Can the Stock Market Crash Anymore?

This week the Japanese announced a 7 trillion yen (A$70 billion) a month money printing program. Japanese stocks rose 3.3% in short order. Not because of the money printing itself, of course. Only because it was more than the expected 5.2 trillion amount. If it had been less, stocks would’ve sold off.

In England, the Bank of England declined to add to its 375 billion pound (A$255 billion) program. The pound rose in value, which is a polite way of saying the British stock market fell 1.19%.

All this leads to a question: in a world of money printing, bailouts, and Chinese growth, can the stock market crash? Could we experience another market rout? Is it even possible anymore?

If Federal Reserve Chairman Ben Bernanke and his counterparts around the world continue to print enough money, surely the stock market will continue to rise. If you knew the Germans would bail out all the governments in Europe, surely Europe’s stock markets would recover.

If you could be sure the Chinese will continue to build empty cities, Australia’s economy would boom. And, most important of all, if you knew the world’s movers and shakers wouldn’t allow another Lehman Brothers moment, how could shares possibly tumble?

Under those assumptions, the ASX200 would go on an epic rally. Now would be an incredible buying opportunity. Maybe it is. But our job is to question. And there are plenty of awkward rhetorical questions to ask when it comes to the state of stock markets.

For example, what happened to the last two rallies like the one we’ve just been through? How did they end?

For 15 years, we’ve been in a sideways moving market. During that time, we’ve rallied and crashed repeatedly, getting nowhere overall. Another rout in the stock markets of the world would confirm the last four years of rallying share prices weren’t that meaningful. They were nothing more than part of a range bound market. The American S&P500 index shows this nicely.

A 60% Drop in the Making?


So our assumption, until proven wrong, is that we’re still range bound — still going sideways. We’re at the top of the range and you can guess what that means — a return to the bottom. A 60% drop in the US stock market would send our Australian shares tumbling too.

Until we experience a genuine breakout from this range, you need to be invested in a way that allows you to benefit from a range bound market.  Why? Well, the one we’re in featured two drops of more than 50%.

Do you want to expose your savings to that kind of rollercoaster ride by investing in growth stocks? You might miss out on the beginning of a new rally if you don’t pile into growth stocks now. But those could tumble too.

Now we’ll leave sorting the genuine breakouts from the false ones to the expert, Murray Dawes. Unlike other traders, Murray makes his subscribers money by picking off the false breakouts instead of the genuine ones.

Looking back at the chart above, there have been four false breakouts from the range and no genuine ones. Each time the stock market rose further than its previous rally or fell further than its previous crash, it ended up turning around and going back into its range. You can find out what Murray thinks about this latest breakout here.

But a chart is just a chart and a range is there to be broken out of eventually. So what is the real world telling you? Could there be a crash? Or could we take off to the upside?

Well, looking around the globe doesn’t inspire confidence for a breakout to the upside. There is a long list of accidents waiting to happen. Rather than going into each of them, why not think about it this way: eventually something will go wrong. So what really matters is the contagion possibilities.

Cyprus in Lehman’s (Brothers) Terms

David Kotok from Cumberland Advisors explained why contagion from Cyprus is important on The Big Picture blog:

  • History indicates that contagions start small. What is worrisome about Cyprus is the complacency that markets are showing, based on the assumption that it is a little, one-off, insignificant event. Here is a little refresher on contagion, and then we will go back to Cyprus.
  • 1. Russian ruble collapse. Remember 1997 and 1998. The sequential problems in worldwide currency-trading exchanges ended with the collapse of the Russian ruble and the demise of the Long Term Capital Management (LTCM) hedge fund. It did not start with the LTCM collapse; that was the final market shock, which triggered a large government intervention. That brought in Alan Greenspan and the US Federal Reserve. The collapse actually started with a single-currency failure in Thailand. Panicked trading in the Thai baht started as what looked like a small, one-off, insignificant event. The contagion from that event took about 18 months to play out.
  • 2. Zimbabwe inflation. The earliest signs of inflation, confiscation of wealth and appropriation of property, and oppression of the populace in Zimbabwe appeared many years before hyperinflation, full destruction of the currency, and suppression of the productive facilities of the country. The collapse was in the incipient stage long before it became evident that the government’s policies were going to accelerate, rather than prevent it.
  • 3. Weimar Republic hyperinflation. When the Weimar Republic attempted to meet international flow requirements under the Treaty of Versailles, it did not immediately cause hyperinflation. The process started with currency expansion and banking manipulation in an attempt to manage foreign-exchange flows. It ended with hyperinflation, the demise of the government, and the rise of Nazism in Europe. Thus, the European contagion did not begin with the fall of the government and rise of Hitler in the 1930s; it started years earlier.
  • 4. The US financial crisis of 2007-09. Thinking back on the recent crisis in the US, we saw the first signs of weakness in the financial sector in mid-2007. There were some pricing anomalies in May that were visible but not explained. Clearly some money movement was taking place, but it was not apparent why. By summer 2007 Bear Stearns had indicated a problem with some mortgage-backed securities. They said it was just a couple billion – not very significant. In 2007, the first signs of the contagion were minor.

