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Dow Loses More than 550
by Randy Befumo (TMF Templr)
October 27, 1997

7:20AM EST - World Market Update

One of the earliest popular examples of a dynamic new science called chaos theory illustrates how tiny events can lead to catastrophe. A butterfly beats its wings in a Brazilian jungle. The wind from the butterfly's wings swirls into the atmosphere, transformed by global atmospheric forces to become a tsunami smashing into the coast of Japan. Like a fractal, the small gust from a colorful insect is amplified by resonant forces in the atmosphere until it becomes a destructive force, rending the coastline like some dark apocalypse.

Mathematicians, scientists, and economists now study complex systems like the one described above under a new rubric -- complexity theory. The inheritor of the intellectual energies of chaos theory, the headquarters for the study of complex, adaptive systems is centered in Santa Fe, New Mexico at the Santa Fe Institute. One of the earliest subjects of this intense, interdisciplinary effort was the 1987 market crash, a poster child for how a series of complex, interrelated events ended in one catastrophic crescendo. Today's 554.26 point drop in the Dow gives these academics another tasty implosion to chew on.

When the historians approach the October 27, 1997 decline in stocks, what will be used to explain the 7.18% one-day decline? Currency devaluations in Malaysia, Thailand, and the Philippines destabilized one of the fastest growing regions in the world throughout the summer and fall. The stock exchanges of all three countries had posted 40%-plus year-to-date declines going into today. A number of key Korean conglomerates reported terrible losses in a variety of operations from steel to semiconductors. The Japanese economy failed for the fifth year running to show much in the way of signs of life.

Finally, last week Hong Kong became a bloodbath as its currency was assaulted by concerns about a potential devaluation. Hong Kong authorities ratcheted up short-term interest rates to control the decline, but a flight to quality drove U.S. 30-year government debt up 0.2% on the week to 6.24%. Although North American markets shrugged off the Hong Kong flu for a few days, today they succumbed as fear-mongering about an Asian recession resulted in panic selling of U.S. equities across the board. Computer, semiconductor, and networking-related companies bore the brunt of the selling pressure given that more than a few sell a good bit of product into that troubled region of the world.

With economic growth in the U.S. stable, inflation low, and yields on long-term debt near twenty-five year lows, what was required to shake stock valuations from their near all-time highs was an exogenous event. Some outside calamity, or series of calamities, was required to shatter the consensus opinion. Will Southeast Asia spin into a recession? This has yet to be determined. However, the possibility of this has already begun to be discounted into shares of dozens of companies -- many only peripherally related. In some instances, declines of 20% to 30% on no news occurred in some stocks due to large-scale selling.

Certainly, the 1980s and the 1990s so far are the two best decades of equity performance in the past 200 years. A 10% decline occasionally is not only possible, it is reasonable given the sustained upward moves we have enjoyed. When speculative options activity masquerading as Wisdom is promoted by ex-real estate charlatans and short-term trading is promoted on radio as a new way for anyone with a personal computer to make a living, there is a lot of money buying businesses that doesn't know why it is there and which is ready to run at the first sign of trouble. How many people who have made 30% to 40% so far this year selling "safe" covered calls saw all of their gains for the last year or two wiped out in a few bloody hours today?

Here is a refrain to ponder. Making money short-term with stocks is a risky gamble. Certainly some will prove themselves nearly clairvoyant, making money at the expense of the many who are not. The majority of investors are going to make money owning the shares of quality companies purchased at attractive valuations over long periods of time. Many of those investors will initiate positions on days like tomorrow, when shares of many market-leading firms trade at valuations that assume they will only muster 5% to 10% earnings growth over the next few years. Now, there may not be bargains galore, but the near indiscriminate selling has made many companies more attractive on a valuation basis for the first time in months since the markets went parabolic after April. Long-term investors take heart -- in ten years today's dip will look as spicy in retrospect as the market drop complexity theorists are still studying from 1987.

 

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