Financial Sense Online Storm Watch Update for November 16, 2002

Monday, October 19, 1987 was a day no one would forget. A storm appeared out of nowhere that would wreak havoc on the world’s financial markets. By the end of the day, it looked as if the financial system was headed for the abyss. In the words of one observer on the Street,

"This one came out of the blue. I didn’t expect it to be so bad…we froze around 3p.m. and just started watching the screens. Even the phones stopped ringing. We were watching history in the making."

That day became everyone’s nightmare. The Dow fell 508 points, a loss of 22.6 percent in a single session. Not since the 1929 stock market crash had the stock market fallen this fast and lost so much of investors' money. The stock market crash of 1929 had shattered public confidence. Over the years, $30 billion disappeared from the American economy. For the financial markets and stock investors, it would take nearly 25 years to recover.

To many on Wall Street, the events of October 19, 1987 resembled similar events nearly 58 years before. Everything was down double-digits. With a 22.6 percent loss, the Dow was making the headlines. However, other markets suffered similar damage. The NYSE composite lost 19.2 percent, the S&P 500 dropped 20.5 percent, and the Wilshire and Value Line Index lost 17.9 and 15.1 percent respectively. The fury of selling was seen everywhere.

No index had been spared that day. Even the Dow Utility Average dropped 15.3 percent. Market internals were just as horrific. For every stock that rose that day, 37 issues declined by comparison. There were 10 new highs on the New York Stock Exchange and 1,068 new lows. Advancing volume was only 1,129,000 shares. Declining volume totaled 602,781,000. Few shares rose that day and those that did were rare and confined mainly to the gold sector.

The crash on Wall Street was a worldwide phenomenon. Stocks were not only crashing in New York, but around the globe. The markets in Japan and Hong Kong crashed and some would remain closed for a week. Experts were attributing the panic selling to program trading, but the carnage was everywhere. Program trading became the scapegoat, but that blame could hardly explain the collapse of markets worldwide where program trading did not exist. Officials were perplexed as to the cause as very few had seen it coming. A Presidential commission was tasked with looking into the matter. While government officials looked for a simple answer for the crash, they looked more at symptoms rather than the cause.

The 1987 crash was universal. No world market escaped unscathed. Many of the global markets faired much worse than the U.S. Those that had fallen far more than ours did not have index arbitrage. This failure left many unanswered questions. If other markets didn’t have program trading, then what, in fact, caused the crash? The answer to that question will be explored in a moment. We do find some clues in what few on Wall Street were willing to acknowledge. The U.S. dollar had been dropping sharply since 1985. Gold and commodity prices had taken off and in April 1987 the U.S. bond market crashed.

By October of that year, interest rates had risen to the 10 percent level. The events leading to the crash could be seen in retrospect and it all led back to the dollar’s decline. It was a declining U.S. dollar that led to rising gold and commodity prices, which triggered the bond market collapse. In a nutshell, a collapsing dollar triggered a whole chain of financial events in other markets that led to the final crash in the stock market.

Understanding the complex linkage between markets and the economic events that preceded them was far too difficult to explain and understand. Instead, the culprit became the symptom rather than the cause. Perhaps a better question would have been, how could the markets change so dramatically in just a few months? Further, how does a seemingly invincible market unravel into a full-fledged panic in such a short time?

Only months before October 19, headlines in the financial press had been extolling the record-setting pace of the stock market. By September of 1987, brokers began pushing margin loans with customers. Ignored in this whole process were events, which began as far back as 1985, to bring down the dollar. Following the early economic summits of the 1980’s in response to oil shocks, the world currency system witnessed a dollar shock, as a relentlessly rising U.S. dollar led to large trade imbalances in the U.S. The strikingly divergent growth patterns in the world’s three largest economic blocks were creating serious distortions in the world’s financial system. This led to a stunning appreciation of the US dollar resulting in loss of competitiveness of US exports. This created a cacophony of protectionist fury in Congress. The gross imbalances in the international economy and the concomitant strains in global debt and fears of an exchange rate crisis brought world leaders together in May 1985 in Bonn, Germany.

