It’s not likely to be news to anyone reading this blog that the US equity market has been consumed by volatility and in a downdraft for the last several months. Given the lags between observing, writing, and publishing a blog, it might already be over by the time you’re reading this, hence amounting to no more than a small footnote in the history of stock market vacillations. 

As distasteful as this downdraft in market prices is to an investor, feel fortunate that you are not in the financial media business when such an event occurs. If you were, it would become your task to find someone to interview who might comment on the risks that have caused such large-scale selling. 

Additionally, you would be tasked with running down sources who could tell you whether the decline in stock prices constitutes a forecast of a recession, or if the stock price decline itself will cause a recession.

To me, the event most similar to our present situation came on October 19, 1987, which was given the nickname “Black Monday.” With a one-day S&P market decline of 23%, it made our recent correction a piker — at least up to this point. But, there are similarities that provide insight into our present situation.

On Black Monday, I was on a trip to Boston for a morning meeting that would utilize real rate financing, after which I scrambled to catch an afternoon flight to Manhattan for a dinner meeting at the Harvard Club, in all its antiquity. I had heard of the market decline while in Boston and otherwise did not know how the market day had ended.

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I still have a clear memory of walking into the Club to find its members stumbling and mumbling incoherently to anyone who would listen, including me. In my life up to this point, I had only seen mass shock of this sort following the Kennedy assassination, so I began to hope that old Ronnie Reagan was O.K. As far as the stock market was concerned, it took eight months to recover on its own and rebound to new highs.

It did not take long for the media to beat the question of cause and effect to death (as it would do to an even greater degree today). In the mad search for possible causes, it turns out there was relatively little on the economic horizon in October 1987 that would logically have caused investors to flee the market all at once and drive stock prices down 23% in a single day. With little in the way of a large and obvious cause, financial pundits had to use their imaginations to fill the paper with risks to report on. 

As it would turn out, investors had been feeling some mild discomfort due to the effects of exchange rate manipulation by central banks in the post-“Plaza Accord” era. It was a first time central banks agreed to manipulate exchange rates after decades of fixed exchange rates. This economic climate was relatively unfamiliar to not just investors but also to economists and news reporters.

What had happened is that that during Reagan’s first term as president, worldwide capital flowed heavily to the US dollar and hence into US$-denominated assets. As foreign capital flowed in, it caused the US dollar to become more expensive and in turn increased the price of US exports to foreign parties. 

For the US, consequences of the more expensive dollar included a decline in exports and a trade deficit. Somehow, Treasury Secretary James A. Baker secured the agreementof our G-5 allies and trading partners to go along with a plan to cheapen the dollar in order to offset the US trade deficit, at the expense of a reduction in their own trade surpluses. 

This was a benefit to the US economy, but because it was done in the new and unfamiliar environment of currency intervention, it was too much new ground for stock market investors to digest without perceiving it as a risk. A similar situation is occurring today, as investors have not easily embraced the Trump administration’s efforts to seek tariff reductions via trade wars as a benefit to the US economy. 

So overall, the 1987 stock market seemed to perceive the central bank’s effort to cheapen the price of the US dollar in an effort to improve the trade balance as a risk to US stocks (which it is, to some extent, as imported intermediate product would become more expensive). 

However, it was not actually a risk that was being priced, as Frank Knight explains in his early finance classic “Risk, Uncertainty and Profit,” published in 1921.

As Knight points out, what distinguishes risk from uncertainty is that to properly evaluate risk, investors need a means for evaluating the probability and extent of losses due to risk, based on theoretical and/or historical precedents.

This is a matter of course: every day in the bond market, for example, a bond’smarket price is discounted based on the probabilities and the extent of losses in a bond’s purchasing power due to inflation. A history of occurrences — and the corresponding extent of inflationary loss in value to the bond — is necessary for investors to reliably judge and price risk. For inflation and bonds, there is more than a century of observed data, with the connection first being made in by Irving Fisherin about 1927.

Today, the leading issue on the table is the probability that a trade war will reduce economic output, and how that might adversely affect the earnings of traded stocks. No history or models of these outcomes exist, so this falls into the category of uncertainty.

The problem is that there is precious little evidence upon which to judge the outcome, and instead we are left with free-floating anxiety. In that case, those wagering on outcomes typically move to the sideline until they can establish odds.

Actually, we have more than trade wars on the psychologist’s couch these days. Brexit and its effect on the EU (and in turn on the US) are also in the inbox of the odds makers.

And then there is Fed uncertainty: will they or won’t they, once again? There is also enormous political change and other major distractionsin play, such as the threat of impeachment, the transition in leadership of the Department of Justice, and the Democrats taking control of the House of Representatives. In addition to these issues, there are future US debt burdens and other palliatives, such as the economic impacts of the corporate tax cut, the repatriation of foreign earnings, and US investment spending on highways and byways.

While there were new occurrences for market investors to spec out, both then and now, in both cases there appears to be another common factor that could generate a market crash.

Interestingly, part of the blame in 1987 fell on the shoulders of a former professor of mine, who along with a few others devised something called “portfolio insurance.” 

The idea was simple enough: computerized program placing sell orders of assets that are falling in value in the markets. The additional sell orders in turn keeps prices moving downward. At that time it was called portfolio insurance, and today its known as high speed trading,which has already come under review for regulatory changes.

Whatever the uncertainty that got us to where we are today, asset prices — more generally than just stocks — have taken it on the chin. Since we are in an environment that is still generating profit growth for assets that are priced more cheaply in markets, opportunities exist. Cash on cash market yields are now available in a number of areas of the markets. 

That would include dividend-paying common and preferred stocks, oil pipeline, and most especially REITs with yields that generate sufficient income to cover IRA minimum distributions requirements without the need to liquidate principal for some time to come.

If you have questions and care to get in touch with me you can use the e-mail link on TheSpellmanReport.com or leave a message at 512 345-6789 extension 301.

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