FYI | Oct 20 2007
By Greg Peel
At about 5am on the morning of October 20, 1987, a young SPI options proprietary trader got a call from his boss suggesting he’d better get into work right away. It was one of the scariest, yet also most exhilarating, days of his life. Fortunately for the young trader, he was not yet senior enough to be responsible for the losses that were about to be incurred by the options book, nor well paid enough to be invested in the stock market.
That was the Tuesday following “Black Monday” on Wall Street. The Dow had fallen 23%. Not only did the magnitude of the fall catch the world by surprise, but on the previous Friday the Dow had fallen about 5% and many had assumed that was the correction the market had needed.
Last night the Dow fell 367 points, or 2.6%. Both the S&P and the Nasdaq also fell 2.6%. In the context of some scary trading days at the height of the credit crisis, and in the context of some pretty significant down days at other times since 1987, this was not an overly remarkable drop. In retrospect, Wall Street had been building up to such a move all week (the Dow closed down a total of 4% for the week). Indeed, it has probably been building up to such a move since the Dow steamrolled through the previous high of 14,000 and hit 14,164 on October 9.
The all-news-is-good-news theme eventually had to trip over. At the end of the day, if the Fed is forced to cut rates again – particularly by another 50 basis points – then something is very wrong. The market had been responding as if the credit crisis had ended the day the Fed cut the discount rate, and been buried the day it cut the cash rate. There was little to suggest this was actually the case, despite some small signs of improvement. Indeed, as the financial sector kicked off the third quarter earnings season, it had become apparent that the credit crisis was still far from over. The direction of the stock market from here was always going to be about earnings, not rate cuts.
As successive financial institutions – such as Citigroup and Bank of America – came out and not only announced worse than expected losses, but ominous guidance for ongoing problems in the fourth quarter and beyond, Wall Street began to get the wobbles. The saving grace was a round of very positive earnings reports in the tech sector, from the likes of Yahoo! and Intel amongst others. Last night, Wall Street was also contending with the extraordinary success of Google. But last night also saw the first of the big industrial companies releasing their earnings reports, and that’s what tipped the balance.
Dow components Honeywell, 3M and Caterpillar all posted disappointing results. Perhaps the worst news came from Caterpillar, which offered guidance described as “abysmal” as it predicted a recession and suggested the housing market was the worst the construction equipment manufacturer had seen in 50 years.
The Dow fell steadily in the morning, flattened out over lunch, and fell steadily again to close on its lows. The VIX volatility index jumped 24%. A fall of this magnitude triggers regulatory restrictions to curb the extent of “program” trading – when computer models flash sell signals and the computers actually send the orders to the market by themselves. Irony? It was program trading activity that was blamed for the crash in ’87 and which brought about the regulations.
The US bond market continued again on its rate cut theme, with yields falling from 4.5% to 4.4%. As the G7 finance ministers meeting commenced, the US dollar managed to hold relatively steady against the euro, but fell sharply from 115.62 to 114.55 yen.
As the Australian stock market had rocked and rolled its way around at the bottom end of the correction, one reliable immediate indicator was the direction of the yen. If it was up, carry trades were unwinding and the market fell. The yen has begun to rise again. The Aussie, which also has the capacity to tank if the yen rises, slipped only marginally last night to be at US$0.8911. The Aussie is now finely balanced between a falling US dollar, the likelihood of an RBA interest rate increase, and the potential danger of carry trade unwinding.
Oil fell US87c to US$88.60/bbl last night in a topsy-turvy session. It initially breached US$90/bbl for the first time, but soon lost momentum as the Dow began to sour. Geopolitical tensions aside, a US recession is not positive for oil. However, losses were crimped when news came in that former Pakistani Prime Minister Benazir Bhutto had suffered a failed suicide bomb attack that otherwise killed 130 people. Throw in the Turkey-Iraq situation, and oil does not necessarily have a long way to fall just at the moment.
Gold also held up well, falling only US$2.60 to US$763.60/oz. While a falling dollar, weak stock market and heightened geopolitical tension should be positive for gold anyway, the trend during the sharp stock market falls of July-August was for gold positions to be initially liquidated to raise cash for margin calls. Base metals were actually quite positive in London last night. Again, metals fell over July-August on recession fears but have since bounced on the back of the weak US dollar.
The SPI Overnight was down 155 points.
On the Friday before the crash of ’87, the Dow fell 5%. On the Monday it fell 23%. If the Dow fell 2.6% last night, does that mean it will fall 12% on Monday?
There are some in the market predicting another stock market crash, but then there are always those in the market predicting a crash. In 1987 the US economy ruled the world. In 2007 it’s still by far the biggest economy, but global economic growth is now widespread. The Australian stock market emulated the Dow’s falls on the Monday and Tuesday in 1987. Then the All-Ords had been up about 50% for the year, today it is up about 20%. Then PEs were around 21x, today they are around 17x. Then we didn’t have China, or a commodities boom (although BHP was then the biggest stock in the index).
Wise heads have not been surprised by last night’s fall, but are not looking for a crash next week. That is not to say there shouldn’t be further weakness as the US stock market tries to sort out what is a realistic, rather than euphoric, level.
But there’s always something about October. Happy Anniversary. For the record, that young options trader is now a financial journalist.
