Video: Marc Faber on the Parallels of 1987 Stock Market Crash

Dr Marc Faber in a short 90 seconds CNBC interview draws some eerie similarities between events preceding the the Black Monday US stock market crash in 1987 and today. (hat tip zero Hedge)

In my view, incompatible forces between record stocks and a slew of negatives--elevated interest rates, $100 oil prices, a prospective shift in the Fed leadership, exploding debt levels, seemingly confused central banks whom are seemingly caught between the desire for more easing but continues to float the 'taper', parallel universes, increasing signs of struggling economies, government manipulation of statistics (China) and pervading symptoms of 'this time is different' manic outlook by the mainstream--all combines to increase the risks of a substantial downshift in global equity markets. 

Although I am not inclined to see a 1987 scenario, considering that financial markets have been founded on the equivalent of sand castles predicated on central banking steroids and guarantees, such a black swan scenario shouldn't be ruled out.

US Stock Markets: The Incompatibility of Rising Stocks and Rising Bond Yields

Facts do not cease to exist because they are ignored. ― Aldous Huxley, Proper Studies

The seeming irony is that gains in the US financial markets appear to be narrowing down to the stock markets.

As previously explained[1] in 2009-2011, global stock markets, bond markets and commodities synchronically boomed. This broad based Risk ON environment started falling apart as BRICs began to weaken in 2011. This has been followed by swooning commodity prices over the same year.

Recently, market infirmities have spread to the global bond markets and ex-US stock markets.

As US stocks surged Friday due to “strong jobs”, which had been accompanied by a huge spike in bond yields, select American benchmarks such as Canada’s S&P TSX, Brazil’s Bovespa, Mexico’s IPC and Argentina’s Merval index took on the opposite direction[2].

Instead of cheering along with Wall Street, these ex-US American markets seem to be haunted by soaring bond yields.

In the US, rising interest rates seems incompatible with a sustained stock market boom.

I have noted of reactions of the S&P 500 to every incidences of rising 10 year UST yields since the bond bull market began in 1980s.

The Wile E. Coyote Moment

I call rising stock markets, in the face of mounting systemic leverage and rising yields as the Wile E. Coyote moment. When stock markets become objects of rampant and excessive speculation fueled by bubble policies, and whose boom has been financed by leverage, stock markets undergo or endure boom-bust cycles. 

The recent US 2003-2007 bubble cycle should be a noteworthy example. The booming S&P 500 (red) had actually been a symptom of a blossoming mania in the US housing markets. The latter peaked in early 2006. 

Yet the stock market continued its ascent despite increasing signs of cracks in the housing amidst climbing 10 year UST yields (blue line). 

The S&P’s rise has been partly financed by cheap credit as evidenced by the record net margin debt (see below)

Eventually the periphery to the core dynamic via the broadening implosion of the US housing markets slammed the banking system hard. A banking and financial crisis ensued. The S&P got crushed. The one year plus bear market cycle reached its trough in 2009.

Net margin debt (green ellipses) has been in near record territory today as it had been in 2007 and in 2000 or during the dotcom bubble[3]. The two prior episodes of bubble cycles, including today, shares the same characteristic: debt financed stock market boom.

A further implication is that today (or soon) will likely share the similar dynamic as in the past: a forthcoming bubble bust.

When rates of return from speculation are overwhelmed by the cost of servicing margin trading debt, the eventual result is either a margin call or forced liquidations. Boom turns into bust.

I would further add that much of the recent stock market growth has been via stock buybacks which has reached a “record”[4].

And a lot of these buybacks has been financed via the bond markets due to distortions from tax laws and from the allure of easy money, as previously discussed[5]

Rising bond yields will put to test the interdependence of stock markets with the bond markets. 

In the dotcom bubble days[6], again the same dynamic can be seen: rising stocks powered by expanding debt eventually had been terminated by elevated 10 year bond rates.

The dotcom bubble bust bottomed in 2002 two years after the bear market cycle surfaced.

A more interesting case is the Black Monday stock market crash of October 19, 1987[7]. This fateful day occurred just a little over two month after the assumption of Mr. Alan Greenspan as former US Federal Reserve chairman in August of 1987[8]. Mr. Greenspan’s action of cutting down Fed Fund Rates to produce negative real yield became the operating standard of financial market rescues that earned such policy, the moniker of the “Greenspan Put[9]”

Prior to the crash, the S&P soared along with the 10 year UST yield. The end result was a horrific one day 22% crash for the Dow Jones Industrials.