The Bonn meeting led to declarations by each country to reduce structural rigidities and to maintain prudent fiscal and monetary policies. Inside the U.S. government, leadership changed as James Baker moved over to the Treasury Department. A series of economic summits followed quickly in succession: the Tokyo Summit of 1986, the Plaza Accord that followed, and the Louvre Accord of February 1987. There was now an attempt to manage floating exchange rates whereby the G-7 agreed to cooperate closely to foster stability of exchange rates around the globe.

With protectionist calls growing by the day, the Reagan Administration embarked on a policy of intervention on the dollar. With large budget and trade deficits, the U.S. dollar had become grossly overvalued. The palliative cure was a policy to bring down the dollar. As shown in the graph below, the dollar began a precipitous decline beginning in 1985 that would not end until the end of 1987.

A gradual decline of the dollar was seen as a cure to America’s growing trade imbalances. The dollar's decline, however, led to unforeseen problems in other markets. As the dollar fell, gold and commodity prices began to rise, which ultimately led to the collapse of the bond market in April of 1987.

What very few understood at that time was that all markets are interrelated. No market moves in isolation whether it is currencies, commodities, stocks, or bonds.

The rise in gold and commodities was a direct result of the dollar's fall. As shown in the charts below, gold and the CRB Index began to rise in 1986. While the dollar was falling and commodity prices were rising, the bond market began to top out in 1986-87 before crashing in April of that year.

Two of the most important props underneath the stock market's rise, low inflation and low interest rates, had been removed. The stock market was rising on thin air. Rising interest rates that began in April 1987 now posed a serious threat to equities. Unfortunately, this rise in interest rates was largely ignored. In fact, the dollar's steep fall was looked upon as beneficial at the time since it was hoped it would correct America’s large trade imbalances. The bond market’s collapse should have been a warning for stocks, but it was overlooked. Widespread bullishness within financial circles overlooked the warnings from a falling dollar, rising gold and commodity prices and interest rates. The dollar's fall was directly linked to the rise in the other three. Certainly the four charts above show this linkage.

The warning signals were there for all to see, but internal biases kept them off everyone’s radar screen. Typical of that time were remarks in The Wall Street Journal such as, "In a market like this, every story is a positive one. Any news is good news. It’s pretty much taken for granted now that the market is going up." That statement was from an analyst quoted in the Journal on 8/26/87, the day after the 1987 stock market peak. By 9/21/87, the DJIA had dropped 8.4 percent. However, to most, this was a historic bull market and the bulls were not about to give up without a fight. Investors had learned to “buy the dips.” On 9/22/87, the stock market had rebounded nicely. The following day's headlines read "Stock Prices Soar in Heavy Trading; Industrials Rise Record 75.23 Points." WSJ 9/23/87

The rally in stocks after their August peak caused many bulls to chastise bears. One analyst was quoted saying, "The bears finally climbed to the top of the ladder and fell off." While another commented, "Yesterday’s reversal marked the end of the correction." On Friday, October 16, the Dow opened about 10 points higher, then plunged over 100 points. Intraday it fell 130 points before closing the day with a 108.35-point loss. The WSJ isn’t published on weekends. Nevertheless, there was a lot of talk from analysts when the Monday edition hit the street. The headlines reflected confusion and bewilderment.

What’s Next? Plunge in Stocks has Forecasters Guessing; Some Stay Bullish, but Bears are “Running Wild”…It was the third major decline in as many days. But several technical analysts said that the big volume accompanying Friday’s session might mean better things ahead.”
Wall Street Journal, 10/19/87- the day of the crash

The answer to the headline “What’s Next?” was the crash itself. I remember that day so well. It was the only day in my entire career that I have ever bought at the bottom and it was all by accident. The previous Friday after the markets had plunged 108 points, I had funded our pension plan by sending off our check to a mutual fund company. The check arrived on Monday, the day of the crash. Therefore, I bought shares at the close of that day. What happened that day was unexpected. I had no idea this was coming. I had most of my clients' money invested in bonds because yields had risen to over ten percent. However, for my employees and myself, we didn’t need the income. We wanted growth. The 108 point drop and the fall from the August peak looked like an opportunity. Little did we know what was coming that Monday.

