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REMEMBERING
BLACK MONDAY
Q
& A with Robert Prechter
President, Elliott
Wave International's
October 24, 2007
What is your most vivid memory
of Black Monday?
The best story I read about at the
time was about the guy who left New York by plane with the market
down 200 points. He landed in L.A. and called nervously to ask
about the market. He was told, “It’s down five-oh-eight.” He
said, “Oh, man, that’s great: down only five points.” Then
the answer came back: “No, five hundred and eight.”
One-day crashes of 10% or more are
relatively rare -- just four in Dow history. Interestingly, they
don't seem to be triggered by an exogenous event, such as a war or
an assassination. What do you think causes these big downdrafts?
You’re
right: News is not the reason for crashes. The market’s trends
derive from the mood of the investing herd, which trends and
reverses according to its own internal dynamics. Aside from brief
emotional reactions to news, the stock market, as R.N. Elliott,
John Maynard Keynes and Alan Greenspan all put it, moves according
to “waves of optimism and pessimism.” Rising optimism in
society causes uptrends in stock prices, and rising pessimism
causes downtrends. Most people think that outside events make the
public’s mood fluctuate, but I think it’s an endogenous
process. Mood changes cause price changes. My paper--co-authored
with a colleague--called “The Financial/Economic Dichotomy” in
the latest issue of The Journal of Behavioral Finance
presents a theory to support this idea.
What causes
crashes?
When
optimism is stretched to an extreme, the market is vulnerable to a
crash.
Is
leverage an important factor?
Sure,
but the widespread use of leverage is the product of optimism.
Psychology leads to leverage, extensive credit, overvaluation, the
seeming low utility of cash, the seeming irrelevance of dividends,
liquid markets for junk mortgages, and financial news on TV.
Most
people find it hard to accept that news is not the cause.
The
mortgage market crashed on no news whatsoever and no change in the
fundamentals. The optimism that sustained it simply melted.
That’s how it happens. That’s why crashes surprise people.
What, in
particular, caused the Black Monday crash in 1987?
In
the traditional understanding of causality, there was no cause.
There was no bad news, no shocking event, and no clouds on the
horizon from an economic standpoint. That’s why so many
investors were bullish at the time. All they saw were reasons for
the market to go up.
After being
bullish for five years, you and your subscribers got out of the
market just before the Crash of 1987. What were the most important
warning signs of a market drop?
The
answer is exactly the same as to the previous question. Those were
the warning signs.
Please
elaborate.
The
set-up for a crash is extreme optimism and complacency, which in
turn produces a background of good news, peaceful times and
seeming stability. These conditions were in place in 1987. That
summer, the Dow’s dividend payout dropped to below 1929’s
level for three months. Low dividend payout indicates optimism
because it means that investors are relying only on capital gains
to make their investments pay off. Among advisors there had been
more bulls than bears for three straight years. When there are few
bears to balance the market, there’s a vacuum underneath. Those
are the conditions that led to the two-week crash from October 6
to October 20.
Is there
any reason to believe that improvements in technology or in risk
management, or the involvement of more different investors, make
such an extreme crash less likely today than it was 20 years ago?
On
the contrary, all the fancy credit and investment structures in
place today, and the spread of investment fever to the broad
population, are consistent with a time of extreme optimism.
Therefore they are consistent with pre-crash conditions.
How
accurately can crashes be predicted?
If
I knew, I wouldn’t have called half a dozen crashes that
didn’t happen!
Can a crash
be predicted using wave analysis?
Trends
and turns can be predicted with some reliability, but it is rarely
possible to comment on whether a wave will unfold slowly or
rapidly. Certain specific junctures in corrective waves are prone
to crashes, such as in 1937 and 1962. Those that come right off a
top, such as in 1929 and 1987, seem to occur after extended fifth
waves, in other words, when the final move up in a bull market is
especially long. But timing that juncture can be elusive to say
the least.
Is it
possible to look at the charts and call a crash for the following
day with some kind of certainty, or can we merely identify moments
of relatively high probability of a crash?
It’s
always a matter of probability, and crashes are so rare that even
when you see likely conditions, the chances of them actually
leading to a crash at the time are slim.
What
determines whether a crash turns out to be a correction (albeit a
very violent one in the case of 1987), or the start of something
very much worse (as in 1929)?
