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Did the Dip in the DJIA Last Week Presage an Upcoming Crash?

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On the Silver Anniversary of the October 1987 crash, the Dow dropped 1%. An investor who lived through both shares his notes.

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It was Friday, October 16, 1987 as I looked across Wheat First Securities' trading desk only to see a stark look on the face of my second in command, Art Huprich. At the time, the Dow Jones Industrials (^DJI) (INDEXDJX:.DJI) were down about 100 points with 30 minutes left in the trading session. And as stocks swooned, I said to Art, "Today is just for practice!" Little did I know how prophetic that statement would prove.

To be sure, the "set up" for the Great Crash was almost preordained with the Dow Jones Utility Average peaking in the spring, while the Dow Jones Transportation Average and Advance/Decline figures topped during the summer months. In fact, I was actually quoted in Barron's three weeks prior to "the crash," stating, "Get ready for a waterfall decline." Accordingly, I had termed the 35% rally in the Industrials during the first nine months of the year as, "The solitary dance of the Dow," because every other indicator I monitored was diverging from the Dow Delight.

At the time, a run on the US dollar was in full swing despite a Yield Yelp for the 30-year Treasury bond from 7.5% to over 10%. Participants, however, were lulled into complacency, emboldened by the belief that "portfolio insurance" would guard them against any stock market decline. As the sagacious Craig Drill, eponymous captain of Drill Capital, writes while quoting that legendary economist Stevie Wonder:

When you believe in things that you don't understand, then you suffer, superstition ain't the way, yeh, yeh...

By that Friday's close (October 16, 1987), the senior index had lost 108 points, accompanied by record volume of 338.5 million shares, leaving participants brooding about their losses. Such broodings were amplified as the crash gathered steam over the weekend when markets in Hong Kong "melted" followed by similar slides in all of the European markets.

When Art and I arrived at work on October 19, 1987, the rout was on, exaggerated by the shelling of an Iranian oil platform in the Persian Gulf by two US warships. As the NYSE opened, there was chaos on the trading floor where the specialists were being inundated with sell orders, causing many of them to throw up their arms and simply walk away.

At the time, I was sporting a rather large position in the preferred shares of Castle & Cooke, now named Dole Foods (DOLE) (NYSE:DOLE). Those shares had closed on the previous Friday at $22, but after a multi-hour delayed opening, they were changing hands at $9 per share. Many other stocks suffered a similar fate on Black Monday as the Industrials shed 508 points (22.6%), leaving that index at 1738.74, on a record volume of 604.3 million shares, for the worst one-day percentage loss in stock market history.

I revisit the events of October 19, 1987 this morning because over the weekend many pundits have conjured up a similar crash sequence for this week, building on last Friday's 205-point tumble. Admittedly there is some correlation to the 1987 fiasco, for as the good folks at the "must have" Bespoke organization write:

While 1987 was a much stronger year for equities, the patterns were similar in both years (see chart below). In each case, the S&P 500 (^GSPC) (INDEXSP:.INX) rallied to start the year, reached a short term peak in the spring, then sold off through early summer, only to rally through the fall. At this point in 1987, however, the S&P 500 had already started to break down. Let's hope that for the sake of stockholders everywhere, the patterns have ceased to track each other.



Bespoke goes on to note:

If there is one key difference between now and 1987, it is valuation. The chart below compares the trailing P/E ratio of the S&P 500 in 1987 versus 2012. In 1987 the P/E ratio of the S&P 500 peaked at an above average valuation of 23.4 just as the market was topping out. Following the crash, the P/E ratio bottomed out at 14.4. This year stocks are far from overvalued and are actually below average (see chart). So far in 2012, the S&P 500's peak valuation was 14.9, which is just half a point above the post-crash valuation in 1987.



Still, I was surprised by last Friday's Fade as stocks finished the week with their biggest single-day decline in four months. Surprised, for as stated in last Wednesday's Morning Tack, "Upside resolutions are often tricky, so we may experience a day or two where the markets stall, and rebuild more internal energy, before we get an upside breakout to new reaction highs."

Indeed, while the market's daily internal energy was used up by mid-week, its weekly and monthly energy levels remained fully charged. Historically that suggests any decline should not gain much traction. Obviously, that was not the case on Friday. The media's causa proxima for the Dow Dive was the slew of weak corporate earnings reports. To wit, so far just 58.6% of companies have beaten their earnings estimates, while only 43.2% have bettered their revenue estimates. This week, earnings season will be in full swing with some 700 companies reporting. Yet while last week's earnings numbers were soft, the economic numbers had a decidedly stronger tilt with 10 coming in above expectations and three below.

Looking at the charts, while the S&P 500 failed to break out above a double-top around 1470, and in the process left what looks conspicuously like a triple-top, most of the indices closed higher for the week. The exceptions were the Russell 2000 (^RUT) (NYSEARCA:IWM), the Nasdaq Composite (^IXIC) (INDEXNASDAQ:.IXIC), and the NASDAQ-100 (^NDX) (INDEXNASDAQ:NDX), all of which were weighed down by the technology stocks. Indeed, the technology sector was the biggest loser for the week with a decline of 2.42% followed by consumer staples (-0.65%) and telecommunication services (-0.15%).

By Friday's close, most of the indexes I monitor were testing, or marginally breaking, their respective 50-DMAs, except for the aforementioned tech-heavy indices. In those cases, not only did they decisively violate their 50-DMAs, but they also broke below their post-QE3 support levels with the NDX closing at its lowest level in more than two months. While I would like to believe the SPX will gather itself together and break out above the now visible triple-top around the 1470 level, it just doesn't feel like that is going to play. A more likely scenario is for a break below the oft mentioned 1418 level followed by a dip towards the 1400, which I continue to think should be bought on the premise the SPX will break out consistent with the presidential election year pattern.

On that premise, one name that has a Strong Buy recommendation from our fundamental analyst is 3%-yielding Covanta (CVA) (NYSE:CVA). Covanta is the nation's largest owner/operator of waste-to-energy (WTE) facilities and disposes of approximately 5% of the nation's waste stream while generating approximately 6 Mwh of renewable energy. As our fundamental analyst writes, "Covanta's recurring revenue stream, including 75% of waste revenue under long-term contract with inflation escalators, provides a stable base while higher power economics, metal recovery and special waste should drive future growth. Covanta's robust free cash flows afford a solid dividend with growth prospects, funds available for a recurring buyback and, in our view, attractive total return prospects."

The call for this week: The Industrials finally experienced a daily decline of more than 1% for the first time in nearly four months. While many believe this is the beginning of a collapse, it does not appear that way to me. Indeed, the evidence of a major top in the equity markets is nowhere near conclusive. So while it may take a few sessions for the markets to stabilize, I continue to think the path of least resistance remains up.
No positions in stocks mentioned.
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