2011: A Sequel to 1987 - 08/09/11

We are not experiencing 2008 price action, but we might have already experienced our 2011 version of the 1987 crash.

In an early-morning email exchange with Jim "El Capitan" Cramer, Jim reminded me that the price behavior of the U.S. stock market over the past week most resembles the October 1987 crash, a period of incomprehensible and unpredictable price action that did not necessarily reflect the economic fundamentals. (Jim writes further on this subject this morning.)

And for all we know, based on the magnitude of the price drop in the last week, we might have already fully experienced 2011's version of the October 1987 crash. My guess -- and I think Jim might agree to some degree -- is that most of the downside could already be behind us.

What about the comparison to 2008?

Circumstances are far different as, in 2008, stocks crashed based on a nearly insolvent banking system and a domestic economy in contraction. Today, in 2011, the banking system is liquid, and our economy is growing -- albeit, at a moderate pace.

As an example of the remarkably erratic present market price action, last night the S&P futures dropped by 30 handles immediately after the close (on no news) then rallied by 60 handles to peak at about 30 handles higher than Monday's close in the middle of the night -- that's a 6% move with little fundamental justification behind it. (At the time of writing, S&P futures were up about 1%, but this is a moving target that is changing every minute.)

In 1987, similar to now, the machines took over. Twenty-four years ago, it was portfolio insurance that delivered the toxic blow. Today, it is high-frequency traders that are motivated not by fundamentals but by price momentum. Add super-reverse ETFs to the mix and a lethal cocktail has been served, rendering our markets temporarily dysfunctional and contributing already to an October 1987-like crash.

In "There's Something Happening Here; What It Is Ain't Exactly Clear", I highlighted the market's instability and randomness three weeks ago:

Everybody look what's going down

There's battle lines being drawn
Nobody's right if everybody's wrong
Young people speaking their minds
Getting so much resistance from behind
I think it's time we stop, hey, what's that sound?
Everybody look what's going down

Paranoia strikes deep
Into your life it will creep
It starts when you're always afraid
You step out of line, the man come and take you away
We better stop, hey, what's that sound?
Everybody look what's going down.

-- Buffalo Springfield, "For What It's Worth" Wall Street Journal report states that the European stress test did not include loans to businesses and consumers in southern Europe.Listen to my Bluebird laugh
She can't tell you why
Deep within her heart, you see
She knows only crying
Just crying.

-- Buffalo Springfield, "Bluebird"

Debt ceiling debate matters and is resolved one way or another: It gets raised, stocks knee-jerk rally, bonds tank as the slosh ebbs and flows. Or maybe the reverse happens.

 

Debt ceiling does not get raised on time, stocks tank, bonds rally, dollar goes nuts in some fashion, or maybe everything tanks.

 

While all the debt ceiling hype churns around, jerking players back and forth, Europe implodes and various parts of the "circus" go nuts in assorted directions.

She's witch of trouble in electric blue.
In her own mad mind she's in love with you
With you
Now what you gonna do?
Strange brew
Killing what's inside of you.

-- Cream, "Strange Brew"

In a strange game
I saw myself as you knew me
When the change came
And you had a chance to see through me
Though the other side is just the same
You can tell my dream is real
Because I love you
Can you see me now?

-- Buffalo Springfield, "On the Way Home"

As much as I can remember of the '60s, Buffalo Springfield has always been my favorite group. The tenure of the band was short (only three years), and their production of only three albums was limited. But Stephen Stills, Dewey Martin, Bruce Palmer, Richie Furay and Neil Young embraced the anger and confusion of a nation in chaos.

Among their songs, "For What It's Worth" (often referred to as "Stop, Hey, What's That Sound?") is the most enduring, and it captured the zeitgeist of the times. The song was written by Stephen Stills after witnessing police actions against the crowds of young people who had gathered in Los Angeles to protest the closing of a nightclub called Pandora's Box.

The song's lyrics also epitomize the confusion in the U.S. stock market today.

Most traders and hedge fund managers today feel the frustration of the tail that wags the dog in an unpredictable investment backdrop (which has no memory from day to day) and are dependent on a plethora of important and rapidly changing macroeconomic hurricanes.

As an example, this morning market participants face the following macroeconomic worries (hat tip to Bill King):

• Goldman Sachs reduced its second-half 2011 GDP growth expectations

 

• The validity of the European stress test has been questioned.

 

• Some German officials are balking at the Greek bailout plan.

 

• More political partisanship has been on display and little progress has been made on the U.S. budget ceiling discussions.

 

• A weekend

Fundamentals Be Damned

Today, our journey for better investment returns is growing extremely difficult given the changing, unpredictable macro events and importance of the political circus (and its headlines) as well as the disproportionate role of momentum-based market strategies and the algorithmic response to the short-term movement in share prices that the headlines catalyze.

Mr. Market's bearings have been lost in inconsistent, lumpy and random prices, in which macroeconomic judgments, technical analysis and guesswork are replacing hard-hitting fundamental company analysis (the microeconomic).

The marketplace has almost become a random walk.

As an example, Bill Fleckenstein succinctly describes "the overriding game theory at present relating to the Washington, D.C., circus":

Easy peasy, right?

 

Strange Brew

Now that the way to play has become so clearly defined (!), market participants party on (with other peoples' money) -- surprisingly, only a couple of percentage points below 2011 (and 2009-2011) highs -- despite the ambiguity of both the economic and the political.

 

Go Figure!

 

Most of the members of Buffalo Springfield went on to future successes. Though Palmer faded into obscurity, Stills went on to form Crosby, Stills & Nash with David Crosby of The Byrds and Graham Nash of The Hollies in 1968. A year later, Young reunited with Stills to form Crosby, Stills, Nash & Young. Furay and Messina founded Poco, and Messina soon after merged with Kenny Loggins to from Loggins & Messina. Dewey Martin founded The New Buffalo Springfield.

Maybe, similar to the band members of Buffalo Springfield, the market will solidify and advance following the current confusion, or maybe most investors should simply pick up their toys and take them home.

Quite frankly, it could go either way -- it's a flip of the coin.