On the way to work that day, I remember hearing a news report on my radio saying the Dow was down 200 points. I thought it was a mistake. When I arrived at my office, I faced the grim truth. I had thought about what I had done that past Friday. That night the media went with comparisons of the day’s crash to the crash of 1929. They christened it, "Black Monday."

It was with trepidation that I awaited the opening of the market the following day. Fortunately for myself and my employees, an unnamed buyer showed up and started buying in the futures market in a major way. The "Plunge Protection Team" had been born. The large intervention by this unnamed buyer helped to turn the markets around. President Reagan addressed the nation and said all was well and the nation believed him. The markets recovered. Behind the scenes, the new Fed Chairman, Alan Greenspan, began a round of shuttle diplomacy among central bankers in a coordinated effort to rescue the markets. It seemed to work. Asian markets reopened and U.S. stocks went on to rally, closing out the year with about a 6 percent gain.

That fateful day changed my practice and my career. I wanted to know the “why” of the crash. I didn’t buy the programmed trading story. I wanted to know what set the programs off. My graduate school training in Keynesian and Monetarism didn’t give me the answers I was looking for. I eventually found many of those answers when I rediscovered the Classical and Austrian Schools of Economics. A few years later, I read a book by famed market technician John J. Murphy “Intermarket Technical Analysis” and the rest of the puzzle fell in place. Murphy’s conclusion drawn from the 1980’s markets was that “all markets are interrelated—financial and nonfinancial, domestic and international. The U.S. stock market doesn’t trade in a vacuum; it is heavily influenced by the bond market. Bond prices are very much effected by the direction of the commodity markets, which in turn depend on the trend of the U.S. dollar.” ¹

Since that time, I’ve always kept an eye on all four markets: currencies, commodities, bonds, and equities. The key relationship for the financial markets is the relationship between commodities and bonds. Rising commodity prices move inversely to bonds. Rising commodity prices are inflationary; which would cause bonds to react negatively. Since the stock market is influenced by the direction of interest rates, the bond futures market is often a key to movements in stocks. But many of these historical linkages are changing in the disinflationary world of the 90’s and the deflation that emerged from Asia after 1997.

The stock market and the bond market began to decouple. The plunge in interest rates since 2001 and the drop in the stock market is a good example of this decoupling. Other relationships, such as gold leading commodity prices, became muted after 1994. Inflation was viewed differently. What is not understood in western economies is that inflation moved from the real economy of “things” to the financial system (paper), especially here in the U.S. in the form of asset bubbles. Rising asset prices are no longer considered inflationary. When stock prices go up more than 20 percent a year for five years or when housing prices go up 20-30 percent, this is considered the good fortune from benevolent government leadership. The “new era,” “new paradigm” shibboleth’s of the 90’s was simply the spin that justified the inflationary asset bubble.

What made the 90’s different, besides the asset bubbles, was that many of these inter-market relationships began to act differently throughout the mid and later decade. I have written about many of these anomalies. Chief among them is the move of credit and money into the financial system. Inflation is always a monetary phenomenon. It is the result of and is directly traceable to monetary actions by governments and their central banks. When money and credit is created, it can go either into paper or into things. Throughout the 80’s and the 90’s, most of the credit and money created went into the financial sector, mainly stocks and bonds. In the 1980’s, it helped to fund mergers and acquisitions financed with junk bonds and equity. In the 1990’s, it helped to fund another meglo-merger wave, a mania in technology and Internet stocks and stock buyback programs. In this new century, it is going into bonds, mortgages, consumption, and housing. The double-digit gains of the financial markets experienced from the 1980’s and the 1990’s had more to do with the expansion of money and credit then it did profits or economic growth. As Warren Buffett wrote in his November 1999 Fortune article, the 90’s were characterized by sub-par profits and economic growth.

