Black Monday 2: October 22, 2007

Note: The chance of this actually happening is minute. This isn't a prediction of what WILL happen, but just speculation over an event that has a tiny chance of occurring.


Investors marked the 20th anniversary of Black Monday on Friday by selling off each of the major exchanges by 2-3%. Bad earnings may have initially triggered the downturn, but it seemed as though investors simply wanted to mark the anniversary with a decline.

However, as the official anniversary passes, I think that the conditions now are the most reminiscent of 1987. If there was or is a time to speculate about a crash, that time is this weekend.

Here's why:

During the week preceeding the crash, the Dow lost about 10% of its value. This past week was not nearly as bad, as the market lost a little less than 5%, or about 600 points. Though not as severe as a drop, it still bears a very eerie resemblance to what happened then. Here's a chart of the Dow over the past week:

Not a pretty chart.

As it's been stated in every other writeup about a potential 2007 crash, the general market conditions are similar; high oil, weakening dollar, and more.


So, why do I think that there's a slight chance of a crash (or correction) in the future?

First, the emotional aspect to this coming Monday. As I am writing this post, a front-page article on MarketWatch.com compares this past week to the week proceeding the crash. As analytical articles of 1987 state "investors had a weekend to ponder losses from the week before," now, today's investors are pondering this week's losses in light of 1987. There's certainly possibility of an irrational, emotionally-driven over reaction on Monday.

The other thing that increases the possibility of a crash, and concerns me, is the high valuations of certain stocks and industries. It's true that the overall market valuation today is less than it was in 1987, with P/Es then higher than they are today.

However, certain sections of the markets have rich valuations: popular tech companies like Apple, Google, VMWare, Amazon.com, and Research in Motion all trade at 30-80 forward P/Es. A 10-20% shaving off of the top of any of those stocks would not be uncalled for.

If Apple or Google were to lose 15% of its value, it could easily trigger a ripple-effect sell off through the broader market. Those tech heroes both represent the current bull market and actually hold lots of investors assets, many of whom may have purchased recently as companies are making new all-time highs. Investors may sell off early to minimize losses, and this effect could be worsened by stop-limit orders that some investors have in place.

Lots of Chinese companies are similarly situated; speculation over the high-growth stocks has created rich valuations, and as the recent 50+% decline in some solar stocks shows, losing a significant amount of value in a very short period of time could occur.


This hypothetical crash would probably begin the same way that 1987's Black Monday did: US investors wake up to news of major, but not crash-level, sell offs in Asian and European markets, in response to US losses on Friday and their own sky-high valuations. (With India's market losing 10% of its value in one day just a week ago, and with Shanghai doing the same earlier this year, a 10% decline on any Asian market isn't too unrealistic).

American investors, shaken by the 5% drop last week and the 5-10% Asian drop overnight, coupled with the emotional fear of a repeat of Black Monday, start selling as soon as the premarket opens. Baidu falls $100, or 33%. Google loses 15%. Apple (who releases earning after the bell, which everyone now forgets about) is down 15% too. Banks, who reported bad earnings this past week, would mirror this fall due to financial fears. Investment banks, with lots of money tied up in mortgages and tech stocks, would also begin to suffer.

A wave of selling has spread throughout the entire market by noon. The tech-heavy, high-PE Nasdaq loses 15%. The Dow and S&P don't fare as poorly, but both are down about 10% too. Things could get very, very ugly.




Now that my scenario is outlined, do I believe that this WILL happen? No. If I did, 70% of my money wouldn't currently be long in equities. I do own puts in ConocoPhillips and the SPDR ETF, so I have slightly insulated my positions against a big loss. But if I thought a crash was inevitable, I'd be 100% cash, or puts, or shorted stock.

The possibility of a 1% gain tomorrow is much, much bigger than the prospect of a 10% loss, but I just figured I'd chronicle my thoughts as every investor is nervously awaiting Monday. Do I want a crash to happen? Absolutely not. But, as my position in SPDR puts suggests, I do expect a correction in the reasonable future, and wouldn't be absolutely shocked with a more sudden drop.