According to an investigative study by the US Federal Reserve on the 1987 crash[10]: (bold mine)

However, the macroeconomic outlook during the months leading up to the crash had become somewhat less certain. Interest rates were rising globally. A growing U.S. trade deficit and decline in the value of the dollar were leading to concerns about inflation and the need for higher interest rates in the U.S. as well

A case of déjà vu?

In short, rising stocks and rising bond yields again signify as a deadly cocktail mix.

Not every incidence of rising yields led to a stock market crash though.

1994 was known for a harrowing bond market crash. 10 year yields fell by more than 200 bps. Because there has hardly been a preceding stock market boom, there was neither a bear market cycle nor a stock market crash. The S&P traded sideways then.

What the bond market crash instead claimed had been Mexico’s Tequila or 1994 economic crisis[11], California’s Orange County bankruptcy[12] and partly the culmination of the Savings & Loans Crisis[13].

Nonetheless the post bond market collapse fuelled a trailblazing run in the stock market.

Finally, the conclusion of the stagflation days of the 1980s ushered in the golden days of US financial asset markets as both bonds and stocks boomed for three and two decades respectively.

When former Fed chief Paul Volcker wrung out inflation in the system by reducing money supply which sent 10 year UST yields to over 15%, the stock markets tanked as the US economy succumbed to a recession.

The S&P rallied by almost 70% from late 1982-84. Unfortunately rising UST yields again took a toll on stock market which went on a brief downside mode. And as 10 year yields fell, the S&P 500 took off.

Lessons of History

As pointed out in last week, we can get some clues from history since cycles are products of people’s short memory.

As English writer Aldous Huxley once wrote in the “Case of Voluntary Ignorance in Collected Essays (1959)”

Most human beings have an almost infinite capacity for taking things for granted. That men do not learn very much from the lessons of history is the most important of all the lessons of history.

Today is different from the past.

Global debt levels are at unprecedented scale and continues to compound. G-4 central bank expansion of balance sheets has gone way past $10 trillion as central bankers turn dovish in the face of rising yields.

Just last week, Mario Draghi, the president of the European Central Bank tossed out his non-committal stance and declared that interest rates would “remain at present or lower levels for an extended period of time” and further signalled a “downward bias” in interest rate. 

Meanwhile, Mark J. Carney’s inaugural act, as governor of the Bank of England was to introduced a supposedly new tool called “forward guidance”. And in an official statement Mr. Carney declared that “any expectations that interest rates would rise soon from their current record low level were misguided”[14]

And like Pavlov’s drooling dogs, steroid starved markets swung heavily to the upside…until the US jobs reports, which offset much of the earlier gains.

In the past, it took a few months for central bankers to weave their magic in tempering bond yields. Now the honeymoon seems to take just a day. UK (left), French (middle) and German (right) 10 Year yield soar along with US yields even as the ECB and BoE says that interest rates are bound to go lower.

The bond vigilantes appear to be in open defiance against central bankers!

One can see how Friday’s bond market rout has affected Europe and the US[15]. Since Europe’s market closed earlier than the US, my guess is that selling pressures in Europe has been subdued as US yields soared at the close of the trading session.

If Asia should carryover the bond market carnage, then it is likely that the meltdown should persist in Europe.

Nevertheless given the oversold conditions a temporary pullback should be expected.

Notice too how bond yields in all American and European has surged strongly over a month.

The lessons of history are that rising yields have largely been incompatible with sustained stock market booms. Both may concomitantly rise but the eventual outcome has been a bear market cycle (2007-2008, dotcom bubble), stock market crash (1987) or a quasi-bear markets (1983-1984 or 1981-1982).

The relationship has hardly been statistical but causal—rising rates eventually prick unsustainable debt financed bubbles.

Yet a stock market boom can be engineered by governments that could destroy historical precedents. Venezuela should be an example. Venezuela’s stock market has been up a stratospheric 160% year to date. This translates to star bound 460% in one and a half years. But Venezuela’s deceiving outperformance comes at a heavy toll: the collapse of her currency the Bolivar which means rising stocks are symptoms of hyperinflation.