Bob Prechter has documented much of this in his new book, Conquer The Crash. As this graph above and the following table illustrate, there was nothing miraculous about the 80’s or 90’s other than the fact that the U.S. transformed itself from the world’s largest creditor nation to today’s largest debtor nation.

NEW ERA - PARADIGM MYTH UNMASKED
Indicator	Wave III 1942-1966	Wave V 1974-2000
GDP	4.5%	3.2%
Industrial Production	5.2$	3.4%
Capacity Utilization	91.5%	84.4%
Unemployment	4.9%	6.6%
Household Liquid Assets	161%	93%
Federal Debt	43.9%	58.6%
Consumer Debt	64%	97%
Personal Savings Rate	6.5%	0.5%
U.S. Balance Sheet	"Net Creditor"	"Net Debtor"
Source: Conquer The Crash, p. 1-16

Other anomalies emerged, one of which was a multi-decade bear market in commodities. This decline made it hard to measure key relationships between bonds and stocks directly since inflation was manifesting itself mainly through the financial markets of which bonds were a chief beneficiary. It is my belief, and that of others such as Peter Warburton, that the derivatives market has been used to control the commodity markets. It is estimated that $200 billion of capital, leveraged through the derivatives markets, controls the actual commodity markets. In other words, the paper markets control the physical markets and not the other way around. It doesn’t matter how big the market or the commodity, whether it is oil, gold, silver, coffee or soybeans. Fiat paper, multiplied to the nth degree through derivatives, rules the real world of things. This control of paper over physical is now in the process of unwinding and will come to fruition in "The Perfect Financial Storm.”

As to the present market, intermarket relationships are once again giving us possible warnings of another phase of a storm that is emerging. To begin with, we need to look at the U.S. dollar. Like 1985, the U.S. dollar is in a crisis. Like 1985, the U.S. is running record trade deficits. The following graphs from Michael Hodges' Grandfather Economic Report illustrate the cumulative trade deficit, which can be measured in trillions. The annual rate is now approaching half a trillion a year. That is half a trillion a year we must borrow from foreign savings to fund our proliferate consumption.

Throughout the 90’s, as America’s trade deficits grew at record levels, foreign investors chose to recycle those dollars back into the U.S. economy, especially into financial assets such as Treasuries. They now own a majority of our debt estimated to be around 43 percent.

As long as foreign investors were willing to accept our dollars in exchange for selling us goods, the dollar remained strong. Those dollars were reinvested into our economy in bonds, stocks, real estate and private businesses. This enabled the U.S. to run record trade deficits, a position no other country could do because of the status of the dollar as the world’s reserve currency. As long as the U.S. economy and financial markets outperformed other economies and markets, the U.S. was a magnet for foreign savings. The wonders of our nation's economy and financial markets were sold as a new economic paradigm, when in fact it was nothing more than a credit bubble fed by monetary inflation. As shown in the chart below, the dollar continued to rise despite a burgeoning trade deficit. It was a part of the Clinton-Rubin strong dollar policy.

However, the U.S. dollar is now under siege in what has become the aftermath of a bubble. The trade deficit continues to expand despite a weak economy. This is siphoning more profits out of the U.S. economy as the consumption bubble led by consumers is channeled into imports. And despite the most aggressive rate cuts in U.S. history by the Federal Reserve and rampant credit creation by banks, GSEs and other financial intermediaries, the economy remains weak and our financial markets continue to hemorrhage. This is raising concern among foreign investors who may now be pulling out of the U.S. financial markets. All major stock indexes are down double-digits this year and the bond market is showing signs of stress. Since this Spring, the dollar has fallen and remains weak. It appears that the dollar has begun a new downtrend. A weekly chart of the dollar shows a head and shoulder formation with the dollar falling below neckline support. If in fact the dollar has peaked, this carries enormous implications for other markets. This can be seen in the charts of gold, the CRB Index, and more recently, the long-term bond yields below.

