The Tripwire on the Next “Black Monday”
“Black Monday” — Oct. 19, 1987 — remains the bloodiest one-day carnage in market history.
508 points the Dow Jones plunged that hell-sent day — an impossible 22%.
A similar stock market event today would translate to a 5,843-point cataclysm.
We compare that October day to the ancient Battle of Cannae, when invincible Rome lost as many as 70,000 legionnaires to Hannibal’s armies — in a single day.
Or to the first day of the Battle of the Somme, July 1, 1916, when nearly 20,000 British soldiers fell flat under the German guns… and never got up.
What could lead today’s market to its own Cannae, its own Somme — its own Black Monday?
Today we consider one harrowing possibility…
Harley Bassman is a world-class expert in derivatives — what Warren Buffett has termed “weapons of mass destruction.”
Not long ago Bassman set out with one question in mind:
The only question one cares about, identifying the tripwire that would tip our system into disequilibrium.
That is, what could turn a bad day on Wall Street into another Black Monday?
And is there a specific percentage decline that could start the dominoes going over?
Bassman’s researches indicate there is.
Before revealing that (black) magic number, let us identify the villain of this tale, a possible trigger for the next horror picture:
After the 2008 near-collapse, the emergency responders at the Federal Reserve inundated markets with oceans of liquidity.
The biblical-level flooding knocked down existing financial signposts… and “fundamentals” no longer seemed to matter.
The tide was rising, and all boats with it.
“Active” asset managers on the hunt for market inefficiencies could no longer separate winner from loser.
Some 86% of all actively managed stock funds have underperformed their index during the last 10 years.
Explains Larry Swedroe, director of research at Buckingham Strategic Wealth:
“While it is possible to win that game, the odds of doing so are so poor that it’s simply not a prudent choice to play.”
“Passively” managed funds — on the other hand — make no effort to pinpoint winners.
“Passive” because they sit back on their oars… and let the flowing tide lift their boat. They track an overall index or asset category — not the individual components.
It is a strategy that has yielded handsome dividends this past decade of rising waters, as Tim Decker, president and CEO of ISI Financial Group, explains:
Passive management came into its own during the long bull market that started in late 2009, after the market had collapsed amid the financial crisis in 2007–2008. Money had been flowing from active to passive vehicles in the preceding years, and investors — disillusioned by their losses in the crisis and the high fees they had paid — started turning to passive vehicles even more. That trend has continued to this day.
Passive investing has increased from 15% in 2007 to perhaps 35% by the end of 2017. It is a percentage that is only rising.
All is swell as long as rainbows appear in the skies over Wall Street and the tide continues to rise.
But the risk is this:
When the tide recedes… it recedes.
As Jim Rickards explains:
In a bull market, the effect is to amplify the upside as indexers pile into hot stocks like Google and Apple. But a small sell-off can turn into a stampede as passive investors head for the exits all at once without regard to the fundamentals of a particular stock.
But comes the central question:
How far might stocks have to sink before unleashing the hounds — and another Black Monday?
The aforesaid Bassman’s investigations have yielded an answer…
A 4% single-day drop could prove sufficient:
It seems possible that as little as a 4% decline in a single day could be enough to create critical mass.
From today’s stratospheric Dow reading of 26,555 … a 4% single-day swoon translates to an 1,062-point loss.
A thumping drop, yes — but not beyond imagining.
The Dow Jones plunged nearly 3% just this March after the Trump administration announced tariffs on China.
Must we stretch our minds far to conceive a 4% loss?
Not much… we dare say.
And then what happens, Jim Rickards?
Passive investors will be looking for active investors to “step up” and buy. The problem is there won’t be any active investors left or at least not enough to make a difference. The market crash will be like a runaway train with no brakes.
“This is one more reason why the next stock market crash will be the greatest in history.”
Let the record reflect… that history includes 1929, 1987, 2000… and 2008.
Perhaps passive investing will write the next harrowing chapter…
Managing editor, The Daily Reckoning