Again rioting bond markets as expressed through rising yields (which are indicative of higher policy rates) seems like the proverbial ‘sword of Damocles’[16] which hangs over the heads of the stock markets.

Differently put, unless bond markets stabilize, rising stock markets in the US or elsewhere, looks like an accident waiting to happen.

Risk is high.

Trade with utmost caution.

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[1] See Phisix Meltdown: A Reality Check on the Bullish Dogma June 10, 2013

[2] Yahoo.com Major World Indices

[3] Doug Short NYSE Margin Debt: Was April a Cyclical Peak? June 28, 2013

[4] Businessinsider.com Stock Buyback Announcements Have Gone Parabolic, May 29, 2013

[5] See How Tax Distortions Contribute to the Boom Bust Cycles May 2, 2013

[6] Wikipedia.org Dot-com bubble

[7] Wikipedia.org Black Monday (1987)

[8] Wikipedia.org Alan Greenspan Chairman of the Federal Reserve

[9] Wikipedia.org Greenspan put

[10] Mark Carlson A Brief History of the 1987 Stock Market Crash Board of Finance and economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, November 2006. Pointer from Zero Hedge

[11] Edwin M. Truman The Mexican Peso Crisis: Implications for International Finance US Federal Reserve 1996

[12] New York Times ORANGE COUNTY'S BANKRUPTCY: THE OVERVIEW; Orange County Crisis Jolts Bond Market December 18, 1994

[13] Wikipedia.org Savings and loan crisis

[14] New York Times 2 Central Banks Promise to Keep Rates Low July 4, 2013

[15] Bloomberg, Rates & Bonds

[16] Wikipedia.org Sword of Damocles

Shadows of the 1987 Black Monday Crash?

Bespoke Invest has a spooky chart which tries to paint a parallel of the S&P 500 today with the infamous October 19^th Black Monday crash in 1987, 25 years ago 

To counter or to alleviate the adverse message from such pattern seeking diagram, the Bespoke writes,

While the patterns between 1987 and 2012 are similar, there are two key differences.  First, the S&P 500 was up considerably more at its peak in 1987 (+39%) than it was at the 9/14 peak this year (+16.6%).  Secondly, in terms of valuation, the S&P 500's P/E ratio is considerably lower now than it was in 1987.  In 1987, the S&P 500's P/E ratio at the low after the crash (14.37) was still higher than it is now (14.28).

Well, crashes really don’t happen because of financial ratios or the degree of year-to-date gains. These are symptoms rather than causes.

In the 1987 episode, the equity market crash signified an amalgam of events: inflationism by global governments via the 1985 Plaza Accord and the February 1987 Louvre Accord, Portfolio insurance, the twin deficits, massive speculation brought about by easy money policies in the US…

As Prudent Bear’s Doug Noland narrates

Credit excesses were certainly not limited to government finance.   Total Non-Financial Debt expanded 14.8% in 1984, 15.6% in 1985 and 15.6% in 1986.  The Credit boom was broad-based, with Federal, State & Local, Household, and Corporate debt all expanding at double-digit rates throughout the period.  Financial Sector Credit Market Debt was exploding, with growth of 17.5% in ’84, 19.3% in ’85, and 26.2% in ’86.  Importantly, this growth reflected the commencement of a historic expansion of non-bank Credit, led by (Agency/GSE) MBS and ABS, along with finance company and (“captive finance”) corporate borrowings.

And equally the influence of Japan’s domestic bubble on the US stock market, again Mr. Noland

The market and U.S. economic environments troubled Toyota executives back in 1987.  They were also plenty worried about Japan.  Japanese policymakers were under intense American pressure to stimulate their economy in order to remedy their widening trade surplus with the U.S.  After beginning 1986 at about 13,000, Japan’s Nikkei equities index surpassed 26,000 in the autumn of 1987.  The Japanese real estate balloon was also rapidly inflating, even as consumer prices remained well contained.  Toyota officials were increasingly worried that loose monetary policy and other stimulus measures had fostered a dangerous Bubble in Japan.  The 1987 crash proved but a minor setback for the Japanese Bubble, as “terminal phase” excesses in 1988 and 1989 sealed Japan’s fate.  The Nikkei ended 1989 at 38,916.  The Nikkei closed Friday, some 23 years later, at 9,003.

