All Business

ECHOES OF BLACK MONDAY

STEVE MAICH October 25 2004
All Business

ECHOES OF BLACK MONDAY

STEVE MAICH October 25 2004

ECHOES OF BLACK MONDAY

All Business

STEVE MAICH

It’s market crash season—and it looks like we’re due for a big one

EVERY OCTOBER, the fear returns. Just as the leaves start turning, traders and brokers everywhere take a deep breath and hold it for a month. Caution rules the day, jittery fund managers seem even jumpier than usual, and in the weeks leading up to Halloween, nobody ever, under any circumstances, utters the word c-r-a-s-h.

This is more than idle superstition. Market historians can tell you that October has yielded a lot of misery over the decades, most notably the great stock market crashes of 1929 and 1987. Smaller tremors in the late summer and autumn months of 1989,1997 and 1998

have only heightened the tension. At this time of year, the same question lurks in everybody’s mind: could it happen again? Will we wake up one of these days to find that stocks have collapsed, in a grim replay of Black Monday? And if another crash does plunge our biggest trading partner back into economic turmoil, what would that mean for Canada?

Think back to 1987 for a minute. Three Men and a Baby, a heartwarming comedy starring Tom Selleck and Steve Guttenberg, was America’s top-grossing film. Blockbuster albums of the day included Sign O’the Times by Prince and U2’s The Joshua Tree. Ronald Reagan was in the White House. Lt.-Col. Oliver North was coming clean about the Iran-Contra affair. And on Monday, Oct. 19, the world watched the biggest one-day financial cataclysm in history— a tidal wave of panic that swept the globe and ended with a 508point, 23 per cent collapse of the Dow Jones industrial average.

In the months and years that followed, the market regained its footing, of course, and a fairly clear set of causes for the crash was identified. And wouldn’t you know it? Seventeen years later, most of those triggers have returned, creating what some experts believe is a market tinderbox awaiting a spark.

The first significant parallel to Black Monday is the weak U.S. dollar. Between 1985 and 1987, the greenback declined 39 per cent against the yen and 21 per cent against the British pound. Over the past two years, the U.S. dollar has dropped about 20 per cent against the euro and 11 per cent against the yen, despite efforts by japan’s central bank to keep a lid on its currency so it can keep

selling Sony TVs and Toyota cars to suburban families in Virginia.

Then, as now, the two main factors driving the U.S. dollar lower were the “twin deficits”—two giant holes in America’s finances. President Reagan’s tax cuts created a sharp increase in the U.S. budget deficit. At the same time, the American current account deficit—which measures the flow of goods and services into and out of the country—worsened, peaking at 3.5 per cent of the nation’s economy at the end of1986.

This should sound pretty familiar because, under George W. Bush, the twin deficits are back, and worse than ever. The U.S. is projected to have a record US$422-billion budget deficit this year, due largely to the Bush administration’s war in Iraq and its massive

IN 1987, when the foreign demand for U.S. stocks finally disappeared, so did the retirement savings of millions of investors. The same thing could happen now.

tax cuts. The current account deficit, meanwhile, has swollen to a projected US$664 billion—or 5.7 per cent of the economy.

Back in ’87, investors got nervous when they realized they were paying dearly for stocks and getting little in return. Compared with earnings, share prices seemed too high and dividends too low. That October, the priceto-earnings ratio on the S&P 500 averaged 19.3, and the average stock dividend was 3.3 per cent. Today those numbers are worse, with the average P/E ratio in the index at 20.1, and the average dividend yield at 1.8 per cent. With rock-bottom interest rates and no

inflation to speak of, investors seem willing to pay higher prices for stocks and accept minuscule dividends for now. But for how long?

The entire market is being propped up by foreign investors who still see North America as the world’s most stable economy, and who continue to buy American stocks and bonds in massive quantities. In effect, those huge budget deficits in the U.S. are financed by investors overseas who buy American debt as fast as the country produces it. ButwiththeU.S. dollar in a slow decline, you have to wonder when foreigners will decide they’ve had enough.

Stephen Roach, chief economist at Morgan Stanley, is already seeing signs that some foreign investors are losing their taste for the American market. Generally, most foreign money comes from private investors, but in recent months the buying has been led by big institutions such as Asian central banks. His theory is that those governments, eager to keep their currencies low and their exports high, are in a “last gasp” effort to prop up the U.S. dollar. The last time they tried that was... you guessed it: October 1987.

When the foreign demand for U.S. stocks finally disappeared, so did the retirement savings of millions of investors.

“There are increasingly worrisome signs of a replay of that same ominous chain of events,” Roach says. “The funding of America is an accident waiting to happen.” Roach figures that the world’s governments are already holding too many U.S. dollars. If and when they decide to stop paying the bill for U.S. profligacy, well, break out your leather ties and leg warmers, folks, ’cause it’s going to be 1987 all over again.

Don’t laugh—Prince is headlining one of this year’s biggest concert tours, and U2 will release a new album next month. If Steve Guttenberg makes a comeback, then you’ll know we’re in trouble. Ifl

steve.maich@macleans.rogers.com