Grow Up To 1,000% Richer In The Great Stock Panic Of 2002


Chapter 5

Wildest Stock Market Gyrations In 70
Years Are The Prelude To Panic

Many months before the terrorist attacks hit America, a new phenomenon had arrived on Wall Street extreme volatility.

Weeks are compressed into days; days into minutes. Market declines (or rallies), which would normally be spread out over time, take place almost instantly ... driving fear and panic into the hearts of investors ... or spurring wild bouts of speculative euphoria.

Everything the torrid pace of buying and selling, the ups and downs of stock prices, interest rates, even consumer sentiment is vastly accelerated. Examples:
  • In January 2000, to kick off the new millennium, we witnessed the fastest decline in the Dow in 45 years, tumbling nearly 12% in just 10 trading days.

  • On just one day, April 14, 2000, we saw the worst single-day point loss ever in both the Dow and the tech-heavy Nasdaq index. At one point during the day, the Nasdaq lost an incredible 13.6% of its value, an amazing $776 billion of shareholder equity.

  • On January 3, 2001, in response to a surprise interest rate cut by the Fed, we witnessed the biggest and fastest Nasdaq surge in history 15.7.% in just 3 hours.

  • Individual market sectors have been even more volatile. On February 2, 2001, the S&P Telecommunications Index plunged 8%. And on February 7, the S&P Communication-Equipment Manufacturers Index plummeted 11.9%. These huge declines in just one day are greater than typical declines in a whole year of trading during less volatile eras.
Along with the unprecedented speed of the declines, we have also seen periods of unprecedented surges in volume: On April 14, 2000 alone, 2.25 billion shares changed hands on the Nasdaq. That's nearly 6 million shares traded per minute ... 100,000 shares per second.

In 1987, the greatest volume ever traded was only 288 million! And back in the early 1930s, volume on the Dow was as low as a hundred thousand shares a day.

You must not ignore this acceleration of time and transactions. It is potentially the most dangerous phenomenon of our times. Even the brightest, shrewdest, most experienced money managers have fallen victim. Julian Robertson of Tiger Management, forced to close up shop ... while George Soros himself had over $5 billion of investor funds go up in smoke in just one month in 2000.

Why are stocks swinging so wildly? If we saw such huge swings and volume during a bull market, won't we see even larger swings and volume in a panicky bear market? How can you protect your finances and insulate yourself from the dangers? How can you turn the tables on the markets and transform these moves into veritable profit bonanzas?

Market volatility goes wild
immediately after the first
phase of a decline, signaling
that the worst is yet to come.

To get a better handle on this phenomenon, I've gone back and studied the swings in the Dow since 1929. I find that each and every time volatility increased sharply, it signaled that a top had been reached and that the worst phase of the decline was just beginning. For example:
  • In 1929, stocks swung an average of 3.24% from high to low just before Black Monday, October 19, 1929. Then, after the first phase of the decline, market volatility exploded and continued to get worse for the next three years. What was happening? Simple: Investors who had rushed in to buy, rushed in even more hurriedly to sell. The Dow continued to go lower straight into 1932, losing 89.4% of its value.

  • During the 42% decline in the 1937 bear market, stocks swung wildly again with volatility rising from an average of 1.4% just before the high in the Dow on March 10, to 4.7% in the months after.

  • In 1937, 1961, 1966, and 1973, stocks also gyrated wildly right after the first phase of the decline before the biggest plunges hit with full force.
The pattern is clear: In each and every case, increasing volatility signaled that the largest phase of the decline was still ahead.

Today's markets are the
wildest they've been in 70
years. And it's about to get
even worse ...

My study proves that high volatility almost invariably accompanies market crashes. Moreover, it also proves that today's stock markets are the wildest they've been since the early 1930s.

Look at this chart. The average daily range in the Dow has climbed from a low of 0.6% in 1944 to 4.2% today. That's the wildest swings since 1930 just before the major decline into the 1932 bottom.

But this is not just another technical indicator. It reflects powerful forces converging into one time and place:

Force #1. Concentration in one sector or even one stock. Instead of diversifying their portfolios, investors loaded up on the latest dot-com, biotech, or e-commerce IPOs, blind to the dangers of investing in a company that sells for over 200, 300, even 1,000 times earnings. In the process, they dumped the shares of thousands of other companies with real value.