The
determinant is whether it occurs in wave A or C. The crash of 1929
was within wave A, the first wave of a correction. That of 1987
was in wave C, the last wave in a correction. But I say that with
the advantage of hindsight. In real time it’s nearly impossible
to tell. In fact, the 1987 crash was so violent that I thought it
was a repeat of 1929. Turns out it was more like the panic of
1926, a precursor to the last leg up.
Most people
would say the response of the Fed is crucial.
When
it comes to interest rates, the Fed is irrelevant. All it does is
adjust its rates to those set by the market. If you plot the yield
on T-bills against the discount rate, you will see that the former
leads the latter. That’s why the ½-point drop in the discount
rate last month was easy to predict. The T-bill yield had already
dropped a full point, and the Fed follows the market. Despite all
the rhetoric about it, the Fed has not kept rates artificially
low, just as it did not make them soar in the 1970s. The market
sets the rates, and the Fed follows. Greenspan said exactly that
on TV last month, and the charts confirm it.
How
important is the response of the Fed in terms of supplying
liquidity and thereby saving the stock market?
When
the Fed engages in a large volume of repos, it helps banks on the
margin avoid immediate disaster. But in doing so, it also delays
the inevitable price adjustments and gives bankers a false sense
of security, thus encouraging them to create more and more unsound
loans. In the end, all this manipulation merely increases both the
likelihood of a crash and the size of the decline. But you have to
realize that the Fed and the banks could not get away with such
activities in the absence of optimism. Society in recent years has
had a voracious appetite for credit, and the Fed is merely helping
the banking system provide it.
So
the central banks won’t stop the decline?
All
they do is make things worse. They aren’t so much printing cash
as offering credit. IOUs are not money; they’re IOUs. When the
reversal occurs, few will want to borrow. If the central banks
make conscious decisions to destroy their currencies, that will be
a different matter. But nothing, not even hyperinflation, can save
the purchasing power of stock shares. That bull market
ended in 1999, and today, the Dow buys less than half of the
commodities and real money (gold) that it did then, despite the
nominal new high. This is a bear market almost no one sees.
Finally,
are there any clear danger signals at present indicating a coming
crash in the stock market?
Let’s
start with the fact that the probability of a major bear market is
unquestionably the highest in history. Just to give you some
perspective: At the 1987 high, the Dow’s dividend yield had been
below that of 1929 for three months; it’s now been below it for 13
years. At the peak in 1987, there had been only 3 readings at
or above 90 percent bulls among stock traders on the Daily
Sentiment Index; in recent months there have been 51 such
readings. Today’s price-to-book value ratio for the Dow is three
times as high as it was in 1987 and 1929. And these are tops.
Forget about comparing today’s values to market bottoms. So
yeah, I would say there’s risk of a crash, too.
Conditions
seem pretty good now.
As
with all major tops, the economy is expanding, times are fairly
peaceful and investors are complacent. Those are top conditions,
not reasons to relax.
When Long-Term
Capital imploded, bankers got together and saved it.
They
can succeed in isolated incidents, but not in system-wide crashes.
I just read that big banks are building a super-fund to keep the
mortgage and securities markets from falling. But such
assurances—-contrary to the popular view—-are very bearish.
Banks did the same thing in October 1929. And guess what. It
didn’t work. They got pummeled.
Is
that what will happen again?
Let’s
put it this way: With optimism at a record in both duration and
extent, with an unprecedented breadth of public participation,
with record leverage in the investment markets, with a grotesquely
bloated debt structure, and with cracks appearing in the credit
markets beginning with sub-prime mortgages, I think the storm
cellar is a good place to camp for awhile. Put your money in the
safest cash equivalents you can find, ideally outside the banking
system, and hibernate. When stocks and property become bargains
again, you can venture back into the markets. But investing at
today’s valuations is not prudent.
What do you
think might trigger the next crash?
When
this wave of sustained optimism reaches a point of exhaustion, the
trend in prices will reverse. That’s all there is to it. But its
duration is already unprecedented by multiples, so the timing of
the next crash will probably surprise me, too.
© 2007 Elliott Wave
International, Inc.
Archived
Editorials
Robert
R. Prechter, Jr., CMT, began his professional career in 1975 as a
Technical Market Specialist with the Merrill Lynch Market Analysis
Department in New York. He has been publishing The Elliott Wave
Theorist, a monthly forecasting publication, since 1979.
Currently he is president of Elliott Wave International, which publishes
analysis of global stock, bond, currency, metals and energy markets. Mr.
Prechter has been a frequent guest
expert on Financial Sense Newshour.
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