Business & Investments

Article by John Reizner

The time at which most people believe a significant stock market correction will occur – whether because of interest rates, war, budget or trade deficits, excessive public and/or private debt, or events in China (or some other reason) -may actually be a time when it is less likely to happen. I have discussed this aspect of market psychology in my article, Stock Market Investing and the Power of Contrary Opinion.

The public has generally been conditioned to buy stocks on the dip when the stock market swoons. This has happened several times: in 1987, 1989, 1998, and recently in February 2007. There was great fear during this most recent swoon, which importantly occurred with terrible breadth and on NYSE volume of approximately 2.3 billion shares traded; but the market has sharply rebounded, at least so far. A significant break from the “buy on the dip” psychology could prove to be dangerous to the long investor, as the market could experience cascading selling waves. I realize that the latter point may appear unsubstantiated at first glance, but there is precedent for it in stock market and economic history.

When the crash of 1987 occurred, the market fell over 20% in one day. Pessimism was rife that a severe economic downturn would follow and that the stock market might follow the path of the last great crash that began on October 29, 1929, known as Black Thursday. The latter occurred on record volume and was followed by further brutal declines despite measures to stem it. After the crash of 1929, policy makers kept credit conditions tight to prevent a return to stock market speculation, restraining the ability of the market and the economy to resume a steady path. Restrictive trade legislation was also added to isolationist trade policy enacted in the 1920s, extending the life of the Depression that followed the crash.

After the 1987 crash, however, the calm demeanor of President Reagan prevailed when he stated that as long as consumers kept on buying refrigerators and such items, that we would weather the stock market storm. Reagan also did not panic and seek to implement legislation of poor policy measures such as the sort of protectionist trade legislation passed during the Great Depression. Further, Fed Chairman Alan Greenspan made the resources of the Fed available to the markets by promising liquidity. Bonds rallied strongly in a flight to safety, and in time, the stock market recovered and went to new highs.

The thing that troubles me about the February 27, 2007 market break is not only the high volume, terrible breadth, and sharpness of the fall, but also the sharpness of the snapback rally in its aftermath. It was reported that some market participants were hoping for a continuation, a washout of the speculation in recent stock prices after February 27th- a further decline. It is known that our market break followed the abrupt fall in the Shanghai market, which has also snapped back in the near term.

I believe in our case and perhaps as likely in the Shanghai market, the snapback may indicate an unsupported speculative fever underlying the markets. In the month or so before Black Thursday in 1929, the market fell but the speculators kept on pushing the market. When market selling finally took over, it was relentless. It may be a bit of stab to say that the two periods bear a resemblance, but the form of the speculative fever is can be compared.

But I will say that in my view the odds of a stock market panic have increased due to the widespread participation of the public in equities, as has happened in prior speculations. Also, hedge funds, for example, have created a culture among many money managers and some investors of short term and ultra short term investment time horizons. Together, these conditions may contribute to high market volatility.

One respected stock market money manager has overlaid our recent market period on the 1995-1999 period and has stated that the two times are quite similar. Both times experienced a trend of rising interest rates that paused the markets. The post 1995 period faced the prospect and in turn the reality of Federal Reserve Board cuts, as we may have now. These cuts, if they occur, according to this money manager, may propel the stock market significantly higher with technology leading the way as did the rate cuts after 1995.

In my article titled Inflation and the Stock Market: Does Anyone Remember the Seventies? I write of the possibility of an end to the benign disinflation we have experienced for over two decades. The prospect of increasing inflation may be the grinch that steals Christmas from the above mentioned money manager’s argument of sharply increasing prices for equities.

As I state in that article, increasing inflation may not permit the Fed to cut its rates. Yet, on the other hand, policymakers’ legislation in reaction to the problem of subprime mortgage defaults may result in a recession. As one subprime lender has stated on financial television, if policymakers “throw the baby out with the bath water,” we will be in danger of overkill. Should the subprime situation turn into a widespread debacle, which is in my view unlikely, then I believe it would be incumbent on the Fed Chairman to lower interest rates. It would be better if some of our legislators had benefited from a study of our economic and stock market history, and thus gained insight into our markets today.

Yet, in terms of the probability of an actual market-wide panic, we all now have the advantage of insight into the 1929 and other more recent stock market panics, and Federal Reserve Chairman Bernanke has studied the 1929 period and its causes carefully. Thankfully, I imagine he is determined as our Fed Chairman not to repeat the mistakes of that awful time in our history should the stock market suffer a serious blow.

This article contains the opinions and ideas of its author and is designed to provide useful general information to the reader on the subject matter covered. The author may or may not have current positions in the investments mentioned in this work, and the author may from time to time make investments in a manner that is not described here. Past investment performance is no guarantee or prediction of future results and any investments made, based on the opinions and ideas contained in this work, may or may not be successful. The strategies contained herein may not be suitable for every investor or situation, and the author is not engaged in, and should not be construed to be, rendering legal, accounting, investment advisory or other professional services to the reader or any other person. Readers should consult their own advisers for advice particular to their individual circumstances.

About the Author

John Reizner was first exposed to financial markets when he started reading the stock quotes out of the newspaper to his businessman grandfather, who was legally blind, when he was about ten. His current e-book, A Way to Wealth – the Art of Investing in Common Stocks, is available at his website, http://www.ReiznersWay.com

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