The point is that crashes (sharp asset deflation) occur because of prior booms (dramatic asset inflation). 

Crash dynamics, therefore, represent unintended consequences from the interventionism from political authorities.

Will the pattern repeat itself this year? I can’t say, though the risks have ALWAYS been present given my definition of crash dynamics.

The conspicuous “parallel universe” or the environment where markets seems to have “detached” or "diverged" from economic reality signifies as evidence of such monetary interventions prompted dislocations that has led to the recent asset inflation (boom). 

The economic activities has simply been out of touch with the markets as shown above.

Yet the key difference between then 1987 and today has been global central bankers aggressive actions to explicitly support asset prices

In short, crash dynamics will be an offshoot to the action-reaction feedback loop of central bankers to the unfolding events or conditions. The balance sheets of central banks continues to balloon. Recent announcements has been made to add up to this (an estimated $2 trillion from the FED-ECB), and more will be coming as central banking inflationism becomes the only remaining tool in support of the political economic status quo. 

Eventually markets will prevail though, (there will massive wave of defaults or super inflation, if not, hyperinflation).

But in the meantime, my bet has been for a non-crash scenario for October or for this year.

Dr. Marc Faber Warns of 1987 Crash if No QE 3.0

From Bloomberg,

U.S. stocks may plunge in the second half of the year “like in 1987” if the Standard & Poor’s 500 Index (SPX) climbs without further stimulus from the Federal Reserve, said Marc Faber, whose prediction of a February selloff in global equities never materialized.

“I think the market will have difficulties to move up strongly unless we have a massive QE3,” Faber, who manages $300 million at Marc Faber Ltd., told Betty Liu on Bloomberg Television’s “In the Loop” from Zurich today, referring to a third round of large-scale asset purchases by the Fed. “If it moves and makes a high above 1,422, the second half of the year could witness a crash, like in 1987.”

The Dow Jones Industrial Average plunged 23 percent on Oct. 19, 1987 in the biggest crash since 1914, triggering losses in stock-market values around the world. The Standard & Poor’s 500 Index plummeted 20 percent. The Dow still closed 2.3 percent higher in 1987, and the S&P 500 advanced 2 percent.
“If the market makes a new high, it will be a new high with very few stocks pushing up and the majority of stocks having already rolled over,” Faber said. “The earnings outlook is not particularly good because most economies in the world are slowing down.”

Profit Growth

More than 69 percent of companies the S&P 500 that reported results since April 10 have exceeded analysts’ forecasts for per-share earnings, according to data compiled by Bloomberg. Profits are due to increase 3.9 percent in the second quarter and 6 percent the following period, estimates compiled by Bloomberg show.

Faber said a third round of quantitative easing would “definitely occur” if the S&P 500 dropped another 100 to 150 points. If it bounces back to 1,400, he said, the Fed will probably wait to see how the economy develops.

see Bloomberg's interview of Dr. Marc Faber below

Media has the innate tendency of reducing investment gurus into astrologers or soothsayers by soliciting predictions over the short term. And investing gurus eager to gain media limelight fall into their trap. And this is why Dr. Faber’s warnings comes with a Bloomberg notice about his latest failed predictions, which has been punctuated by "whose prediction of a February selloff in global equities never materialized."

Dr. Faber, who introduced me to the Austrian school of economics through his writings, is simply stating that if a tsunami of central banking money has been responsible for the buoyant state of markets, then a withdrawal of which should mean lower asset prices. In short, the state of the financial markets heavily, if not almost totally, relies on the actions of central bankers.

Yet since we can’t entirely predict the timing and the degree of central bank interventions, or if they intervene at all, we should expect markets to be highly sensitive to excessive volatility.

And aside from money printing, the risk of high volatility has been amplified by many other interventions on the marketplace (via various bank and financial market regulations). And heightened volatility could translate to a crash. And don’t forget a crash could be used to justify QE 3.0.

As to whether the Fed’s QE 3.0 will come before or after a substantial market move is also beyond our knowledge, since this will depend on the actions of political authorities. I have to admit I can’t read the minds of central bankers.