A weakening U.S. dollar is bullish for gold and commodity prices (of which gold is a leading indicator.) Rising gold and commodity prices would be bearish for bonds as well as equities. The dollar is the key for my Perfect Financial Storm scenario. Unlike 1985-1987, the dollar is more vulnerable today because so much of our bond market, and to some extent our equities market, is now in the hands of foreigners. A weak currency discourages foreign investment. Foreign investments in Treasures have risen in value this year as interest rates have fallen. However, due to the decline in the dollar, those gains have evaporated.

History shows that the primary beneficiary of a falling dollar is gold and especially gold shares. The charts of the HUI and the XAU below seem to confirm this historical relationship.

The charts of a falling dollar, rising gold prices, a rising CRB Index, and now rising interest rates indicate that this recent rally in stocks is moving against very powerful headwinds. Of particular concern is the recent breakdown in the bond market. As the charts below of the S&P 500 and long-term rates illustrate, each new rally in stocks this year was accompanied by falling interest rates. Rates continued to fall during this summer's stock market rally. Part of this was a flight to safety. Each new stock market plunge would be followed by a drop in long-term interest rates as institutions and individual investors moved into bonds, driving up prices and lowering yields. This is evident by looking at the chart of interest rates and the drop in the S&P 500, which occurred simultaneously.

The table below of mutual fund assets also supports this. Notice the increase in dollars into bond funds in September and from the beginning of the year. Notice as well the outflows and the drop in the value of stock funds in September and from the beginning of the year. Mutual fund redemptions are now running at an annual rate of 32 percent of average net assets.

Net Assets of Mutual Funds (billions of dollars)
	Sept 02	Aug 02	% Chg	Dec 01
Stock Funds	2,506.8	2,781.8*	-9.9	3,418.2
Hybrid Funds	305.5	324.9*	-6.0	346.3
Taxable Bond Funds	757.4	739.8*	+2.4	630.1
Municipal Bond Funds	331.9	324.1*	+2.4	295.0
Taxable Money Mkt Funds	1,894.1	1,951.3*	-2.9	2,012.9
Tax-Free Money Market	263.2	266.2*	-1.1	272.4
Total	6,059.0	6,388.2*	-5.2	6,975.0

Net New Cash Flow of Long-term Funds (millions of dollars)
	Sept 02	Aug 02	YTD 02	YTD 01
New Sales	54,226	69,200*	697,180	719,554*
Redemptions	-63,514	-69,182*	-676,696	-676,496*
Net Exchanges	-6,790	-3,081*	-39,200	-29,956
Net New Cash Flow	-16,078	-3,063*	-18,715	13,101*
* = revised data Source: Investment Company Institute

What is more revealing during this recent market rally is that the main gains came in a few one-day wonders. What has followed has been a weak market characterized by low volume, few new highs and weak momentum. While stocks were rising, interest rates were rising on the 10-year note and the 30-year bond. There was a brief rally after the Fed’s surprise rate cut, but rates are on the rise again as are gold and commodity prices. The US dollar is also falling again and may test key support at 104.

Of great concern is the trend on Wall Street and in the financial media to either ignore or spin bad news. It doesn’t matter whether it is economic news, earnings reports, terrorism acts or threats, government bond defaults (Argentina) or global banks in trouble, every story is either spun to sound better or is simply ignored and buried. This past week the markets rose on the assumption that Iraq’s compliance meant there would be less of a possibility for war. Argentina’s default on close to $1 billion in debt was ignored as was the possible bankruptcy of major airlines. Stories over next year’s corporate pension fund crisis are buried in the back pages and ignored. Even the retail sales report, which was flat, showed signs of deterioration and retrenchment by consumers. The estimates were lowered and were spun to make them look better. The real story, that in most categories sales were flat or declining, was overshadowed by the spin of beating estimates. There is a tonal quality to this rally that appears superficial and unsustainable. The fact remains that this is the worst profit recession in more than half a century. Profits have been harmed by four main factors:

