How to predict market crashes

The history of capital market crises is punctuated by black days during which billions of dollars were lost. Were they avoidable? And what do they tell us about potential problems for markets today?

Despite different circumstances and dynamics, the common preconditions for those bad days have been leverage and insufficient liquidity. Focusing on Black Tuesday in 1929, Black Monday in 1987 and Black Monday in 2008, we will examine the vulnerability of large systems to systemic risk and leverage.

1929

From October 1923 to September 1929, U.S. stocks represented by the Dow Jones Industrial Average (DJIA) of thirty blue-chip companies rose a stunning 344%. But on October 29, 1929, the DJIA fell 12%, and a total 23% during that week. Within a month, stocks were down 40% from their September peak. The Great Depression that followed may not have been directly caused by the market’s collapse, but investors had lost confidence in the financial system. It took three years before the market bottomed, down 89.3% from its highs. The preceding bull market featured broad participation by new investors who benefited from margin. Buoyed by optimism and the economic growth following the First World War, investors believed they could get rich overnight in the stock market. They could invest $10 for every dollar they put up. Leveraged ten to one, the cascading impact of margin calls tested the limited liquidity of markets as trading volumes tripled. Debt on personal balance sheets, exacerbated by the sharp decline, fuelled the retreat.

1987

On October 19, 1987, the DJIA declined 22.6%. Liquidity again played a role as electronic and manual “programme” trades to execute index-arbitrage strategies overwhelmed stock exchanges. Compounding the problem was portfolio insurance, which hedged against declines by selling stocks and futures. Corporate raiders who acquired companies with borrowed money had been leveraging balance sheets and selling off companies in pieces.

Using a company’s own cash flow to service the debt, these raiders held America’s big businesses hostage, forcing many to issue unnecessary debt in an effort to keep their jobs and fend off attackers. Threatened with changing tax laws that disallowed interest deductions for debt used for acquisitions, valuations began to unwind as takeover premiums were reduced. The debt on corporate balance sheets provided the powder keg that contributed to the rapid sell-off.

2008

The financial collapse of 2008, which led to a 52% decline in U.S. stocks, was largely the result of leveraged financial institutions and homeowner exposure to residential sub-prime mortgages. Not unlike the margin calls of 1929, $325 billion in bank capital was at risk of systemic margin calls related to sub-prime mortgages, according to JPMorgan Chase. Ultimately, 15 banks went under as adjustable-rate, sub-prime mortgage defaults doubled from 15% in 2007 to 30% in 2010. By comparison, prime fixed-rate mortgage defaults were 2.5% in 2007 and 6.5% in 2010, according to the Mortgage Bankers Association. Falling house prices, leading to negative equity, worsened the problem.

What we learned

Today, both governments and Canadian households are highly leveraged, which has micro- and macroeconomic implications (see Table 1, “Global debt ratios,”).

Greece faces a difficult future, according to these estimates. The rigidity of Eurozone rules and the lack of a safety valve, like a freely floating currency, suggest Greece will face continuing challenges unless it can negotiate either an orderly withdrawal from the European Union or more accommodations. The Japanese predicament is instructive, because it illustrates a mature economy that has suffered from an extended period of stagnation. Could this be the future for Europe or North America?

Canadian household debt, when considered with housing prices (see Figures 1 and 2, below), looks ominous when compared to the U.S. situation. Note that leverage in previous crises was a condition that had the effect of magnifying imbalances. Catalysts for crises are difficult to anticipate, but once trouble ignites, leverage is like adding gasoline to the fire.

A bullish view is that Canada avoided the excesses created by the sub-prime mortgage problems in the U.S., and that no correction in prices is needed. High household debt may be a brilliant strategy if inflation picks up and borrowers repay their loans with inflated dollars.

The bearish case is self-evident. This cursory look at leverage and the history of stock market collapse doesn’t necessarily suggest that the current situation will end badly. However, the potential for significant unwinding is greater when factors, such as individuals, corporations, countries or central banks are extended, and left without choices when trouble hits.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.