Stop Losses for Plunge Protection?
The 1987 Crash Offered Little Warning
by Martin Goldberg CMT. March 4, 2004
An e-mail comment from a reader on a recent FSO Market Observation article, "Could the Market Crash – Everyone Says "No":
"I agree with your thoughts but because we have made a lot of money these past months, I am keeping tight stops on my long positions."
Are stop losses adequate protection from a crash in today's stock market? You would have to consider that throughout history, one purpose of the stock market was to take wealth from the less informed public speculators and move it to the richer and more capitalized and informed players. However, the recent rally off of the October 2002 low has contradicted this timeless trend. You have a lot of the public, who are operating as technical analysts. The practice of the technical analyst public has probably reached unprecedented levels over the last few years. At this stage of the rally most of the public is net long in the usual suspects – technology stocks. So how do you think the market can return to its timeless trend of fleecing the public while the public playing the technical analysis/momentum game in unprecedented numbers? There's only one logical answer, and that is a crash.
I realize that the Crash Theory I suggest has no basis in the "science" of technical analysis. The science suggests that technical analysis enables the analyst (us) to detect underlying weakness in the stock market before a precipitous drop or crash occurs. But with practically everyone practicing technical analysis and observing the same weakness-indicators, it is logical that everyone will act in the same way to the same "stimulus". This, I believe, is the stuff of a steep and devastating crash.
You must consider that technical analysis is an art as well as a science. If technical analysis including such tools as trends and oscillators is considered a series of theorems, then you have to consider the corresponding underlying "postulates" (or unproven bases) of technical analysis including:
- One purpose of the stock market is to provide a market where the uninformed public loses money to the more highly capitalized and informed professionals.
- The stock market renders the greatest number of participants wrong in the long run.
- The biggest stock market gains are made by the public on paper, and that's where they stay.
The most logical way that the three rules described above hold in today's environment is if a Crash occurs.
Public Participation in the Momentum Game
I have no specific statistics to document prevalence of public participation in technical analysis and momentum trading. However, the anecdotal evidence is plentiful and suggests an alarming bubble-like situation. I've mentioned the increasing popularity of the technical analysis-based Investors Business Daily (IBD) before. Also consider the new preponderance of technical analysis products hawked on financial cable radio and TV stations, and newspapers. Look at the preponderance of technical analysis articles on the Yahoo Finance home page. On Bloomberg radio, there is a commercial for day trading courses, where a happy customer tells listeners, "My best day so far, I made $7,000, and on that particular day, I was done by 11 O'clock in the morning." For further evidence of public participation in stock speculation, consider the recent stock charts of publicly traded on-line brokers, Ameritrade and E*Trade, below:
In addition to the public, many professional technical analysts are also "playing" this rally, while relying on their skills in the "science" of technical analysis to make profits, and maintaining stop losses for crash protection. I question the risk with such a strategy by professionals or amateurs because of the potential of a stock market crash. (And I wouldn't depend on the rumored "free" insurance from the "plunge protection team" (PPT) either.) This is because, when a crash hits, stop losses are not likely to help very much. The crash may be similar to Black Tuesday, 1929. At that time the stock market hit an "air pocket" where there simply weren't any bids for stocks. I realize that at first glance of the comparison of 1929 to today's modern age of computers may not seem relevant. However, consider whether your on-line broker has ever experienced "technical difficulties"? Mine has. How will stop losses be executed if there is anything resembling a panic in the stock market? My guess is that the little guy with long positions in the usual suspects will get his financial head handed to him, stop loss or no stop loss. Consider the typical on-line broker's disclaimer:
"System response and account access times may vary due to a variety of factors, including trading volumes, market conditions, system performance, and other factors."
Finally, I realize that suggesting a crash is likely to render bearish people like me a bit eccentric at best. Generally before a crash, it is the most negative market observers that seem the most foolish. This is also a timeless constant of the stock market. Remember how Gail Dudack was ousted from Louis Rukeyser's stock market "elves", when she was the only bearish "elf" in 1999? Bearish market observers have been looking like the village idiots lately. The stock market may be ready to crash when there are no sane bears standing. Given the current environment, it can happen at any time.
The 1987 Crash Did Not Issue a Forewarning to the Public
Consider the 1987 July through October daily charts of the Dow Jones Industrial Average (DJIA). At a time when that many people think a crash will issue a forewarning for technical analysts, much of the public is counting "distribution days" and other similar technical indicators. (A distribution day is defined by IBD as a day in which the average finishes significantly down for the day on higher volume than the preceding day.) However in 1987 the crash offered no such forewarnings. I've outlined the distribution days with a red arrow on of the charts below. As you can see, there were very few "distribution days" before the October 1987 crash.
July '87
August '87
September '87
October '87
For comparison purposes, let's count distribution days for the recent NASDAQ:
The recent NASDAQ chart contains about 18 distribution days, compared to 8 in the four months preceding the 1987 plunge. On the basis of distribution days, compared to the 1987 Dow, the current NASDAQ is practically screaming, "sell" at us!