Yet QE 3.0 may come yet in the form of actions of other central bankers, e.g. ECB’s LTRO and or SMP.

What I know is that inflationism has been seen by the mainstream and by the incumbent political authorities as very crucial for the survival of the current forms of political institutions. This is why I, or perhaps Dr. Faber, sees the probability for more central bank interventions over the marketplace. This is because the cost of non-intervention would be a substantial reduction of the political control over society from vastly impaired political institutions.

It must be noted that Austrian economics is basically an explanatory science, where given a set of actions we see the consequence being such or such. The idea of reducing logical deduction into some form of predictive science is wizardry.

In short, while I don't predict a crash I would not rule out this option. Especially not in a highly distorted and politicized markets

Global Risk Environment: The Transition from Red Light to Yellow Light

One of the foremost concerns of all parties hostile to economic freedom is to withhold this knowledge from the voters. The various brands of socialism and interventionism could not retain their popularity if people were to discover that the measures whose adoption is hailed as social progress curtail production and tend to bring about capital decumulation. To conceal these facts from the public is one of the services inflation renders to the so-called progressive policies. Inflation is the true opium of the people and it is administered to them by anticapitalist governments and parties. Ludwig von Mises

Remember what I have been saying about financial markets being dependent on policy steroids?

Here’s what I wrote during mid-September[1]

If team Bernake will commence on a third series of QE (dependent on the size) or a cut in the interest rate on excess reserves (IOER), I would be aggressively bullish with the equity markets, not because of conventional fundamentals, but because massive doses of money injections will have to flow somewhere. Equity markets—particulary in Asia and the commodity markets will likely be major beneficiaries.

As a caveat, with markets being sustained by policy steroids, expect sharp volatilities in both directions.

Global financial markets, from equities, commodities and currencies have been playing out almost exactly as I have described.

The difference is that instead of being driven by the US Federal Reserve’s credit easing policies, last week’s ferocious global stock market rally appears to have been impelled by the Eurozone’s bailout which came with both a 50% ‘voluntary’ haircut on Greek bondholders and the $1.4 trillion expansion of the European Financial Stability Fund (EFSF).

Insanity: Doing The Same Thing Over And Over Again

Some experts have even been so perplexed by the heft, scale and breadth of the market’s rally to even label this ‘crazy’[2]. However what is seen as ferly to others has long been understood by us as transitional episodes of boom bust cycles. And flouncing markets could even serve as an indicator of major trend reversals[3].

My problem then was that without concrete actions and commitments from policymakers, markets were functionally fragile or vulnerable to a crash.

The Eurozone’s bailout deal fundamentally confirms my earlier exposition on the mechanics of the proposed bailout[4]. But the deal covered more conditions, aside from the conversion of the bailout fund into an insurance-derivative mechanism, this included the ‘voluntary’ 50% haircut of Greece bondholders, the creation of a Special Purpose Vehicle (SPV) which allows private and other non-EU investors (such as the IMF or possibly China and other emerging markets) to participate in the financing of the bailout, bank recapitalization—where banks capital ratio would be increased to 9% by June of 2012, and importantly the continuation of the European Central Bank’s asset purchasing program.

The unfurled package has ostensibly been way beyond the markets expectations and had been warmly received. This exhibits the state of the current markets—deep addiction to policy steroids.

The deal’s insurance-derivative model provides guarantees to investors on the initial (20%?) tranche of debts issued by select EU governments that would allow four to fivefold increase of the debt issuance through leverage; where the details of which has yet to be threshed out[5].

There are valid reasons to be skeptical on the final mechanics of the supposed bailout scheme.

One, questions as to the actual available resources to implement these programs. For instance, the EFSF supposedly will be used as insurance to guarantee debt issuance AND also as last resort financing access to bank recapitalization, so how will the fund be apportioned? Are EU leaders assuming that these resources will only function as contingent resources? Wouldn’t this be too optimistic?

Next the supposed leveraging of debt issuance will likely come from already debt distressed nations.

