Fear This


What would you do if the Dow dropped 5,000 points tomorrow?

Really?  Be honest with yourself.

I know how I would react because I remember a phone call.

My mother-in-law.

The least investment oriented person in the world but… even she was in a panic.

That call was Oct. 19, 1987.

The Dow Jones Industrial Index had crashed more than 20% in one day.

She wanted to know, “will this crash get worse?”

The truth?

I did not know.

When it comes to investing…  there is always some risk.

geese

Investments are like a flock of geese.

We know they go north in spring.

But exactly when they fly is a mystery.

We know they go south in the fall.

Yet not the exact day.

Nor can we say precisely which goose will lead… for how long…  at what time.

The movement of geese and the price movements of equities are both ruled by laws of nature that we can never totally know.

The chances of seeing a gaggle of geese migrating south in October is more likely, but ask any hunter, photographer or bird watcher sitings are hardly assured… especially at any specific time.

When it comes to investing…  there is always something we do not know.

There are, however, three things we do know about the stock market.

#1: Periods of high performance are followed by periods of low performance (and vice versa).

#2: Periods of low performance move more quickly that periods of high performance and usually start with a sudden drop.

#3: We are more likely to see a period of low performance begin in September or October.

We dodged a September bullet this year and saw the DJI reach an all time high over 22,400.

Now we face October.

Will the stock market be good or bad?

We do not know, but we do know that another law of nature, one that prepares us as humans to survive, makes most of us ill prepared emotionally to trade in shares.

The Wall Street Journal article “Will You Be Ready When the Stock Market Crashes Again?” (1) dramatizes our human frailties when it tells this true story.

With U.S. stocks hitting all-time highs this past week and the calendar just about to flip to October, think 30 years back with me to Friday, Oct. 16, 1987.

The stock market is up more than 30% for the year so far. But traders are jittery: Interest rates are rising, tax rates are in flux and the U.S. is bickering with international trade partners and skirmishing with Iran.

James O’Shaughnessy, a young investor in St. Paul, Minn., has made a “five-figure” bet on stock-index put options, a way of profiting from a sharp fall in price on a basket of big U.S. stocks. Plugging his phone into a modem that dials up a stock-quotation service, he grows more and more nervous as the day goes on and the Dow Jones Industrial Average falls a record 108.35 points on unprecedented volume of nearly 339 million shares.

The selling is “completely overdone,” he thinks: Stocks are bound to bounce back big on Monday “and then I’ll get killed” for hanging on to the bearish bet. “A feeling of panic washed over my entire body,” Mr. O’Shaughnessy says. “I’ve just got to get out.” He calls his broker a half-hour before the market closes and sells it all.

Humans have a bias against risk.

Feelings that we’ll “get killed” for holding our bets are natural.

Panic that washes over our entire bodies. This emotion creates a performance gap.  Investors overall earn less than the sector they invest in.

This performance gap is very real.  We should face this fact and prepare for it.

The WSJ article tells how O’Shaughnessy missed a huge opportunity.  On October 17, 1987 he sold his his puts, to avert a huge loss.  The next day the Dow drops 208 points in the first 90 minutes, of trading.

A wave of global selling caused the Dow to fallen 22.6%, “the worst day in Wall Street history,”.   That’s the equivalent of a 5,000 point drop today.  He lost a 1,000% one day profit!

You can’t survive a market crash if you think it can’t happen. And something like Oct. 19, 1987, will happen again. In fact, it already has: On May 6, 2010, many stocks dropped 60% or more in a flash, although they bounced right back. On Aug. 24, 2015, the Dow fell more than 1,000 points, or 7%, in six minutes, before closing down nearly 4% for the day. Between the market’s peak in October 2007 and its bottom on March 9, 2009, the S&P 500 fell 55.2%, even after counting reinvested dividends.

Take it from Mr. O’Shaughnessy, who today manages nearly $6 billion at O’Shaughnessy Asset Management in Stamford, Conn. Even though he based it on factors he no longer believes in, his original analysis was absolutely right: The stock market was overvalued. Between September 1986 and the end of August 1987, stocks had gone from trading at 16 times earnings to a price/earnings ratio of 21.4, a 33% rise that put the market’s P/E at its highest level since the end of 1961.

His emotional reaction, however, was dead wrong. Had Mr. O’Shaughnessy held his ground for one more day, he would have made roughly 10 times his money, he recalls.

No one knows when the super heated US stock market will begin its next bear trend.

What we do know is the value of the US market compared to its history and to other stock markets around the world.

The numbers below from Keppler Asset Management, another source of data we follow at Pi,  shows that the price-to-book of the MSCI US Share Index at 3.13 price-to-book is still well below the super inflated price to book of 4.23 in December 1999.

keppler

A bear will again descend on Wall Street.

The autumn and winter months ahead are a likely time.

Yet we cannot be sure.

We can still see profits and growth in US shares and we will… until we won’t.

All stock markets have risk and volatility, but that if you invest in the top ten good value markets, that have a price-to-book of just 1.43,  this is a much better deal than paying 3.13 price to book  for US shares that are their record high.

Take extra caution in your equity investments now.  The volatility quotient of the DJI is about 10%.

The trend is bullish so the trend won’t break until the DJI drops below 20,000.

That could happen in minutes tomorrow… or any day.

Remain alert.  Short-term trading algorithms can cause market trends to shift at astounding speed.

Prepare now what you will do if the markets panic.

Create a plan based on math based good value economic data.

Include watching the price of gold.

When the crash comes, stick to you plan.

Do not panic.

Turn on the auto pilot and normally add to your position.

Do not let feelings influence you too much.  Use logic.

Gary

(1)  wsj.com: Will you be ready when the stock market crashes-again


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