Now, with more and more investors crowding into fewer and fewer stocks, any lurch for the exits has a far more devastating impact. That's one of the key reasons technology stocks took such a horrific beating so quickly. It also helps explain why the entire market has been so volatile. And after a major unexpected event, such as we've seen recently, that volatility can be even greater.

Force #2. Electronic brokering and day trading. The growth in online brokerage firms and trading has been nothing short of extraordinary. Problem: It's also attracted a growing number of amateur investors, with no experience in down markets, little or no capital to cushion against losses, and a very quick trigger finger to sell at the drop of a hat.

This chart measures the volatility in the Dow since 1929. For each day over the past 71 years, we subtracted the low from the high to determine the range of fluctuation during the day, measured in points. Then we divided it by the low to get the percentage fluctuation. Finally, for each year, we calculated the average percentage fluctuation.

Notice how this year's volatility has now surged far about the level reached in 1929 (the first bar in the chart, marked with an asterisk). Also notice how the volatility got even worse in the years following the 1929 Crash! Conclusion: The bull market is now over … but the bear market will bring swings that are even more violent.
 
Just a few years ago, online trading was barely a blip on the radar screen of most investors. Now, E*Trade has 2.6 million customers ... Ameritrade has 354,000 ... and Datek has 500,000 and that's just a sampling. This makes it incredibly easy too easy for millions of investors to buy and sell stocks on a whim ... on the flimsiest of tips ... or in the midst of panic in the marketplace.

Discount commissions or virtually commission-less trades make all the difference in the world. Years ago, when you had to pay commissions equivalent to several dollars per share to buy a stock, you thought long and hard before making any transactions. Today, it may cost almost nothing, fueling massive in-and-out trading and opening the floodgates to waves of buying and selling at a moment's notice.

Right now, the average share of stock on the NYSE is being bought and sold nearly 8 times per day! That's the highest turnover rate since the crash of '87. And back then, it lasted for only a short period. Now, the high turnover is continuous and far greater when averaged over several months.

Force #3. The huge, dangerous increase in leverage used by average investors. Volatility and speed of change wouldn't be quite so dangerous if it were all based on cash. Throw in big debt directly from broker loans or indirectly from credit cards and refinanced mortgages and you can see this market is a time bomb. The reality: America's stock market investors are in debt up to their ears ...
  • From 1998 to 2000, margin debt increased to a total of $199 billion. This is the highest dollar level of borrowing to buy stocks ever seen in this country or in the entire world, for that matter.

  • Margin debt is a drop in the bucket compared to other credit excesses, as I showed you in the previous chapter.

  • And I repeat: The average family has the lowest savings rate in 45 years (negative 0.8%) ... and is more leveraged with debt than ever in history with consumer credit hitting a record $1.6 trillion.
What have American consumers done with all the money they borrowed or didn't save? Many have thrown it into stocks with wild abandon. And despite the shocking tech stock debacle of 2000-2001, many went back in again for a second helping. Indeed, we have more American families invested in the US stock market than ever before in history over 50% of all households, which is far more than that of 1929.

Force #4. Foreign investors could also pull out at almost any time. Right now, there is more foreign capital in the US markets than ever before an estimated $6.3 trillion. As long as America was viewed as a safe haven in an otherwise dangerous world, foreign investors held on. But that is now in doubt. And foreign investors, uninhibited by concerns of patriotism, are bound to sell in droves.

Force #5. Derivatives. Individual and institutional investors both in the US and abroad have placed bets to the tune of $38 TRILLION, using derivatives. These are mostly high-risk side bets on stocks, bonds, currencies almost any security or commodity under the sun. And they are especially vulnerable to unpredictable sudden events, such as the attacks on America.

The problem is derivatives are poorly understood, and even more poorly regulated a mega-trillion-dollar casino that can only add more momentum to the decline. (More on derivatives in Chapter 15.)

Put all five forces together and the picture is clear: A massive debt bubble that has driven investors into the greatest stock market fever of all time.

The only possible outcome: A Great Stock Panic bouts of panic selling, driving stock prices into the swiftest declines in a half century, with great, unprecedented volatility. However ...

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