Friday, October 19, 2012

Today Marks the 25th Anniversary of the 1987 Stock Market Crash ... Also, Lessons to be Learned from Portugal's Financial Debacle

The stock market crash later dubbed "Black Monday" of October 19, 1987 "celebrates" its 25th anniversary today.

On that one day, the Dow Jones average dropped about 23%, or 508 points, to 1738. So how's it done since then? Well, the Dow now stands almost 8 times higher today at 13,548. And more than 13 times higher if dividends are included. And that's a great lesson about why people should own stocks over the long haul.

Of course, we'll always have problems, and there are no guarantees, so what could go wrong today?  As always, plenty of things.

So let's begin our story with the current example of today's welfare state in Portugal and that country's dangerously weakened financial situation. Automatic Destabilizers contains a lesson worth heeding about what could happen to us if we don't get our own government spending and debt under control sometime soon:

"When economic growth slows and people lose their jobs, government spending rises as more welfare benefits are paid out. At the same time, tax revenues decline as profits, income and employment fall. The effect is called an "automatic stabilizer"—the idea being that growth in government spending helps offset the decline in private incomes and softens the blow to the economy as a whole.

That's the theory, anyway. For it to work, however, governments have to be able to borrow freely. More spending and less revenue means higher deficits, which also have to be paid.

Portugal is the latest example of what happens when governments can't borrow what they need to fill that gap. Call it automatic destabilization. With unemployment at 15.9%, the economy set to shrink by some 3% this year and a budget deficit of at least 5% of GDP, Lisbon is proposing a 4% across-the-board tax hike on wages. That goes along with a three-percentage-point increase in the capital gains tax, to 28%, and a reduction in the number of income-tax rates, to five from eight, that will push many people into higher brackets.

None of this can be good for Portuguese taxpayers. But the welfare state demands its due. The government also plans to cut public-sector pay by 7% and reduce the government work force by 2%.

For Portugal, where government spending equals 49% of GDP, there is no pain-free way to rebalance an economy during a downturn. Cuts in government payroll could send people to the dole or into early retirement, where they will still collect checks from the state. Cutting welfare spending often hits those forced onto government dependency by economic stagnation. Tax hikes take money out of private hands.

Working, saving and investment provide the wealth that pays for the welfare state. When the system can only be maintained by ever-higher taxes on productivity, a country like Portugal risks chasing an ever-larger share of a shrinking economy. That's the road to Athens."


Now let's return to the stock market's crash on this day in 1987 and its relevance to today's investors. 

Protect your money from the next stock crash contains solid advice from economist and money manager David Rosenberg:

"It’s that time of the year again where the ghouls and ghosts of Octobers past serve to spook the market.

A lot of this “boo”-like behavior stems from the October setbacks in 1929, 1987, 1989, 1998, 2001 and again in 2007. Frankly, being someone who focuses more on the fundamentals, I find calendar quirks to be just that. Interesting, but still quirky.
Investors should remain squarely focused less on seasonality and more on the factors that drive the markets — the economy, liquidity, earnings, valuation, technicals, fund flows and investor positioning. . . .

But let me just say at the outset that investing success is not measured in terms of being simplistically “bullish” or “bearish” on one market or asset class. You have to focus on the fundamentals and have the right combination of strategies to exploit the numerous opportunities in front of you. Read more: Jim O’Shaughnessy says market drops create money-making opportunities for stock buyers.    

Slow growth

Global economic growth has been below trend for some time now, and this weak condition has forced central banks to become much more aggressive in their monetary policy. People may debate and history will eventually reveal whether these are wise policies or not. My job is to prudently assess the implications for various asset classes and securities and to do my best to generate desired risk-adjusted returns with whatever the markets present to investors.

Two things do look certain. First, deleveraging by consumers and governments means below-trend economic growth in most of the world’s developed economies for a number of years.
Second, central banks will continue to resort to aggressive and highly unconventional means of monetary stimulus to offset this slower growth and avoid a deflationary stall.

In the immediate near-term, investors are faced with U.S. presidential and congressional elections in November that will have significant implications for U.S. economic policy. Investors also must pay attention to a once-a-decade change of the senior leadership in the new economic giant, China, and the ongoing political and economic challenges in Europe.

All of this is happening at a time when short-term interest rates are close to zero in many countries. These near-zero short-term interest rates (which the Federal Reserve expects to prevail until at least mid-2015) have the direct and indirect effects of reducing the expected returns for a number of asset classes, which makes the investing environment all that more challenging too.

Money back

In this milieu, cash really is “trash” only if one hopes to earn a return that will exceed expected inflation, and even more so if one hopes to generate an attractive return commensurate with taking appropriate and well-understood risks.

That’s why the current backdrop, as tumultuous as it may be, is far different from the conditions that led to the Dow Jones Industrial Average’s October 1987 crash. Then, cash yielded close to 7% and global central banks were busy draining liquidity from the marketplace.

Of course, that was in the context of robust self-sustaining growth and inflation. Today, we hardly have an organic economic revival on our hands, and deflation risks trump inflationary pressures. But cash, bank deposits, money market assets and Treasury bills are all offering near-0% returns and that is what is most critically different.

To be sure, cash and cash-like proxies offer the ultimate in terms of capital preservation, but they will not leave you or your future generations with any means to build on your existing wealth. Return on capital — not just of capital — is still an extremely important objective.

Accordingly, stock dividends have become such a key feature of the marketplace, largely because they have played a leading role in the Standard & Poor’s 500 Index’s annualized return over the past five and 10 years. My sense is that this income theme within the equity sphere will remain in vogue until the global economy picks up steam, at which time aggressive-growth and capital appreciation strategies will return to the front burner.

Until we reach the other side of the mountain, you may as well get paid to wait. And in a deflationary environment where all you get is 0.6% in the “belly” of the Treasury curve, a 2%-plus dividend yield doesn’t look so bad. In fact, we haven’t seen a wedge this big since 1958!

If you are averse to risk, then be diversified as well as defensive, but try at least to generate an economic rent until such time as the global economic clouds do part once and for all.

As cautious as I am, that day will come, I assure you." 


Summing Up

It is worth noting how far we've come since the market fell by 23% on Black Monday in 1987. 

It's also noteworthy that we have a much better outlook for private sector performance in the next several years than we did at that time. We're at the low point now and beginning to recover as a nation from our long and painful economic slide. In addition, interest rates are at historically low levels.

Cash and bonds may not be "trash," but they're no protection against future inflation.

Climbing the "wall of worry" is often an element of stock market success. While we certainly   have lots to worry about these days, we also have many good reasons to believe that things will gradually improve from here and for many years to come as well.

Should that happen, and I expect that it will, the future for individual investors is bright indeed.

Now all we have to do is avoid becoming another Greece or Portugal.

And with their lessons staring us in the face, my view is that our political leaders will take the necessary actions to remedy our financial ills before we run out of time to do so.

Government needs a vibrant and prosperous private sector which is able to contribute the "automatic stabilizers" to fuel future job growth, tax revenues and enable redistribution payments to those in need during the tough times.

Even our U.S. government knows best "public servants" must realize the importance of the private sector to our future prosperity as a people. Unfortunately, however, the Portuguese and most of the rest Europe are now learning that simple lesson the hard way.

Now all we need to do is pay close attention to what's happening over there and avoid making the same mistakes here.

Thanks. Bob.

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