasement has always been the politicians' first response to getting out of an economic pickle; reviews of past performances (such as Weimar Germany) are not promising. But who knows, maybe this time it will be done "right", and it will work. The Japanese sure hope so.
No, I cannot guarantee that the ultimate top won't be a little higher, but you are really pushing your luck if you try to ride this tulipmanic, near-parabolic rise any longer. In case I have not made myself clear, let me say it again:
** MESSAGE TO EVERYBODY.... GET OUT OF STOCKS NOW. **
If you are comfortable with short-selling, you may go short now, either directly or by buying your favorite long-term stock or index put options.
Finally, the stock market appears to be putting in a top, and we are still awaiting the official "Timer's Trend" sell signal. But the 10% signal was good enough for me, because it showed a loss of momentum from the near-parabolic feeding frenzy. Will the official sell signal, as in 1987, come in late August, leading to a crash in October? Time will tell.
I did some wholesale cleaning out (selling) of my portfolio in July. Interestingly enough, the prices at which I sold my holdings were, for the most part, lower than the valuations shown in my end-of-May brokerage statement. Only those stocks which were in the Dow or other averages had moved higher. My July brokerage statement shows a negative (net short) portfolio value. Unusual.
Notice to Internet readers: To date, there is no adequate Macintosh software tool available that will allow me to "convert" the portfolios printed in the paper version of The Contrarian's View (which are actually spreadsheet tables in a word processor) into something that can be viewed by a World Wide Web browser. Consequently, they are omitted here; just the summaries and commentary follow.
A. "Hedger's Delight" - real portfolio, includes commissions:
SUMMARY - "Hedger's Delight" :
Original cost: $10,455.77
Present value: $ 5,559.31
Increase: $-4,896.46 [-46.83%]
Yield: $ 22.00 [0.21%]
The performance of this portfolio from January 1987 to the present (adjusted for the dilutive effect of added cash) is -45.44%, for a compound annual rate of return of -6.79%.
B. "Present and Future Income" - real portfolio, includes commissions:
SUMMARY - "Present and Future Income" :
Original cost: $ 9,548.98
Present value: $12,229.49
Increase: $ 2,680.51 [28.07%]
Yield $ 114.25 [0.96%]
The performance of this portfolio from January 1987 to the present (adjusted for the dilutive effect of added cash) is +43.31%, for a compound annual rate of return of 4.28%.
C. "Crapshooter's Folly" - real portfolio, includes commissions:
SUMMARY - "Crapshooter's Folly" :
Original cost: $10,817.13
Present value: $16,695.86
Increase: $ 5,878.73 [54.35%]
Yield $ .00 [0.00%]
The performance of this portfolio from January 1987 to the present (adjusted for the dilutive effect of added cash) is +70.07%, for a compound annual rate of return of 6.37%.
D. "Professors' Investment Group (PIG)" - investment club portfolio.
SUMMARY - "PIG" :
Original cost: $ 3,374.94
Present value: $ 3,653.69
Increase: 278.75 [7.63%]
COMMENT on "PIG" :
COMMENT on "PIG": The professors neglected to buy the shares of USData I mentioned last month. (The treasurer didn't hear the vote.) Just as well, as far as I am concerned. For their next purchase, the professors have decided on about $200 worth of NewVision $6/1999 warrants.... in spite of my warning that the value of warrants can go to zero, and then they expire. Speculation, anyone?
Original (1983-86) cost: $ 8,326.19
Present value: $20,020.55
Increase: $11,694.36 [140.45%]
Current yield: $ 886.19 [4.49%]
The performance of this portfolio (including its predecessors) from January 1, 1987 to the present is +82.55%, for a compound annual rate of return of 7.25%.
I am considering selling the Berkshire Gas shares, and sufficient shares of New Germany Fund to recoup my original investment.
F. CREF Pension plan; I switch between indexed stock/bond/money funds:
Date Sold Bought
13Mar92 stock @ 56.65 MM @ 13.41
29Apr92 MM @ 13.48 bond @ 31.19
19Jun92 bond @ 32.14 MM @ 13.55
29Jun92 MM @ 13.57 stock @ 56.74
24Jul92 stock @ 56.76 MM @ 13.61
29Oct92 MM @ 13.72 stock @ 58.61
23Dec92 stock @ 61.48 MM @ 13.78
16Jan95 MM @ 14.83 equity-index @ 26.44
20Jan95 eq-index @ 26.19 MM @ 14.84
Values, 40Jul95: stock, 83.82; MM, 15.33
Gain, 1988: 18.91%; 1989: 14.48%; 1990: 8.28%; 1991: 27.93%; 1992: 10.20%; 1993: 3.08%; 1994: 4.07%
Gain, January 1 through March 31, 1995: 0.48%
Total gain since January 1, 1988 (7.25 years): 124.01%
Compound annual rate of return: 11.77% (My long-term target: in excess of 15%)
Gain shown excludes the impact of additional monthly cash contributions.
Buying CREF stock on January 1, 1988 and holding it gained 138.24%, for a compound annual rate of return of 12.72%.
COMMENT on "Timer's Trend" : We're still on the March 14 buy signal, but now out of stocks while waiting for the formal "Timer's Trend" sell signal.
{, } = "Timer's Trend" (4% and 10% exponential) SELL ({) or BUY (}) signal
=============================TIMER'S TREND===========================
Tue 25 Jul 95 . | . # | 4714.45 | . + *
Wed 26 Jul 95 . | . # | 4707.06 | . + *
Thu 27 Jul 95 . | . # | 4732.77 | . + *
Fri 28 Jul 95 . | .# | 4715.51 | . + *
Mon 31 Jul 95 . | .# | 4708.47 | . + *
Tue 32 Jul 95 . | # | 4700.37 | . + *
Wed 33 Jul 95 . | . # | 4690.15 | . + *
Thu 34 Jul 95 . | .# | 4701.42 | . + *
Fri 35 Jul 95 . | . # | 4683.46 | . + *
Mon 38 Jul 95 . | .# | 4693.32 | . + *
Tue 39 Jul 95 . | .# | 4693.32 | . + *
Wed 40 Jul 95 . | .# | 4671.49 | . + *
=====================================================================
[, ] = 4% exponential change unconfirmed by 10% exponential (not a signal).
@ = market overbought or oversold. I or & (on baseline) = 10% exponential SELL.