As the Bloomberg chart of the day rightly points out[6]

the average rating for the bloc, calculated by Bloomberg from the assessments of the three main evaluators, has worsened to 3.14, representing the third-best grade, from 2.12 in May 2010 when the European Financial Stability Facility was designed. The measure fell 0.23 point in the previous 15 months. The average is calculated by giving a numerical grade for each grading, where 1 is the highest, and adjusting it for each country’s share of the EFSF guarantee.

Seven of the 17 euro-sharing nations have had their ratings downgraded since the announcement of the facility, which maintains a top grade from Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. As the contagion has spread to banks, prompting governments to work out recapitalization plans, further cuts, mainly for the top-rated countries, may reduce the strength of the fund.

So the EU bailout is essentially applying what Albert Einstein defines as Insanity: doing the same thing over and over again while expecting different results. More debt will be compounded on existing debt.

A major credit rating agency Fitch Ratings sees the proposed deal on Greece bondholders as a default that would not remove the risk of further downgrades for other sovereigns[7].

However my general impression behind all the ‘smoke and mirrors’ promoted as a comprehensive rescue strategy is that these measures fundamentally stands on the ECB’s monetization of government debt.

In short, the EU’s Bazooka bailout deal represents as an implicit license for or as façade to the ECB’s massive money printing program.

Global Market Responses

And the commodity markets appear to have responded to the grandiose measures in terms of increasing expectations of the inflationary implications

Gold has regained its bullish momentum (top most chart), while oil (WTIC) appears to be testing the 200-day moving averages where a breach would mean a reversal of the ‘death cross’. On the other hand, copper has reclaimed the 50-day moving averages.

The coming sessions will be very crucial as they will either reinforce the formative uptrend or falsify the recent recovery.

Importantly, as I have been repeatedly saying, I don’t see the imminence of a recession risk for the US economy for the simple reason that money supply growth has been exploding.

And a possible evidence of the diffusion of money supply growth has been the very impressive record breaking growth of US capital spending[8]. Capital spending growth should be seen as a leading indicator which should mean more improvement in the employment data ahead. Besides, record capital spending growth demolishes the popular mythical idea of a liquidity trap[9].

China remains as my focal point in my assessment of risk.

Again it is unclear whether China has merely been experiencing a cyclical slowdown or a bubble bust. Signs of piecemeal bailouts including the latest rescue of Ministry of Railways[10] could be signs of a popping bubble.

However signals generated from global equity markets seem to indicate that developments in both the Eurozone and the US could likely influence China, than the other way around.

Major global equity markets appear to have reaccelerated to the upside.

The US S&P 500 has broken above the 200-day moving averages, where a continuation of this upside momentum would extrapolate to the inflection of the ‘death cross’ into a bullish ‘golden cross’.

And it would seem that my hunch of a non-recession short-lived US bear market ala the Kennedy Slide of 1962 and 1987 Black Monday crash may come to fruition[11].

Meanwhile Europe’s Stoxx 50 appears to also trail the price actions of the US S&P 500 along with China’s Shanghai index whose recent bounce off the new lows has brought the index to test the 50-day moving averages.

Of the three major equity market bellwethers, the US seems to provide the market’s leadership, although it has yet to be determined if the momentum of China’s market can be sustained.

Overall, the impact of the collective inflationary policies being undertaken by the developed nations seems to permeate on both global equity markets and the commodity markets.

And in downplaying the predictive value of mechanical chart reading I recently wrote[12], (bold emphasis original)

The prospective actions of US Federal Reserve’s Ben Bernanke and European Central Bank’s Jean-Claude Trichet represents as the major forces that determines the success or failure of the death cross (and not statistics nor the pattern in itself). If they force enough inflation, then markets will reverse regardless of what today’s chart patterns indicate. Otherwise, the death cross could confirm the pattern. Yet given the ideological leanings and path dependency of regulators or policymakers, the desire to seek the preservation of the status quo and the protection of the banking class, I think the former is likely the outcome than the latter.

Events appear to be turning out in near precision as predicted

In addition, while the markets may have been discounting a QE 3.0 from the coming Federal Open Market Committee (FOMC) meeting this November 2^nd, any surprise from team Bernanke could even escalate the current surge in the inflationary boom momentum.

Remember, US Federal Reserve Chair Ben Bernanke has repeatedly been dangling QE 3.0 or has been emphasizing that QE 3.0 remains an option[13], which could readily be redeployed as conditions warrant.

