Black Monday Revisited?

Source : The Business Times, October 22, 2007

IT WAS exactly one month ago that the US Federal Reserve cut its short-term rate by a surprise 50 basis points, sparking off a worldwide rally in stocks and consigning the then-prevalent US sub-prime fears to the market's backburners.

Exhibiting the same disregard for risk that marked trading throughout the past year or so, investors then pushed Hong Kong's Hang Seng Index up more than 40 per cent in the ensuing four weeks and the Straits Times Index about 30.

Complacency once again set in as program trading kept the upward momentum going in the major indices and, significantly, virtually not a single broker released warnings about increased risks or even discussed the possibility of a steep correction.

In the US, the VIX indicator, which measures implied volatility in S&P 500 options and is often used by contrarians as a complacency indicator, settled back to sedate levels (the lower the index, the higher the complacency; conversely, the higher the index, the higher the fear in the market). It spiked up 24 per cent following Friday's plunge.

Although painful, Friday's collapse here and on Wall Street was thus long overdue, given that oil has kept up its inexorable climb to US$100 per barrel, while the sub-prime crisis' effects on corporate earnings are still not fully known, the US dollar is crashing, the US economy is slowing drastically and, perhaps most crucially, the China stock market continues to inflate in mania-like fashion.

The fact that Friday's falls occurred on the 20th anniversary of the crash of Oct 19, 1987 was however pure coincidence, the date probably playing only a minor role in creating nervousness in the market's collective mind.

You'd have to wonder, though, how was it that the selling on Friday started here first, way before Wall Street opened for trading and way before big names Caterpillar, Honeywell and 3M released their disappointing numbers? Even with markets as interconnected as they are, how is it that funds know to sell or buy stocks here because Wall Street is going to fall or rise later that day?

No matter, the big question is: Will we see a repeat of the crash of 20 years ago? It's possible but not probable. While Asian markets will surely have to brace themselves for a 'Black Monday'-type sell-off this week, it's unlikely to be of the magnitude suffered 20 years ago.

The main reason for this is simple - the US Fed, first under Alan Greenspan and now Ben Bernanke, has repeatedly signalled its willingness over the past decade to cut interest rates at the first sign of trouble and the markets have taken note of this.

In addition, the US and world economies are a lot stronger than they were back then and the political scene was vastly different - China was nowhere as open as it is today, India was not an economic force to reckon with, and the Berlin Wall had yet to crumble.

So when asked by US newspaper Barron's whether a repeat of Black Monday was possible, Byron Wein, chief investment strategist at Pequot Capital Management, echoed the view of most practitioners when he said in the Oct 15 issue: 'I don't think there's a chance that the market can go down 22 per cent in one day. There's too much liquidity and too many buyers to cause a cascade like that.'

However, there are undeniable similarities between then and now. In 1987, the US dollar was weakening, oil and commodity prices were rising, the Fed had a chairman who was only a few months into the job, the major market indices were at all-time highs, and the US economy was at the tail end of a prolonged expansion.

Of the lot, the sliding dollar and rising oil are the most significant because if both persist in the direction they are heading, they could seriously undermine growth, fan inflation and dampen sentiment.

To recap: the odds of a full-scale repeat of Black Monday are low because liquidity is high and the Fed is on the side of the markets. Risks, however, have increased. Prices will collapse today, but how far they go will depend on how Hong Kong, China and the US futures market perform in the wake of Friday's much-needed shot of reality.