The economic boom of the 1990’s was not in fact a new paradigm or a technology boom. Hedonic indexing by government statisticians turned meager technology investments and distorted their effect by grossing up the numbers. Wall Street and Washington continue to live in denial by their failure to recognize that the 90’s boom was a product of the greatest monetary profligacy and the largest credit boom in our nation's history. Its lasting effects are still with us in the form of giant asset bubbles in the stock market, the bond market, the mortgage market, housing, and consumption with record debt on the part of government, corporations, and consumers. Against these bubbles are added the valuations as reflected in the P/E multiple, the dividend yield, and the price/book ration for the S&P 500. Buried in the news of today is the S&P’s report on core earnings as of Q2 of this year. The S&P 500, despite its drop of 40 percent from March of 2000, is more overvalued today then where it was before the 1987 crash.

There are many who feel that a crash is not possible given the exchange controls put in place after the 1987 crash and the formation of the Plunge Protection Team. Arguments have been made that the market has already fallen over 20 percent for the Dow, 40 percent for the S&P 500, and 72 percent for the NASDAQ. However, real P/E ratios remain high, dividend yields miniscule, and price to book ratios are above the norm of past market peaks. Despite government intervention in the financial markets, history shows us, that in the end, the markets are more powerful than governments. The longer those distortions persist, the greater the corrections when they occur. What has made this bear market unique is that individual investors have held on to their stocks and mutual funds. There has been no capitulation or a series of 90 percent down days that precede a market bottom. Money has been steadily flowing out of mutual funds for the last five months. Outside of July when a record $52 billion flowed out of mutual funds, the redemption levels have slowed down with each new rally. Money is still coming out of equities, but not in torrents.

Looking back at this bear market from its origination shows a series of short-term rallies after stock prices have descended to lower levels. Following each drop we get a brief bounce based on renewed hope that the worst is over. There is nothing in today’s economic environment here in the U.S. or globally that would indicate a turn around is about to take place. For the first time in more than half a century, the world is experiencing a synchronized economic downturn. Viewing the present situation, I find it more dismal than most investors realize. It is thought in policy circles that a strong housing market and robust spending by consumers is a "healthy sign" of the economy's vitality. In fact all that has taken place is a bond, mortgage, housing, and consumption bubble has now conjoined with a bubble in the stock market. Instead of one bubble, we now have multiple bubbles held up by a continuous stream of new credit.

The environment of today is very similar to the events following the 1929 crash. From 1929 to 1933, public figures in Washington and on Wall Street kept reassuring the ordinary citizen and investor with "All is well" all the way to the stock market bottom in 1932 and the collapse of the banking system in 1933. All were fooled by the turn of events with few able to recognize where the markets or the economy were headed. This included the President, the head of the Federal Reserve, and the wealthiest man in the world (John D. Rockefeller), who insisted on buying stocks after the October crash. One can view this sequence in Colin Seymour’s “The Pompous Prognosticators Hall of Fame.”

Today's popular opinion with policy elites is that the U.S. economy’s fundamentals remain sound. In fact, they have worsened. Growing government budget deficits, rising trade imbalances, declining business investment, zero savings, and record levels of debt on consumer and corporate balance sheets are not fundamentally sound. The current boost to the economy by the sharp drop in mortgage rates created additional bubbles in consumption and housing that will end when long-term rates begin to rise. A stock market bubble eliminated the need for savings by the end of the 90’s. Now a real estate bubble is being used to extract additional equity from an inflating asset to feed consumption. What happens to all of that debt when real estate prices deflate? One cannot help but think that consumer bankruptcies and mortgage defaults will soon join the weekly headlines of sovereign debt defaults and corporate bankruptcies. It may be one reason why financial stocks have been in a freefall and that credit spreads have widened rather than converged.

