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Some Thoughts on a Great Market Crash
by Robert B. Gordon, Sc. D.
March 6, 2004

The stock markets of the world ring a bell at the close of trading that determines prices until the next trading day. The last price on each security holds for all the shares of that stock until the exchange opens for another trading day. Most trading days end with little price changes and excitement on the trading floor. Big news events can effect specific stock prices for a while. Major stock crashes occur infrequently and usually without warning. The last crash in the New York stock exchange occurred in October 1987 and struck with little or no warning. I have been reading very few crash predictions until I happened to read the words of Martin Goldberg who kindly agreed to my bringing them to your attention.

Please read his warning words and then go to my next paragraph where we will discuss the vulnerability of various asset classes to a crash and what changes if any need to be made in your portfolio. All the words in the next section are those of Martin Goldberg taken from his 12/04/2003 article in FSO.

IS YOUR PORTFOLIO VULNERABLE TO A SEVERE CRASH?

Could the Stock Market Crash? Everyone Says 'No.'

Congratulations to the traders who rode this market rally up from what Larry Kudlow refers to as "the mother of all bottoms." The rally appears to be in full bloom and stockowners are happy. Any one suggesting that a crash is possible would be dismissed as a nut case. Yet that’s exactly what I am going to suggest in this article...

Once again, nobody cares that stock investing consists of owning shares in businesses. No one cares that any purchase of a business should be viewed as an investment, and should provide earnings, growth prospects, and dividends to justify the purchase. Today’s market is speculative and prices are being determined purely by happy feelings and emotions. There is a gigantic discrepancy between intrinsic values of most companies’ stocks and their stock market prices. In many companies, wealth continues to be transferred from its shareholders to its management via stock options and share buybacks of stock market-overpriced businesses. Shareholders don’t have a clue or even care. At the margin where prices are being determined, shareholders are not shareholders at all. Consider two of the top performing stocks of this year, Cisco and Amazon.com. An average share of Cisco changes ownership every 5 months or so, and the average share of Amazon.com changes hands every month! Imagine any company that is under new ownership every month! Under these "hot-potato" share-trading schemes promoted by Wall Street and practiced by many well respected money managers, would the shareholders care about the long-term prospects of the company? Of course not. Most are only trying to roll triple hearts at the slot machine.

I believed that throughout this rally, the stock market has had the potential to crash. It hasn’t yet, but when the market does crash, it may crash in a devastating manner. You should consider the question of, "If the market goes down, HOW would it go down?" The questions that are explored in the mainstream financial media, TV, and Internet, deal with IF and WHEN the stock market can go down. They rarely explore the question of, HOW it may go down? How far, how fast, how devastating? The dumbed-down public does not consider this question because in their collective minds, we have already seen the answers to these questions in the stock market from March of 2000 to October of 2002. The answers in their minds are VERY far, PRETTY fast, and by in large, NOT TOO devastating. By in large, they think we are now in a new bull market.

But the facts are that the market is valued similarly to October 1929, Wall Street chicanery is at peak levels, consumer debt is at record levels, corporate debt is at record levels, the dollar is plunging, and the trade deficit is rising along with the Federal budget deficit. The Federal budget deficit doesn’t scare any one any more. Why? The public remembers how it was extinguished in the late ‘90s. They are thinking, "No problem. If it was paid off before, we can do it again". What very few people think about is the fact that the elimination of the deficit was largely a result of capital gains taxes that the government enjoyed from the late 90s stock market bubble. They don’t see this as an, (aha’ hem), "one-time event". The current Federal budget deficit can only be extinguished again if we can manage to create a bigger stock market bubble than before. My money says it can’t. In the absence of another stock market bubble we will have to pay the money back. This will have to be achieved through the sweat equity of our children and us or from inflation, which will dilute (reduce) our wealth.

Every casual stock market participant is now bullish. Everyone KNOWS that the stock market is going up. Greenspan will continue to keep any crash from happening. Corporate management will continue with the positive press releases that "beat-by-a-penny", and are "better-than-expected". Mark Haynes, and Joe Kernan will continue to joke, and Sue Herrera will continue to smile. Stimulus-induced government economic data will continue to be positive (yet unsustainable). William O’Neil will continue to tout the speculative favorites in spite of irrational valuations, and Investors Business Daily (IBD) followers will continue to bid these stocks up. Merrill Lynch and others will continue to issue analyst upgrades, and the public will continue to listen to them and gap up these stocks. In short, the game will continue! (Nasty but truthful e-mails from Wall Street analysts about suspect companies will not continue though!)

Overvaluation, chicanery, and everybody thinking alike suggest to me that all the ingredients for a stock market crash are in place. The only thing missing is the catalyst, and there are a variety of potential ones on the horizon. The risk (of a crash) greatly outweighs the marginal gains that can be made at this point.

What most people are thinking is typified in the Charles Schwab commercials:

"The market has changed and this time we’re going to change with it."

I think Schwab’s use of "change" is code language for knowing that the rally will end and Schwab investors should know when to bale out when they see market weakness. There is a serious risk that this will not be possible, though. Almost every one is thinking the same thing at the same time. When the time to exit arrives, the hatch may be too small to let the public out in time. There is every reason to believe that a crash may ensue.