Kotok was deeply involved in two of these crises as a policy maker and advisor. His point is that Cyprus is your early warning signal. Remember, the crisis of the Great Depression started with a bank run in Austria. From here on in, the contagion could pop up anywhere.

So did the movers and shakers of the Cyprus bailout just allow a Lehman moment? Some commentators are calling the decision to ‘bail in’ Cyprus’ bank depositors ‘policy burnout’. Just like with Lehman Brothers, the governments got to a point where they couldn’t save everyone. Someone had to be made an example. In America it was Lehman Brothers. In Europe, Cyprus’ depositors took an unexpected hit.

But Lehman Brothers’ failure spooked the markets, triggering the worst of the financial crisis. Will the same thing happen with Cyprus? There’s certainly the potential.

Of course, the governments, central banks and other institutions of the world will counter with more bailouts, money printing and other desperate policies if things go bad. Luckily for us, history has plenty of examples for how this sort of thing ends.

Eventually, governments get into financial trouble themselves because of all the bailing out they have to do. And then they force central banks to print money. We’re at that point in Japan, very close to it in Europe and nearing it in America.

Given that a poor economy leads to deflation, triggering an inflationary response from governments, how do you invest? For inflation or deflation? For rising stock markets or falling ones?

The Growth Trend is Dead

The answer lies in how you invest and what kind of shares you invest in. For example, dividend investors over the last 15 years have watched their shares go up, down and all over the place to very little effect in the end. Meanwhile, the right shares continued paying cash dividends regardless of the stock market’s rollercoaster ride. Every drop in share prices allowed investors to reinvest their cheques at cheaper prices. Every rise in share prices made investors wealthier.

So whether the global economy was in a deflationary crisis or an inflationary bubble, dividend investors collected cash.

That’s just one way of benefitting from a range bound market during uncertain times. Investing in companies with breakthrough technologies, big resource finds and even active trading are other options.

But anyone relying on rising share prices generally must be going round the twist after the last 15 years. In The Money for Life Letter, we call this phenomenon the end of the Growth Trend. The Income Trend has been much more profitable. In other words, dividends, not rising share prices, are driving returns.

It’s a Trap

The Big Picture blog also featured a story about a couple, both doctors, who sold their shares in 2009 after the market collapsed. Today they are sick of missing out on the rally and buying in again. If the sideways distribution continues and shares drop, they’ll face another rout of their investments.

This is a great example of exactly the kind of behaviour that wipes out vast amounts of wealth. A sideways distribution is predictable, but your emotions completely misinterpret it. They tell you to buy because shares went up, and sell because they went down.

Murray’s Slipstream Trader strategy takes advantage of those emotions by doing the opposite of what the couple did. He looks to buy at the bottom of the range and sell at the top. Can you guess what he’s up to now?

Maybe historians will one day look back at today and see Cyprus as the new Lehman moment. Another rout in shares will bring stock markets back to the bottom of their range. That will be a wonderful buying opportunity for dividend and growth stock investors alike.

But it might not be Cyprus that triggers a crisis. There’s certainly no shortage of other shambles to choose from. Here’s our favourite:


Australians may be getting their mortgages cancelled  by the hundreds, but the Irish just stopped paying!

Regardless of what triggers the next crisis, you should be prepared by adjusting for what kind of returns you invest for. Relying on a rising stock market isn’t a good idea at the top of a trading range.

Nickolai Hubble.
Markets and Money Weekend Edition

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About the author: having escaped from academia, Nick decided to drop his tights (the required attire of a trapeze artist) and join Port Phillip Publishing. Instead of telling everyone about the Markets and Money, he now spends his time writing for the weekend edition.

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Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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