To add, except the US almost every major economy central banks have recently undertaken to expand on their respective versions of QE (chart from Danske Bank[14]). Aside from Bank of England[15] (BoE) whom earlier this month has announced the expansion of their QE policies, last week the Bank of Japan (BoJ) also increased their asset purchasing program[16].

Thus, the dramatic shift in sentiment to my interpretation epitomizes a transitional phase that can be analogized to the shifting in traffic light signal from red to yellow.

I would reckon the current climate as a gradual phasing-in or a cautious buy for risk assets.

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[1] See Definitely Not a Reprise of 2008, Phisix-ASEAN Equities Still in Consolidation, September 18, 2011

[2] See Global Stock Markets: The Euro Bazooka Deal and the Boom Bust Cycle, October 28, 2011

[3] See Sharp Market Gyrations Could Imply an Inflection Point, October 16, 2011

[4] See More Evidence of China’s Unraveling Bubble? October 16, 2011

[5] See Euro’s Bailout Deal: Rescue Fund Jumps to $1.4 Trillion and a 50% haircut on Greece bondholders, October 27, 2011

[6] Bloomberg.com Euro Region’s Debt Quality Is Worsening at Record Pace: Chart of the Day, October 25, 2011

[7] Wall Street Journal Fitch: Greek Debt Deal a Default, October 28, 2011

[8] Wall Street Journal Blog Vital Signs: Capital Spending Hits Record, October 27, 2011

[9] See No Liquidity Trap, US Economy Picks Up Steam, October 27, 2011

[10] See China Bails Out the Ministry of Railways, October 25, 2011

[11] See Phisix-ASEAN Market Volatility: Politically Induced Boom Bust Cycles, October 2, 2011

[12] See How Reliable is the S&P’s ‘Death Cross’ Pattern?, August 14, 2011

[13] International Business Times, Market, FOMC Officials Suggest ‘Increasing Likelihood’ QE3 is Coming, October 26 2011

[14] Danske Research Preview: Bank of Japan Further easing likely, renewed intervention close, October 26, 2011

[15] See Bank of England Activates QE 2.0, October 6, 2011

[16] See Bank of Japan Expands QE, October 27, 2011

Promises of Bailouts: How Sustainable will Positive Market Expectations Be?

The following news account[1] from the Bloomberg on Friday’s discernible jump in the US equity markets reasonably encapsulates what has been driving the global markets for a long time—financial markets highly dependent on political actions.

U.S. stocks advanced, giving the Standard & Poor’s 500 Index its longest streak of weekly gains since February, amid speculation of an agreement to contain Europe’s debt crisis and further Federal Reserve stimulus.

How Strong will the Market’s Expectations be?

So let me play the devil’s advocate: what if the market’s deepening expectations of the political resolutions from the above predicaments does not materialize?

These may come in many forms:

-adapted political actions may be inadequate to satisfy the market’s expectations (possibly from divergences in commitments or the inability to ascertain the optimal adjustments required)

-expected political actions don’t take place (possibly due to schisms or continuing disagreements over the measures or dissensions over the enforceability, degree of participations and or divisions over the efficacy of proposed measures)

-the festering crisis unravels faster than the applied political measures (possibly from miscalculations by the political authorities on the scale of the crisis or from unintended effects of their actions)

-sanguine markets expectations for an immediate resolution erode from either procrastination or persistent irresolution or indecisions (possibly from a combination of the above factors—divergences in calculations, variances in tolerable commitments and doubts on enforcement procedures and dissimilar political interests in dealing with the above junctures or more…)

October 1987 Risk Paradigm

I am in the camp that says that current dynamics suggest that the risks of a US are not as material as many mainstream experts have been projecting. Most of their projections have political implications, the desire for more government interventions.

But there could be a marked difference; stock markets may not be reflective of the actual developments in the real economy. In other words, actions in the stock market may depart from the economy.

Has there been an instance where there had been an adverse reaction to the stock markets from unfulfilled expectations from policymakers which had not been reflected on the economy?

Yes, the global stock market crash of October 19, 1987.