There are additional reasons for a crash such as an overactive public. Momentum investing has never been more popular with the public than it is now. Chat boards are once again ablaze with the number of postings from the "lunatic fringe". Momentum-based IBD has raised the price of its Monday issue (with the "IBD 100") to $2.00. There is a 2-hour radio call in show here in Philadelphia on a station catering to the elderly that consists of mostly momentum-based stock trading. The radio program also promotes a $15/month web site, where "investors" can get stock tips that "make money" from a local stock personality (with a New York accent). I’ve noted similar radio programs elsewhere. Now there is a TV commercial where an actor appearing as a typical citizen complains, "All the ideas I give to my broker, he should be paying me!" The Yahoo! Finance home page is loaded with momentum-based technical analysis articles. New mutual funds are once again starting up. Once again CNBC plays at the local bistros. The game has become easy again.

More reasons a crash can occur: Visions of 1929 and 2000. Margin debt is again on the rise as it was in 1929 and 2000. It rose to $26 billion in July. This debt, which is secured by the stock shares purchased on margin, represents additional potential energy in fueling a crash. Just curious. I wonder how many shares of insider’s stock were sold to buyers who were using margin? There’s a lot of insider selling and negligible insider buying. (Of course, all of these insiders are simultaneously trying to diversify their personal portfolio holdings. What a coincidence!)

The NASDAQ is like a shark. If it stops swimming, it will suffocate. Without any resemblance to fair deal valuation, the primary reason people are buying and are long the NASDAQ is simply because its going up (swimming). Once the NASDAQ stops going up, there will be no reason to buy and/or hold these stocks. The shark will suffocate. (So far the shark has devoured many value-minded stubborn short sellers. It’s been like the first hour of Jaws, so mind your stop losses.)

Finally, additional fuel for a rapid stock market crash may be provided by the potential public outrage from scandals involving mutual fund crime. So far no one cares about such trivia because after all, everyone is getting rich "on paper" in the stock market. When the market changes, everyone will be outraged. Remember Enron?

All this smells like fish to me. The public and its short memory are being set up again!

In summary, the stock market is set up in a similar manner as in 1929; however unlike 1929, most people have 2000 fresh in their minds. A lot of people all thinking the same thing at the same time. It’s a formula for a devastating crash. Remember what legendary trader Jessie Livermore said in the 1930s:

"The biggest stock market gains are made by the public on paper…and that’s where they stay."

FROM DOW 10,500 TO DOW 500

Robert Prechter has been steadfast, since writing his great book At the Crest of the Tidal Wave, that the Dow will eventually fall below 1000 and then below 500. If one accepts this prediction, does it really matter if the drop in prices occurs in one huge drop or in one long, slow process? In my view, it will matter greatly in the ultimate amount of money lost by experienced investors and the general public.

The history of other major bear markets has shown that typical small investors are extremely reluctant to sell shares in a falling market. Apparently this is based on their assumption that "paper" losses are not real and the losses can be retrieved by a hoped-for general rally in the market. Eventually, in a long bear market with few sizable rallies, small investors do finally sell their shares as a new bottom is forming at very low volume.

The leaders on the down side in a huge bear market crash will be the popular, highly priced favorite stocks held by the public and popular mutual funds. The panic selling will eventually shift to higher quality dividend paying stocks that will be sold to preserve capital by better informed investors. At some point in the selling, stock markets may be closed but this move might actually cause a negative impact and increase selling when the market reopens.

WHICH STOCKS AND FUNDS ARE MOST VULNERABLE IN A CRASH?

Selling will start in the most popular industries, e.g. Technology, and spread quickly to the most popular classes of growth mutual funds. Experts and insiders will use their knowledge to get out before the general public becomes aware of the grave situation. Investors in small funds with unusual portfolios such as the Permanent Portfolio fund will have far fewer redemption calls than the typical large growth funds. Dr. Hussman’s two hedged funds will get their first test in a declining market. My guess is that they will do quite well and gain in popularity.

Many U.S. Treasury and foreign government bond funds of short to intermediate maturity would be expected to do well as will some of the better managed 60% bond 40% stock income funds. Short funds will do very well in the crash and many more investors will learn the reasons why smart investors use them. It’s difficult to predict what some of the volatile asset classes like energy and precious metals will do. But one fact will clearly emerge. Large, sensibly diversified portfolios holding stable assets classes will survive in good shape and will enjoy the acclaim of serious investors. It is even possible that mutual fund ads will start to advertise their new category of "stable" funds.

SELL ALL THE WEAK PERFORMERS IN YOUR PORTFOLIO

If you are a new reader, read the last half dozen essays in my FSO archive. The next leg down in this bear market could start at any time.  Old readers know that I personally prefer to own a large, well diversified portfolio based on selected stable asset classes. But it is possible to do it with five or less asset classes as shown in recent essays.

Buy a fully managed short fund just to get used to its price behavior in different markets. BEARX is the oldest and best. Buy it now and add more as you feel comfortable with it. It will soon become your best friend in a down market.

Start weaning yourself from your broker/advisor. Free yourself from your loaded funds. Future changes in the fund industry may eventually eliminate the sales charges that tie investors to one fund family. You will never regret it. Build a small stable portfolio right now and add to it as you can. This bear market may very well last for the rest of your life.

If you are stuck in the mud and need help, send me an e-mail.

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© 2004 Robert B. Gordon, Sc. D.
Dr, Gordon's Editorial Archive

Note: Quotation used with permission from Martin Goldberg,
weekly contributor to Financial Sense's Market WrapUp.

Robert B. Gordon, Sc. D.
Sun City West, Arizona
March 6, 2004
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