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How Far Down Can Stock Markets Go ?

Stock-Markets / Stock Markets 2011 Aug 21, 2011 - 11:19 AM GMT

By: Andrew_McKillop


Best Financial Markets Analysis ArticleThe crash of Oct. 19, 1987, AKA “Black Monday” witnessed a 20-percent-plus fall of index numbers, and therefore nominal stock market value in 1 day: since early August 2011 we have had falls of around 15 percent in 15 days. 

Retrospective mythmaking on the 1987 crash noted that Iran had fired missiles over the Persian Gulf, causing some nervous moments, rather like Hamas firing missiles on Israel, today. The decisive factor, for some mythmakers treating the 1987 event, was that 24 years ago the US wanted a lower-valued dollar, rather like today, prompting foreign investors to start to dump stocks fearing exchange rate-related losses.

The curious thing, here, is that cuts in 1985 of the US dollar's value against the yen by about 40 percent, and by around 20 percent against the German deutschemark had almost no impact at all on "investor sentiment" ! Can we imagine it took them 2 years to wake up to the news ?

As we see already, "investor sentiment" is a special herd thing, possibly quite mysterious.

Another favoured explanation of why sentiment was so bad in October 1987 is that markets were not well protected by Plunge Protection at the time. Programme selling software did not face the circuit-breakers which today stop trading after there is about a 10 percent decline in any one trading day. In other words and in theory, we could have a 50 percent fall in one 5-day trading week but we can't have 20-percent-off in a single day. In March 2011, following the Fukushima nuclear disaster, Japan's Topix index tanked by 12 percent in a single day (15 March), the biggest single day loss since the 1987 crash, in a panic sell off similar to what all stock exchanges are capable of, when sentiment is right.

In the good old days of 1987, falling markets resulted in yet more selling, which basically snowballed as computer-generated trades kept pressure on the markets all day and all week. As observers remarked: “The only thing that kept the market from melting down even more was the closing bell” - but the bell rang on a very different world relative to 2011.

Money growth is one feeder of market growth. It is obvious this is the basic fuel for the delirious and unreal illusions vectored and sold, to the unwary, by stock markets since they started operating in their 'modern' format, in the first two decades of the 18th century. At a larger, more aggregate level it is also obvious the amount of nominal "value" a market can lose will depend on how much fiat monetary value existed and circulated, before the crash. The two forms of unreality are linked. Both are a socialized and cultural bet on what the words "value" and "confidence" mean.

Taking as one example, fast growing emerging economy giant India shows what kind of expansion of money supply is possible in a short period of time

On top of the money supply growth, multiplying the potential damage from stock market crashes, we have at least two other key factors.

The revolutionary expectations - always growing - of market operators and traders are surely and certainly raised by so-called 'financial engineering', raising the fuel available and interconnecting previously separate 'asset spaces', to build ever bigger and hotter asset bubbles. Next, we have the interconnection of exchanges worldwide, further raising the potential for "value growth". In nominal value terms (although nominal value has no real meaning, because all engineered assets have counterpart liabilities - sometimes huge) world stock market turnover volume has grown by more than 25-fold since 1987.

Present day nominal value turnover on the world's 16-largest exchanges is around $ 36 trillion-a-year

This apparent turnover number is however a certainly heavy underestimate of real amounts of "hoped for value" being created and traded, due to the extreme spread or leverage between cash buying of traded assets, and derivatives trading, which is a common theme for all financial markets worldwide.

 This in turn makes it difficult to know how far down markets can go, because we have no real handle on what value has been created, at what point of time in the future, and what is purely notional, in the literal meanings of that word.  Can we suppose a 99 percent loss of nominal value is possible, penny-on-the-dollar style ?

The crash of Oct 1987 drove a loss of notional stock market "value" of about 1600 billion US dollars in 1987 dollars with the US DJIA falling to around 1850 points (currently about 10 800 points, as of 22 Aug 2011). Today's crash could, or perhaps should therefore be 15 times bigger, that is 24 trillion dollars, to stay in the running for Guinness book of records status, which in very rough terms would represent a 75 percent loss of nominal capitalization for the world's 16-biggest exchanges, but how would we engineer these losses ?

This will be difficult, even with Hamas rockets raining into Israel and Mr Obama talking down (without even moving his lips) the dollar each day, despite the huge competition the US dollar has - for lost value - facing the overvalued and shaky euro, and heavily stretched yen.

To be sure, we could stay traditional, and not target more than about a 60 percent fall in asset values from the preceding peak to the trough of the crisis sequence, in a hectic and interesting week of trading - that is selling everything. This in turn throws up the main damage causing potential of crashes, while also noting the preceding bubble was the mother of the crash.

In a crash sequence, everybody tries to sell everything, with or without the help of asset "management" software. The effect should first be inflationary - a certain amount of cash leaks out of the paper circus - and should then be deflationary, due to enterprises being starved of credit, loans, or investment capital.

In the preceding and following bubble sequence, however, when everybody tries to buy anything, more assets can be created simply through printing them, exactly like fiat money. During the crash, these assets must be destroyed - and if not can further intensify the collapse of confidence and "value", as the bad paper assets chase other bad paper assets in a downward spiral.

The 'flat-line' solution is theoretically possible, in both cases. Markets top out or bottom out, and stay there. To be sure, political and legislative action (and cultural revolution) is needed to ensure that. They can or may also have done this all alone and without the help of political Visible Hands, simply through totally mixing-and-molding paper economy assets, and real economy assets with almost no unaffected and independent "stores of value" - outside gold and some other precious metals.

This in turn  makes the gold price in dollars, euro and yen the key indicator of what is happening the world's paper asset pile, and its nominal value. Using the above ballpark numbers for potential losses of nominal value, perhaps 75 percent, we can suggest gold should only 'top out' around $2500 per Troy ounce, but in a sequence where the real economy will suffer serious collateral damage.

By Andrew McKillop


Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2011 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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