<h1>A Stock Market Crash?</h1> <h2>by Dr. Mark White<br> Partner, White & Associates</h2> <h4>25 November 1996</h4><p> <p> The financial media, as typified by recent issues of The Wall Street Journal, are giving voice to more market analysts expressing concern about the record high price levels in US stocks. Indeed, as US stock prices break record after record, such notable analysts as Henry Kaufman and Robert Shiller are either beginning to speak out about the present danger of a market crash, or are repeating more emphatically the concerns they expressed earlier when prices were lower. These analysts point to certain reliable indicators, such as the hot IPO market and high price/earnings and price/dividend ratios, that suggest that today’s valuations are historically excessive. They fear that when frothy stock prices return to historically-normal valuations, today’s inexperienced stock investors could make this inevitable correction very short, sharp, and overdone as they withdraw in mass from their much-beloved mutual funds, rather than smooth and gradual as it might be if more investors began heeding the storm-flags they’re flying today.

It’s easy to point to other indicators, such as closed-end fund discounts and price/earnings/growth ratios, suggesting that today’s valuations are actually consistent with historical levels, and that record price levels simply reflect today’s record earnings and tomorrow’s healthy prospects. In fact, given technology’s combinatorial growth, the future earnings capacity of adaptive corporations, whether well-established or brand-new, more than justify today’s record prices. Although part of these adaptive corporations’ growth will come from clients abandoning the increasingly obsolescent products, services, and processes stubbornly offered by well-established-but-non-adaptive corporations, much of the adaptive corporations’ growth will come from new clients spending newly-generated wealth on the same explosion of new products, services, and processes that generates that new wealth. Even taking into account the expected failures among those major corporations now rushing headlong into the downsides of their life cycles, today’s stock indices are cheap on the fundamentals, and many individual“high- priced” stocks are screaming bargains.

In considering the prospects for a market crash, though, this comforting view of the relationship between prices and fundamentals has no more explanatory power than the frightening view offered up by the Cassandras. Short-term trading has far more impact on price levels than long-term investing because George Soros’ in-and-out style generates far more volume than Warren Buffett’s buy-and-hold . That means trader psychology will determine whether or not the markets crash. A fair valuation, like the October 1987 market, does not prevent an immediate crash, nor does an obvious bubble, like the August 1929 market, provoke an immediate crash. J.P. Morgan had the wisest answer to queries about the market’s future course: "It will fluctuate." It would ill-suit this essay to pretend any more knowledge about the short term than the formidable Mr. Morgan, even if today’s facts make as manifest the very favorable long-term prospects for the market as a whole and many individual stocks as they make absolutely clear certain other stocks that buy-and-hold investors should avoid like the plague. Rather, by judiciously observing trading technology, trading volume, and day-trading activities, one can clearly say that rapid advances in all these trading variables set the stage for a very strong crash -- should one occur. Were old J.P. watching today, he would likely say "It will fluctuate even more!"

For individuals concerned about preserving and advancing their wealth in these modern markets with their ever-increasing potential for huge swings in the fat tails of their conditional volatility, the best strategy is gearing up to join the growing ranks of day traders. With more and more capital set to move on a hair trigger, the trend is your friend and an hour is a very long time. If nature has blessed you with good market sense, you can use it to earn extraordinary returns on your capital without ever setting foot inside an exchange or dealing room. If you lack that sense, you can only hope to find an offshore fund whose management has the good administrative sense to hire a complement of highly talented traders, and then pay the imminently reasonable fees that they charge to place you long in bubbles and short in crashes. Even if the offshore fund isn’t day- trading, make sure they use a long-short strategy.

Public policy makers, of course, have a different brief. Unlike their financial sector counterparts who simply set up ever more powerful trading rooms, these regulators are ostensibly responsible for anticipating the excesses that can burst forth when massive capital flows try to move instantly and globally through the very narrow doors that markets open up between instruments, and then developing the rules that will rein them in. Given that the regulators are moving in the opposite direction by accomodating the markets’ increasing volume and potential for volatility, the individual investor really has no choice but to follow their lead and get ready for a crash of epic proportions -- whether it comes or not.

Readers with questions or comments for Dr. White can call 011(525)595-6045, fax 011(525)683-5874, or email white@profmexis.sar.net

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