If the Market Tanks This Month, Here's Why

20 years ago this week, Black Monday came pretty much out of nowhere and evaporated more than 20% of the Dow Jones Industrial Average market cap in a single day.  Ten years later, the "mini-crash" of October 1997 saw an even larger point decline and forced the New York Stock Exchange to suspend trading for the first time in history.  The Crash of '29 that ushered in the Great Depression: also an October surprise.

Fed Chairman Ben Bernanke seems to think it might now simply be a matter of tradition, an echo of the bygone agricultural seasonality that used to make October a more legitimately dicey time of year.

"Classically, October has always been the month for financial problems ... If you look at the reasons for the Federal Reserve Act in the beginning, one reason was to provide an elastic currency. The main purpose of an elastic currency was to provide extra money as needed during periods of harvest or planting which in turn was intended to keep short-term interest rates more stable. ... The high short-term interest rates during the fall and the spring created a shortage of liquidity and often provided the backdrop in which banking panics would take place.”

Although, it’s hard to understand why this should still be the case when agriculture has become such a smaller part of our economy. Perhaps, people just can’t let go of harvest traditions, whether they be jack-o-lanterns or banking panics.

Of course, panic is a self-begetting emotion in any crowd (perceived bank insolvencies create bank insolvencies, anticipated market sell-offs yield market sell-offs, expectations that lines would form early for iPhones ensured that lines would form early for iPhones, etc.).  All that's needed is a credible catalyst to seed the panic.  On the surface, we'd seem to have plenty of panic-inspiring catalysts: oil at $85/barrel, a lingering and complex housing/credit crisis, an uncertain 3rd quarter earnings picture, an inflection point in Fed policy, a growing but slowing economy, geopolitical unrest aplenty, multiple years of market gains without a single 10% correction, and so on.

But a couple factors augur well for us avoiding an onerous October sell-off.

1. Efficient market theory hates the idea of predictable seasonal effects, self-reinforcing panic tendencies notwithstanding.  As market participants become ever more sophisticated, diverse, and diversified, the severity and frequency of panic-driven panics ought to decrease over time.  And while we haven't yet had a textbook correction during this bull market, we have had a couple of notable retrenchments, which may have induced genuine corrections (or even sparked enduring bear markets) 10 or 20 years ago.  The notable resilience of the current bull run (in spite of high oil prices, war, natural disasters, the credit crunch, and other headwinds) may be a telltale of a fundamentally less panic-inclined marketplace.
2. Putting a natural floor on equity prices is the relative valuation of stocks (as measured by the multiple of annual earnings investors will pay for a company) today compared to 1997 and 1987.  The broad S&P 500 index has a composite price-to-earnings multiple of roughly 18x.  Twenty years ago, the index P/E was at 20x.  Ten years ago, it was above 23x.  Relatively speaking, stocks are simply cheaper on average than they were going into the fateful Octobers of 1987 and 1997.  So long as earnings hold up, it'll be hard, even for a panicking market, to drive relative prices (and therefore the multiples) much lower for a significant period of time.

The relatively cheap valuation of today's market is even more dramatic, taking each era's respective prevailing multiples into consideration.  As markets mature, as new hedging tools allow more perfect portfolio optimization, and as communications, technology, and the evolution of corporate reporting enable more transparency (and thus higher quality) to corporate earnings, the multiple investors have been willing to pay for a given level of earnings has not surprisingly risen fairly steadily over the last 25 years.  As illustrated at left, the S&P 500's 10-year moving average P/E has jumped from 10x in 1982 to more than 26x today.

Acknowledging that markets tend to merit higher multiples in recent business cycles than they did in earlier decades, we can modify our measurement of relative valuation by looking at the difference between the index's earnings multiple at a given point in time and the average value of that multiple over the 10 years prior.  Using that gauge, we appear not only to be in a relative valuation trough, but significantly below the levels that preceded the big October sell-offs in 1987 and 1997.  What's more, we're actually very near a generational absolute minimum in that measurement, one which over time ought to revert to zero or slightly higher (assuming ongoing financial market innovation, enhanced corporate transparency, etc. continue to warrant gradual expansion of market multiples).

This gauge can be thought of as the relative over- or undervaluation of stocks, within the context of the last decade.

This measurement is particularly depressed now, due to the fact that the sky-high internet boom era multiples are still part of the current 10-year average.  As they trickle out, the moving average will come back down and the valuation gauge above will climb out of its unusually deep trough.  Conservatively, then, if you choose to disavow any merited multiple expansion since pre-bubble days ten years ago, you're left with a market multiple somewhere in the high teens (two charts up circa 1997), roughly where the S&P 500's P/E sits right now (18x).  That would place current conditions at roughly the zero line on the chart immediately above, still well below levels observed before significant market downturns and still near generational lows.

Of course, none of that means the market won't decide to put on an old fashioned October freak out anyway, should the right catalysts come calling.  But if nothing has fundamentally changed and those catalysts are little more than spooky reminders of risks already baked into stock prices, look at it as an opportunity for your cool head to prevail over your less rational, panic-stricken counterparts.  Buying into the market at even more compressed multiples might not only make you money, it might even help staunch the panic of others, to be replaced by the placid pangs of regret - an expensive but nonetheless worthwhile lesson you will have helped inflict on irrational market participants, and in so doing, perhaps helped us all avoid the scourge of panic-induced panic in future Octobers.