The blindness of analysts and economists to the current structural imbalances within the U.S. economy is followed by an equally myopic belief in the efficacy of Fed policies. The conviction in the omnipotence of central banks has helped to foster a false sense of security. All that the Fed has done is to help create an illusion. This should be self-evident by looking at what 12 interest rate cuts have failed to deliver. They failed to keep the U.S. economy out of recession. They did not stop a bear market from unfolding. All that has been accomplished is to replace one bubble with multiple bubbles to form the largest asset bubble in history. It is being nourished and kept alive with $2 trillion of new credit each year, a figure in itself, which should be seen as astounding. Even more incredible is that fact that this money/credit creation goes unrecognized and is considered to be healthy.

The belief in the omnipotence of central bank policy, and in particular the belief in one man’s ability to apply it, has created a moral hazard of epic proportions. It has also helped to foster a false sense of security when none exists. This has led to the pursuit of greed and overconfidence in the ability of central banks to underpin financial asset values. The belief in this infinite power has encouraged leverage and risk taking I have never seen before. The financial system has become more leveraged as a result. Banks have been encouraged to take on more risk, hedge funds have become more leveraged, and investors have become imprudent and complacent with their investments. In the professional arena, this has led to most lenders and investment mangers distancing themselves from the consequences of their actions. Ben Graham’s “margin of safety” has been completely abandoned. What else can explain the high valuations in today’s market? Valuations are no longer considered meaningful. In the past, a P/E ratio was used to measure the number of years before an investor should recover his initial investment (assuming that all earnings could be distributed). A P/E ratio also measured what an investor would be willing to pay to buy $1 worth of earnings from a company.

All of the above reminds me of the thesis of Peter Warburton’s book “Debt & Delusion.” In his book the author states, “ ... the developed world has taken leave of its collective senses so far as financial matters are concerned, led astray by its central bankers and its own foolishness in roughly equal proportions… the truth is that (asset) prices rest on a shaky pyramid of debt. Low inflation, through its beneficial effects on bond prices, ably assisted by derivative markets, has created an illusion of plentiful saving in the western countries when the opposite is true. Knock away the pillar of the bond market support, and the whole edifice of equity prices comes crashing down.” ²

It is the bond market that should now concern us. As mentioned earlier, currency prices have an inverse relationship to commodity prices. A rising dollar produces falling commodity prices. In turn, commodity prices influence bond prices. Rising commodity prices are inflationary. When they rise, bond prices fall and interest rates rise. Bond prices tell us which way inflation is headed -- a trend that influences stock prices.

There are times when each market can be out of sync with other markets. This is due to the lag effects of either a rising dollar or a falling dollar working its way through the economy and the financial system. A rise or fall in the dollar has a long lead-time before its effects are felt in other related sectors. For example, the effects of the dollar's fall in 1985-87 did not start to manifest itself until 1986 when it showed up in rising gold prices, followed by a breakout in the CRB Index in the latter part of that year. The impact of the falling dollar and rising commodity prices would not show up in the bond market until 1987 when bond prices plunged and yields rose in April and then again in September and October. More than any other factor, the rapid rise in interest rates became the greatest contributing factor leading up to the October crash.

Since the October '87 crash, authorities have implemented various mechanisms to help avoid another repeat of such an event from reoccurring. Program trading curbs and various circuit breakers have been implemented to help mitigate such circumstances when they occur. However, they haven’t prevented them from occasionally surprising the markets as they did in October of 1989 and again in 1994, 1997, 1998 and September 2001. Each of these years witnessed financial rogue waves in the form of a currency crisis, a debt crisis, a distressed hedge fund or a terrorist event. The fact the markets held up with central bank intervention has given way to the illusion that financial crises can be contained through coordinated intervention. It is widely believed that we have learned and enhanced our ability to handle crises whether financial or geopolitical.

