Rational Advisor

By Standard & Poor’s reckoning, the bull market celebrated its fifth anniversary this week. The lowest point touched by the S&P 500 after the tech bubble blew up came on October 9, 2002. It has been on an up trend ever since.

The same applies to the Morgan Stanley Capital International World index, which covers the world’s developed markets, and which troughed on the same day.

It seems like nothing fazes the equity markets these days, not even October, the month that brought us the memorable crashes of 1929, 1987 and one or two others. They are quick to rally on the flimsiest of favourable news and eager to discount any signs of trouble.

It’s as if the August meltdown never happened, and the U.S. housing crisis, subprime mortgage disaster and continuing global credit crunch were just figments of borrowers’ overactive imaginations.

Could it be that investors are stirring happy pills into their morning coffee?

It’s no coincidence that the recent turnaround began right after the Fed slashed interest rates last month, just weeks after the Fed, the Bank of Canada and other central banks poured money into the financial system to fend off the credit crisis.

Just pour piles of money into the financial system, slash interest rates by half a percent and the bears are all trampled to death. All that money in a few hands is powerful and it doesn’t take much to power the markets higher through buy programs, futures, ETFs and other derivatives.

Both the MSCI World and Emerging Market equity indices struck lifetime peaks, while Wall Street also set new records

However, it was Asia that enjoyed the lion’s share of gains as investors remained convinced that strong growth in the region would offset any slowdown in the US.

Hong Kong has been one of the strongest performers it has been the chief beneficiary of funds from mainland Chinese investors following Beijing’s relaxation of investment rules. On August 20th, Beijing said that Chinese retail investors and other investors could purchase Chinese shares through Hong Kong.

This market almost seems to be gloating. You throw everything at us and we’re already back setting new highs.” But that’s what happens when central banks pour in liquidity and punters become convinced that the bailouts will keep coming if the financial system smashes into any more icebergs.

But volumes have been down so I know there is not a lot behind this.

That means it would not take much to send stocks spinning the other way and quickly drive out such non-economic players as the quantitative funds that base their bets on trading data and other technical factors.

Certainly profits are weakening. The credit crisis is still there, but has been pushed into the background. The housing market is a mess. The consumer is tapping his credit cards as a last defense.

Plenty of people have lost their shirts betting against the remarkably resilient U.S. consumer, whose continued free spending is all that stands between continued slow U.S. growth and an outright recession.

For instance, half of U.S. states report that sales tax revenues are falling short of expectations, a sure indicator that higher mortgage costs, falling house values and uncertain job prospects are restraining consumers.

There is also a range of rather less joyous anniversaries this month

On Friday, October 19, brings the 20th anniversary of Black Monday, the worst day in the history of the developed world’s stock markets. On that day alone, the Dow Jones Industrial Average fell 22.6 per cent, its worst single day.

Wait another week for an even more inauspicious anniversary. On Monday, October 28, 1929, the Dow fell 13.5 per cent. The next day it fell a further 11.7 per cent. This was the Wall Street Crash that would usher in the global Great Depression.

And the 10th anniversary of the worst day of the 1997 Asia Crisis, which finally hit the US and Europe on October 27, 1997, is also almost upon us. That day, the New York Stock Exchange was forced to close early by the weight of selling, although it soon recovered.

The biggest dive in terms of points on the Toronto Stock Excvhange came on Wednesday, Oct. 25, 2000, when the index fell 840.26 points in a day as the tech bubble burst, while the Toronto market fell more than 10 per cent on Oct. 19, 1987.

Four of the 10 biggest single-day point drops for the Toronto index came in October, none in September. And the mother of all bad days on the markets, Black Tuesday, came on Oct. 28, 1929, when the Dow fell 12.8 per cent.

The results of such dramatic declines can vary. After the crash of 1929, the Federal Reserve responded by tightening monetary policy. The result was an economic disaster.

But in 1987, and again in the late 1990s, the Fed reacted by easing monetary policy, and the markets went on to new heights.

Also, true turning points can be difficult to spot. Black Monday changed investor psychology, but it did not blow the economy off course. Meanwhile, there was no single dramatic day in March 2000 to signal that the tech bubble had at last burst. That realization dawned over a matter of months.
There was also little ballyhoo in October 2002 when, it now turns out, the new bull market took life.

In combination with the realization that the current “up” or bull cycle has now lasted 60 months, while the average for the 12 post-war bull markets as measured by S&P is only 56 months, the raft of nostalgia for big market crashes can only help to unnerve investors.

It is hard to find too many similarities with the horrors of the worst Octobers past, but world markets do show some disquieting tendencies.

Interest is focusing on particular sectors and stocks that are showing positive momentum. That suggests investors are herding into stocks that are already moving forward.

This is a dangerous business and can lead to sudden falls as soon as investors decide it is time to jump off. Market advances are becoming narrower, with fewer big stocks leading the forward motion. Advancers are increasingly outnumbered by decliners in the major indices.

In the options market, investors are showing an abnormally strong preference for “put” options - which confer the right to sell at a given price and hence act as insurance against a market crash - rather than “call” options, which allow you to buy at a certain price.

But the most worrisome examples are in the Asia-Pacific region, particularly Hong Kong. Whatever the case for the underlying economies in the region, the growth in their stock markets in recent weeks is unnaturally fast and plainly driven by flows of money. Most alarmingly, Hong Kong’s Hang Seng has
gained 46 per cent in less than two months, since Chinese authorities cleared the way for domestic retail investors to invest there.

A comparison of the Shanghai Composite over the last 16 months with the NASDAQ Composite in the 16 months leading up to the bursting of the tech bubble in March 2000, is cause for alarm. The two charts are similar, except that Shanghai has accelerated even more.

The odds of a meltdown probably are low, but they’re not so remote that investors shouldn’t be maintaining liquidity. Giddy markets should inspire caution. And the markets — as they were in 1987 — are giddy now.

We believe that the disconnect between stock prices and fundamentals will self-correct over time.

While the markets have rebounded from earlier lows, it’s important to understand that volatility is a normal part of investing. Long-term investors go through many ups and downs over the years. The successful ones are those that filter out the day-to-day fluctuations and focus on the things they can control, including their emotions.

Rational

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