On this date 32 years ago, the New York Times included the following paragraph in an article titled, "Dark Days On Wall Street."
In the past two weeks, all the market averages have plunged to new lows as Wall Street, beset by cruel economic news from all sides, has time after time been unable to mount a sustained rally. That is a discouraging omen, an indication that the bottom has not been reached, many securities analysts say, and a sign that even the most steel-willed optimists may be about to throw in their towels.
As is their habit, the news media and many investors tend to focus on what has already occurred. In this case, there seemed to be many reasons for pessimism: Collapsing stock prices, down almost 25 percent from 1981's peak; a second recession in two years; rampant inflation; and erosion of corporate profits. Weaker earnings were leading to dividend cuts. Banks were experiencing loan write-offs, and cutting off credit. In the political arena, President Ronald Reagan was forsaking his tax cuts in favor of increases to tame soaring deficits.
It might not have occurred to readers that this information was already reflected in stock prices. Indeed, inflation, courtesy of Federal Reserve Chairman Paul Volcker, was about to take a two-decade-long tumble. Yields on three-month Treasury bills were falling from 12.5 percent to 9.35 percent. The price-earnings ratio on the Dow Jones Industrial Average was a mere 6.5. The Standard & Poor's 400 industrials -- does this index even exist anymore? -- was only 7. The S&P 500 Index was trading at book value, while the Dow was below book. Stock prices were just about at their lows.
Dare I say it, but moments of deep pessimism are ideal entry points for buyers.
The classic risk-aversion ratio holds that investors feel two times as much pain from losses as the pleasure they get from gains. Hence, the effect of a crash leaves psychic wounds that can take years or decades to heal. It took 25 years for the stock market to reach the highs of 1929 (at least on a nominal price basis). It was as if it took an entire generation without memories of the ‘29 crash to grow up, get jobs and start investing.
The stock-market low of March 2009 was a capitulatory event. Some of the more strident commentators had been forecasting catastrophic plunges to follow. Pacific Investment Management Co.’s Bill Gross mentioned that Dow 5,000 wasn't out of the realm of possibility. Elliott Wave International Inc.'s Robert Prechter called for Dow 1,000.
The psychology of that sort of uber-bearishness stays with investors. During this entire rally, there have been expectations that another crash was right around the corner. Just as 1929 had its 1931, wouldn’t 2009 have an echo crash? The 80 percent fall in the Dow in the Great Depression set the template for market collapses, right? The Nasdaq Composite Index fell roughly that amount after its March 2000 peak. So did the homebuilders in the mid-2000s, and the banks a few years later.
The legacy of these crashes stays with many folks for a long time. It colors everything they see for years.
As the New York Times put it more than a generation ago:
The last leg of a bear market is often crushing - a swift plunge in stock prices on heavy volume that pounds small investors and institutions alike, leaving them with big losses and shattered emotions. The effect can be cathartic. But in the vacuum that remains, investors can begin rebuilding their confidence.
One of the few to recognize the cathartic cleansing generated by capitulation was Robert Farrell, then chief market analyst at Merrill Lynch. That same article contained a quote that summarizes why he became an investing legend: “I believe you really will see the start of the Great Bull Market of the 80's.”
I wonder what Farrell would say today?
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Barry L Ritholtz at email@example.com
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