One would have thought that the financial system would have learned a lesson from the growing frequency of past crises. Instead the ability of the system to adapt, mutate, and multiply new hazards has grown like an uncontrolled virus. Fed by a constant stream of liquidity and credit, the debt pyramid continues to multiply and leverage itself in uncontrolled ways. The expansion of credit and the concomitant growth of derivatives have created the need for credit swap insurance and various permutations of counterparty risk in a system that has become highly concentrated. If LTCM, with $1 trillion in derivatives and $3 billion in capital, nearly brought the whole house down, what happens if a $26 trillion dollar player with only $40 billion in capital goes down? One cannot assume that the linear relationships that exist today will extrapolate linearly in the future. Life is full of random events. Unfortunately, the financial world is based on linear assumptions that operate in a world that is nonlinear.

This is where the present system falls grossly short. It assumes that the present relationships of today will exist tomorrow. But random events occur much more frequently then admitted. This is evident when reviewing the last two decades. What stands out is that in each succeeding decade the number of crises have multiplied; while the time span between them keeps getting shorter. The '87 stock market crash was followed by the S&L crisis, the peso crisis, the Asian crisis, LTCM, Russia, Y2K and then 9-11.

Judging by the amount of credit and hot money that sloshes around the world, it appears that random events may no longer be random, but continuous. It appears that crises have become the norm rather than the exception. It is symptomatic of a system that is no longer working and indeed is breaking down. To paraphrase Warburton, all of the debt disorders and crises of the last two decades can no longer be viewed as random, but must be seen as symptomatic. A day of conclusion is drawing near. "For all our financial sophistication and cleverness, there is a sense that this confrontation with reality cannot be postponed indefinitely…there lies ahead an economic and financial event (or geo-political) of awesome proportions, one that will overturn the prevailing perceptions and priorities of the western world.” ³

The "day of conclusion," whether financial or geopolitical, will be a ten-sigma event. When it erupts, it will shake the very foundations of the financial system. It will not be programmed in any model, for no model will be able to foresee it. Models can give us probabilities, but they can’t tell us when those events will occur. This event, whatever it turns out to be, will be magnified in a world that has become more leveraged and synchronized. Today millions of eyeballs and computers are focused in on the very same things. Events are telegraphed instantaneously around the globe. Trillions of dollars can be mobilized in microseconds in an instinctive reaction without thought or reason. Money mobilizes faster on fear than it does on greed. Greed may be a lost opportunity, whereas fear is motivated by survival.

The stage is set and all of the props are in place for another crash. The fact that we are told it cannot occur should give an alert person reason to pause. The regularity in which financial crises keep reappearing with increasing frequency is proof enough in itself. The fact that the markets have become more leveraged with each new crisis is troubling. The intervention of central banks as lender of last resort reinforces risk taking and emboldens the reckless. Add to this the detachment of investment professionals from the consequences of their decisions which makes them even bolder in their risk taking. It is other people's money and not their own that is used in this speculator's game. In this high risk environment, risk has been defined as volatility. Leverage and margin of safety are excluded. They are considered shibboleths and anachronisms of a bygone era. Today's investment professional hides behind the safety of his models or the infallible belief in mechanistic black boxes. To them, all risk lies under the bell shape of the curve. The tail end is excluded or has been marginalized by the firm belief in the sanctity of hedges. They are asleep and unaware of the risks that surround them. There are multiple candidates. It is these risks, and their whereabouts, that will be the subject of Part 2 of CRA$HMAKER: Ten-Sigma ~ JP

1 Murphy, John J., Intermarket Technical Analysis, John Wiley & Sons, 1991, p.1.
2 Warburton, Peter, Debt & Delusion, Trafalgar Square, 1999, p. 208-209.
3 Ibid. p. 228.


	Storm Watch Update CRA$HMAKER by Jim Puplava www.financialsense.com November 22, 2002