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Look at the Facts When Expecting Market Crashes

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With some people calling for a significant correction by year-end, it could help to take a look back in time.

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Let's talk about crashes. Or, rather, let's talk about talking about crashes.

Over the past week a piece by Paul B. Farrell published by MarketWatch is getting a good deal of circulation, mostly via email among concerned market participants. Titled "Market Crash 2011: It Will Hit by Christmas," Farrell's timing couldn't be better. Mr. Market's been going straight up since early fall 2010 and parabolically so since the New Year. At points along the way YTD the market's climb has sustained a compound annualized pace exceeding 45%. It's human nature for people to chew their nails up to the elbows under such circumstances as they react to the good with fear of the bad. It may be insane, but that's how we're wired. Farrell says get ahead of the Sadistic Santa and get out now! Yikes!

Permit me to extend the credit Farrell deserves for his well-written contention because he is addressing human nature as well -- I am not taking him to task but actually commending his work. He's trying to tell us about the fallibilities of the human brain and something he characterizes as that species' susceptibility to seeking truths in a world of lies and liars, particularly among the very politicians and Wall Street figures who do the most lying and the most damage to our gullible state of existence.

Not bad, Farrell, that's an absorbing postulate. I'm going to take you at your word on this and try to respond because this point is well taken, and I also recommend your thoughtful commentary to everyone who wants to learn something about fundamental analysis. Thank you for taking the time to observe and write down what you've observed. Most people don't know what it's like to struggle in front of a computer when you boot up Word and there's nothing but white space, when what you'd like to see is a few hundred words of intelligence with your name attached to it.

Ladies and gentlemen, get a collective grip on yourselves and by that I mean calm down and take a historical look to gather some base data. Why? Because if you're going to make a business of worrying, at least worry in a productive way. Useful worrying is a good thing. It's an impetus to be concerned and focused about something that may be important. It lights a fire under our communal pants, so to speak. So start with a hose and a pail and get near a copious faucet -- maybe even a fire extinguisher or two. Unprepared worry is directionless, fruitless, and -- in this case -- potentially searing. Check your insurance coverage. If you're wondering what the heck I'm talking about, just ask yourself if you'd like come out of this on the street, burned with a cardboard box full of once cherished and now charred remnants of possessions. Or instead look back upon a day that you were prepared -- a day the smoke detectors went off and you were pleased they did because you'd regularly checked the batteries, a day you discovered a minor flame in a wastebasket, doused the pesky combustion, and lived happily ever after.

Let's accept the premise that Santa is going to bring us a crash, either early or on time. Let's begin our learned nerve-racking by asking, "What is a crash?" That way we'll at least know what we're perturbing about. I always like to proceed in such situations by taking an extreme example, and the word crash connotes the extreme anyway, so that too should seem logical. If you want to do it another way that's fine, but if you're reading these remarks you'll have to follow my lead for now.

What put us in this mood? As of this writing the S&P 500 Index stands just shy of 1320, up some 62 points or about 5% since the calendar started reading 2011, which is to say over the past eight and a half weeks. We've been getting some headwinds of late (just as we did June through August last year, some may recall) and, because the Middle East and North Africa are in flames and oil has shot up to $100 a barrel, we're a little anxious. "Overvaluation" is coming up, and understandably so, especially considering Bernanke's low interest rates and what a minor pop could cause. We're still advancing this year at a compound annualized clip north of 30% versus that 45% we were silly enough to get used to as "normal," a terrific upward bias. Yes, breadth and some other internal measures have broken down a bit but the portion of stocks trading at or above their long-term moving averages doesn't (yet) conform to bear market conditions. And if you look at the specific days in which prices have "corrected," if you will, the percentage declines have not been hair-raising. Nothing to fret about? No, I'm not saying that. I'm just pointing out how psychological factors can get alarmists raving when perhaps a little mitigating quietude and reason might be a good idea. I'm not calling Farrell a raving alarmist either, even though he says the S&P 500 is worth 910 -- 30% below its currently traded value. Maybe he's right; Farrell's valuations-based argument has validity. Let's examine what it portends.

Highlighting an extreme example can introduce numerical information good for agreeing on what the subject is, or at least -- by the example I've chosen -- what one crash was. October 19, 1987, is now known as "Black Monday." Now that was a crash. What happened? Early that month, the Dow Industrials peaked intraday at about 2700. Then on October 20, with much yelling, screaming, and other commotion -- and furious trading, of course -- that same index found itself hovering at an intraday low of 1616.21. Poof! Forty percent up in smoke in a matter of days peak to trough, and it caught a lot of folks, both smart and not, by complete surprise. Now you know why people get emotional regarding crash talk. And you also know that what Farrell says can happen has happened before.

But wait! Just a couple of years later, that same index closed out the year 1989, on December 29 to be exact, at 2753.20 and P/E valuations hadn't changed much either.

That is just one version of events of one of the greater upsets ever to occur in the entire history of equities markets, and one way of summing it up. I was there when it happened, and I can tell you that people were definitely losing their minds. But I was also there two years later when the same people described that bit of history with total amnesia toward their emotionalism in the moment of its incidence, saying things like, "Oh, yeah, I remember that. The market got a little ahead of itself and adjusted."

This is the way humans are wired, as Farrell points out. And I might add that during the period of reminiscence in 1989 I'm calling attention to, you might also say that the real-estate market was in far worse trouble, that that market had deteriorated quite a bit since that stock market crash in 1987. You might say that that the stock market could have been said to have "presaged" the real-estate conditions of 1989 (and for a few years after that), but that's another story for another day.

So now what? What can be concluded about all this? Well, for one thing, had you been just a quiet unemotional bystander staying put with your stock market money in the 30 Dow Industrial stocks during that period, nothing much happened to you (at least in the stock market portion of your life). On the other hand, you might also have been fired from your job, or had any number of personal mishaps -- so it all depends. The collective view has its limitations.

Here's a chart for the Dow versus the XAU gold/silver stock sector for that slice of history over a slightly more elongated time frame, courtesy of www.chartsrus.com.



No positions in stocks mentioned.

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