Could We Suffer Another 1987-Style Crash?

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Last week the Dow surpassed 23,000 on the 30th anniversary of the 1987 crash, rising 2% for the week. The S&P 500 rose 0.86%, setting yet another all-time high at 2,575 last Friday, up 15% for the year. That’s great, but I’m especially proud to report that the #1 stock mutual fund last quarter was none other than a fund for which my firm is the sub-advisor. According to The New York Times (“The Stock Market Charges Ahead, Despite the World’s Storms,” October 13, 2017).

In other news, President Trump is expected to announce the new Fed Chairman in early November, with the current Fed Chair, Janet Yellen, still in the running to be reappointed. If Ms. Yellen is reappointed for another term, the stock market will likely celebrate, since under Yellen both the Fed’s unemployment and inflation mandates have been met and exceeded. On Thursday, Janet Yellen met with President Trump and I would have loved to be a fly on the wall to listen to their conversation. If President Trump does not reappoint Janet Yellen, his new Fed Chair should be a decisive leader since the Fed needs to project far more stability and certainty, since some infighting among the Fed governors has generated uncertainty.

Since last week marked the 30-year anniversary of the October 19, 1987 market meltdown, the financial media could not help themselves. They got an early start on Halloween by attempting to scare investors. In fact, several of our money management clients asked if they should lock in their profits and get out of the stock market. Since I am finalizing a new white paper that warns that the Robo-Advisors could trigger a brief market meltdown, I thought that I would highlight some of the 1987 research I’ve been reading.

Barron’s featured a credible review entitled, Black Monday 2.0: The Next Machine-Driven Meltdown (October 16, 2017). This article highlighted the recent “quant quakes” and “flash crashes” that struck on May 6, 2010 and August 24, 2015. As the volume of machine-driven trading continues to steadily rise, the trading algorithms have had the positive benefit of providing liquidity and making financial markets more efficient, but they also have severe liquidity limits when overloaded by extraordinarily large orders that could “break” most trading systems. In other words, poorly designed algorithms are ignoring trade volume and liquidity limits, so in the end, they are designed to fail, just like portfolio insurance failed in 1987.

Trading algorithms that do not have liquidity restraints are destined to ultimately fail. The best analogy is that it is physically possible to push a watermelon through a keyhole, but it’s going to be extremely messy!

Another helpful review from October 16 was a MarketWatch article entitled, “Would ETFs hold up in a 1987-style crash?” The article asked two more key questions in its subtitle: “Would ETFs exacerbate or limit a decline? Would they have functioned properly at all?” This article pointed out how a stock market crash in 2017 or later would be entirely different than it was in 1987, due largely to the explosion in ETFs.

There is no doubt that the influence of ETFs is growing. In 2016, 14 of the top 15 securities – as measured by the highest trading value and trading volume – were ETFs. According to Credit Suisse, ETFs accounted for 23% of all U.S. trading in terms of value and 30% in terms of volume in 2016. Since ETFs do not trade at their underlying net asset value (NAV), but instead typically trade at premiums (on up days) and discounts (on down days), reckless Robo-Advisors can overwhelm automated trading systems with excessive volume. In such cases, these premiums and discounts could widen from a negligible 0.1% to a potentially devastating 35% or more. This is exactly what happened during the flash crash on August 24, 2015, when large liquid ETFs traded at up to 35% intraday discounts to their NAV.

The MarketWatch article pointed out that UBS strategists concluded that “if there is a ‘rush to the exit’ an ETF will likely trade to a discount that’s influenced by the volatility and the liquidity of the underlying market.” Just how much ETFs will exacerbate a market decline remains unknown, but my new white paper is predicting that the Robo-Advisors could trigger another market meltdown due largely to poorly designed algorithms that can overload fragile trading systems with excessive volume.

Speaking of meltdowns, Treasury Secretary Steven Mnuchin issued a stern warning to Congress to pass his proposed tax cuts or they risk blowing up the stock market. Specifically, Mnuchin said, “There is no question that the rally in the stock market has baked into it reasonably high expectations of us getting tax cuts and tax reform done.” He added that “to the extent we get the tax deal done, the stock market will go up higher. But there’s no question in my mind that if we don’t get it done you’re going to see a reversal of a significant amount of these gains.” Yikes! This seems a bit desperate to me and I suspect that he may have jinxed himself with a threat that Congress risks hurting the stock market if it does not pass tax cuts.

Housing Market Likely to Recover After Natural Disasters

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The Commerce Department on Wednesday announced that new housing starts declined 4.7% to an annual rate of 1.13 million in September compared to August. In the past 12 months, however, housing starts are 6.1% higher than a year ago. Single-family home starts are especially strong and running 9.1% higher than the same month a year ago. There is no doubt that after the devastating flooding from Hurricane Harvey and now the horrific fires in Northern California, new home construction will pick up in the upcoming months. The biggest problem that builders now seem to have is a shortage of qualified workers.

On Friday, the National Association of Realtors announced that existing home sales declined 1.5% in September vs. a year ago, the first monthly decline since July 2016. Compared to August, existing home sales rose 0.7% to a 5.39 million annual pace. August home sales were impeded by Hurricane Harvey and represented the slowest month this year. September was the second slowest month. Hurricane Irma also impeded existing home sales in September. The current supply remains at a tight 4.2-month supply.

On Wednesday, the Fed released its Beige Book and openly discussed that it cannot find any evidence of inflation despite a labor shortage and the cost of some materials increasing. Interestingly, all 12 Fed regional banks said companies “were having difficulty finding qualified workers.” Labor shortages were especially acute in the construction, manufacturing, trucking, and health care industries. The Beige Book survey said that the U.S. economy weathered three major hurricanes better than expected, even though these hurricanes dampened economic growth in September. The Fed still seems to be on track to raise key interest rates in December to fight mythical inflation before it actually shows up. However, growing infighting within the Fed between the doves and hawks might forestall any key interest rate increase.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

Disclaimer: Please click here for important disclosures located in the “About” section of the Navellier & Associates profile that accompany this article.