10 October 2008

The Record Bear Market And Its Implications

The stock market is setting new records for collapsing prices.

Frozen credit markets and a loss of confidence in the world’s financial system have caused the Dow to drop 21 percent in just 10 trading days. The blue chip index tumbled 678 points Thursday, and is heading to its worst weekly point and percentage drop since being created 112 years ago. . . . At its low point today, the Dow was down 696 points at 7,882.51, just 60 points above its low in Wall Street’s last bear market, 7,286.27, reached Oct. 9, 2002. . . . The Dow, which began the session down 16.9 percent, was on track for its worst weekly decline ever. Previously, the worst performance came in the week ended July 21, 1933, when the blue chips fell 16 percent.

Through Thursday, the Dow lost 2,271 points, suffering its worst seven-day point drop. Its percentage decline of 20.9 percent over that stretch is the largest since the seven-day plunge ending Oct. 26, 1987, when the Dow lost 23.8 percent. That sell-off included Black Monday, the Oct. 19, 1987 market crash that saw the Dow fall 22.6 percent in a single day.

By comparison, during the first week of trading after the Sept. 11, 2001, terror attacks, the Dow lost 1,369.70, or 14.26 percent. But during the eight trading days following the attack, the decline came to 1,038.12, or 10.8 percent, as buyers returned to the market at the end of that stretch.

The Dow and S&P 500 reached their all-time highs a year ago, on Oct. 9, 2007. Through Thursday, the Dow has lost 5,585 points, or 39.4 percent, since closing at its record of 14,164.53, while the S&P 500 index, meanwhile, is off 655 points, or 41.9 percent, since recording its high of 1,565.15.

Meanwhile, the value of all the shares in the U.S. stock market has plunged $8.33 trillion since last year’s high. That’s based on figures measured by the Dow Jones Wilshire 5000 Composite Index, which tracks 5,000 U.S.-based companies’ stocks and represents almost all stocks traded in the country.

This episode will be a test of how much impact Wall Street has on Main Street. The lesson of Black Monday in 1987 was that markets can collapse while having only a slight impact on the "real economy." The current collapse has happened at a time when economists are saying that we are experiencing slow GNP growth, rather than a recession, although almost everyone expects that we are about to enter a recession if we aren't in one already. It has also become fashionable in academic economics circles to de-emphasize the economic importance of the stock market crash of 1929 as a cause of the real world economic hardships of the Great Depression.

Generally speaking, day to day changes in the stock market don't impact the companies that own those stocks much, because the stock market is a secondary market between stock owners, that only rarely provides significant new equity funding for existing companies.

But, the market collapse does hurt investors who need to take money out of the market to spend, like retirees, or families that are forced to tap into their long term investments to use them as an emergency fund in hard economic times.

The market collapse also hurts companies that want to raise funds by going public, or want to issue new stock to raise funds.

And, finally, a market collapse of this magnitude has dramatically reduced the wealth of the senior executive class, to the extent that their outsized compensation is based upon stock options. The vast majority of employee stock options in publicly held companies that are currently outstanding are now worthless or nearly worthless. In a large share of companies, stock options are the principal source of income for senior corporate executives, so the crash is effectively the biggest senior executive paycut in the history of the United States.

This is new. Stock options are uncommon as a form of executive compensation prior to the 1980s, and were far less common on Black Monday in 1987 than they are today. Stock options were, of course, very common as a means of compensation in tech companies prior to the 2001 busting of the tech bubble. But, in 2001, the loss of stock option wealth was fairly industry specific. This time around, in contrast, almost the entire market is taking a beating (less than 10% of issuers on the market have avoided falling stock prices).

One can also fairly assume that the notion of investing some or all of the Social Security Trust fund in the stock market is dead for another generation, despite the fact that the bailout bill and other federal government intervention in the markets (like the conservatorship of Fannie Mae and Freddie Mac) have increased government ownership of private enterprises to unprecedented levels.

UPDATE: According to preliminary calcuations, the Dow fell 128.00, or 1.49 percent, today. to 8,451.49. The Standard & Poor’s 500 index fell 10.70 or 1.18 percent, to 899.22. This was the worst week ever for the Dow (in terms of percentage and point losses) and also for the Standard and Poor's 500 index.

Both the Dow and S&P 500 are down more than 40% from the market peak.

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