From the US Federal Reserve of Boston[2],

While in hindsight the data provide no evidence that interventions in foreign exchange markets were used to signal policy changes, it is possible that, at the time, market participants interpreted interventions as signals of future policy. If so, significant movements in the exchange rate would be expected at the time of interventions. Central banks actively intervened in foreign exchange markets after the Plaza Accord. Evidence suggests that combined interventions to increase the value of the dollar during this period did result in a significant decline in the deutsche mark/dollar exchange rate. As it became apparent that intervention was not signalling monetary policy changes, market participants apparently stopped interpreting intervention as a signal.

In short, market expectations diverged from the results intended from such political actions.

Many tenuous reasons have been imputed on non-recession stock market crash of 1987. However, the major pillar to this infamous event has been the boom policies of the Plaza Accord of 1985[3] which had been meant to depreciate the US dollar against G-7 economies via coordinated foreign exchange interventions, and the subsequent Louvre Accord of 1987[4], which had been aimed at arresting the decline of the US dollar or the reversal of the policies of Plaza Accord.

What had been initially perceived by policymakers as a US dollar problem, emanating from the advent of globalization, technological advances and the gradual transitory recovery of major Western from the recession of the early 80s, which affected the ‘goods’ side of the global economy, and the increasing financial globalization of the US dollar from the hyperinflationary episodes of some emerging markets (e.g. Latin American Debt Crisis[5]) which affected the ‘money’ side of the global economy, essentially transformed into a problem of policy coordination of interest rates[6] that led to an abrupt tightening of previously loose monetary policies which eventually got vented on global stock markets.

The decline of the trade weighted US dollar (apple green) stoked a boom in the US S&P 500 and similarly on the CRB Precious commodity metals sub-index (red) and an increase in inflation expectations as measured by the 10 year yield of US Treasuries (green). The yield relationship difference between stocks and bonds became unsustainable[7] which consequently culminated with the historic one day decline.

True, the dynamics of 1987 has been starkly different than today. We are experiencing a contiguous banking-welfare based crisis today which had been absent then in 1987.

But one striking similarity is how market expectations, which have been built on political actions, had completely diverged from what had been expected of the directions of policymaking.

Nevertheless the recent temblors experienced by the global financial markets following US Federal Reserve Chair Ben Bernanke’s no ‘QE’ stimulus[8] during last September 21^st resonates on a ‘1987 moment’ but at a much modest scale.

This is NOT to say that another 1987 moment is imminent. Rather, this is to say that the sensitiveness to such market risks increases as political actions meant to resolve on the current issues remain ambiguous or will remain in an indeterminate state.

And this is to further emphasize that while a grand “aggressive” “comprehensive” strategy may forestall any major market convulsion for the moment, they are likely to be temporary measures targeted at buying time for the policymakers from which another crisis would likely unravel in the fullness of time.

For now, it would be best to watch closely on how policymakers will react.

I believe that a monumental buying opportunity may arise soon.

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[1] Bloomberg.com S&P 500 Caps Longest Weekly Gain Since Feb., October 12, 2011

[2] Klein Michael Rosengen Eric Foreign Exchange Intervention as a Signal of Monetary Policy US Federal Bank of Boston, June 1991

[3] Wikipedia.org Plaza Accord

[4] Wikipedia.org Louvre Accord

[5] Mises Wiki Latin American debt crisis

[6]Ryunoshin Kamikawa The Bubble Economy and the Bank of Japan Osaka University Law Review, 2006 In the U.S., on the other hand, the new FRB Chairman Alan Greenspan raised interest rates in September. However, the dollar depreciated. Then, the U.S. government requested Japan and West Germany to reduce interest rates. Both countries declined and the Bundesbank performed an operation for increasing in the short-term interest rates in the market. Secretary Baker resented this and stated that the U.S. tolerated a weaker dollar on October 16. Investors recognized that this statement meant the failure of international policy coordination and they moved their financial assets out of the U.S. for fear of collapse of the dollar. This caused the heavy fall in the New York Stock Exchange on October 19 (Black Monday). The depreciation of the dollar continued after that and inflated asset prices and bond prices collapsed in the U.S. Then, Secretary Baker persuaded West Germany to lower the short-term interest rates)

[7] Mises Wiki Black Monday (1987)

[8] See Bernanke Jilts Markets on Steroids, Suffers Violent Withdrawal Symptoms September 22, 2011