Spring Cleaning Reveals Old Barron's Edition and More Suggestions of an Overvalued Market
While cleaning out a closet, I discovered an edition of Barron's dated 20 March 2000. I superimposed similar data from the most recent edition next to the 2000 data, and this is presented in the table below. It's interesting to note that the current P/E ratio of the Dow Jones Industrial Average (DJIA) today of 20.2 is very close to the height of the largest bubble of our generation. The DJIA index value of about 10,600 is about the same also. Also note that in March of 2000, the "consensus estimate" for the next year called for a similar percentage increase (13.6%), compared to today's "consensus" (14.3%). Today's valuation of the S&P 500 is also similar to those near the height of the 2000 stock market bubble. While the most bullish of fundamental analysts may argue that most of the bubble was confined to technology and telecom, it would be very difficult to suggest that the Table below indicates a present day stock market that is cheap.
| Comparison of March 2000 to Today Source: Barron's | ||
| 20-Mar-00 | 1-Mar-04 | |
| DJ Ind. Avg. | 10,595 | 10,584 |
| P/E Ratio | 22.8 | 20.2 |
| Earnings Yield, (%) | 4.37 | 4.94 |
| Earnings ($) | 463 | 523 |
| Divs Yield (%) | 1.46 | 2.03 |
| Divs. ($) | 155 | 214 |
| Mkt. To Book | 6.26 | 4.63 |
| Book Value ($) | 1692 | 2287 |
| DJIA Consensus Estimate for Next Year | 526 | 598 |
| Consensus % Earnings Increase | 13.6 | 14.3 |
| DJ Trans Avg. | 2624 | 2902 |
| P/E Ratio | 8.4 | 38.0 |
| Earnings Yield, (%) | 11.89 | 2.64 |
| Earnings ($) | 312.1 | 76.5 |
| Dividend Yield, (%) | 1.34 | 1.16 |
| Divs. ($) | 35.23 | 33.62 |
| Mkt. To Book | 1.85 | 2.34 |
| Book Value ($) | 1418 | 1242 |
| S&P 500 Index | 1464 | 1145 |
| P/E Ratio | 30.4 | 29.7 |
| Earnings Yield, (%) | 3.3 | 3.37 |
| Earnings ($) | 48.26 | 35.58 |
| Divs Yield (%) | 1.15 | 1.63 |
| Divs. ($) | 16.84 | 18.66 |
| Mkt. To Book | 6.99 | 3.53 |
| Book Value ($) | 210 | 324 |
Fed Chairman Alan Greenspan indicated recently that the late '90's stock market bubble could not be identified until it finally was broken. He also suggested that it was a good strategy for the Fed to deal only with the aftermath of the bubble, and not the bubble itself. That "post bubble" strategy essentially consisted of easy money policy through an abundance of low interest credit. It makes a reasonable person wonder how, with the current Fed fund rate at 1%, and valuations about where they were in March of 2000, what will happen when this bubble (assuming it is a bubble) is "pricked". Advance indications suggest that talk will be the name of the game from the Fed. To quote "Mad" Magazine's Alfred E. Newman, "What, Me worry?"
Got Jobs?
We're seeing a lot of positive economic data regarding the jobs picture that suggests that new jobs are just about ready to show up (just in time) in a strengthening economy. Are you seeing the same thing from your perspective? I think that you should have some anecdotes about company meetings where management indicates that, in spite of the productivity gains you all are providing, there is a need to hire new people (in the US) and soon. Feel free to e-mail these experiences to me. Or send a note if you are not seeing such management desire to increase pay rolls to meet demand. It doesn't have to be a long note (short is preferred) or fancy.
Today's Market
The Nasdaq was up almost 21 points (1.2%) today. In spite of this optimistic price action, it did not even trade an average day's volume. In general, markets can move down on either high or low volume, but it takes volume for a sustained move to the upside. The Nasdaq sits just below its 50-day average. Intel disappointed in its mid-quarter sales update, and is down only marginally in after hours as I write this. Ask Jeeves announced the acquisition of two low-tiered search sites and was up over 40%. It's notable that there are about 40 million floating shares of Ask Jeeves, and 35 million shares traded today. Jeeves should probably post a note on their site, "Under New Ownership"! Just because it flipped its float today doesn't mean the party is over. There is likely to be another group of fearless gamblers to bid Jeeves up over the next few weeks, similar to what is happening to Research in Motion.
The Dow and S&P 500 did very little today, and the Russell 2000 was up to 1st quarter of 2000 levels. Truly amazing, and speculative! You probably will not find any chart resembling the 5-year Russell 2000 in any texts on technical analysis.
Silver continued to show relative strength finishing up 10 cents, and gold was little changed. The gold bugs index (^HUI) was up almost 1.5%.
The dollar continued its rally. The 10-year note was up. The yield dropped 0.031% to finish at 4.029%. Seems the trading range on the 10-year note is getting narrower as time goes on.
Have a great evening!
Martin Goldberg
© 2004 Martin Goldberg
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