What Caused the Correction of October 1997?
October 31, 1997
The correction of October 1997 was caused by four factors:
The number one reason for the correction of October 1997 was the financial news media. Stories of the crash of 1987 were ubiquitous in September and October. All the financial news media were asking, "Is there going to be another crash like 1987?"
It didn't matter what business magazine you read or what evening business report you listened to, or what channel you watched, CNBC or PBS. Investors were bombarded with stories about all the reasons for a repeat of the 1987 crash in October 1997. With most of the institutional investors being inexperienced they were ready to jump on any bandwagon (like Hong Kong), which brings me to my second reason for the correction.
Just look at the indexes on a daily basis for the past several months. What do you see? What you see is 95% of the industries and indexes will be either up at once, or 95% of them will be down at once. This happens because the institutions that control most of the money in this country are basically sheep, they buy when everyone is buying and sell when everyone is selling.
The mutual fund companies and brokers want you to believe that investing is based on fundamentals, research, and hard work. That's what you pay them for right? Maybe that's the way it used to be and should be, but that's not the way it is anymore. Investing is becoming more and more simply a momentum play. Momentum has been the driving force behind the rise in the S&P 500 index for the past two years which inturn is the reason for the very high growth in index funds. Many small investors are seeing the light: why pay a mutual fund company money in the form of higher expenses when you can get better returns and pay less expenses by simply buying an index fund.
More evidence supporting index funds can be found by checking your returns for your individual mutual funds in October. Compare what your individual funds did compared to the S&P for the same period. You will find that the vast majority of mutual funds did worse than the S&P. Again, why pay more in expenses for a mutual fund that can't even, at least, keep up with the S&P. You may as well buy an index fund that equals the returns of the S&P and charges less for expenses. If mutual fund companies don't want to earn their money by turning in performances better than the S&P, I say dump them.
The third reason for the correction was the NASDAQ market makers. Almost all large brokerage houses are market makers, even Schwab owns a large market maker operation. Market makers make their money off of volume, the higher volume the more profit. Market makers have a vested interest in driving prices up fast and down fast and that's exactly what they did this past week (the spread and volume determines the market maker's profit, number of shares traded times spread equals profit to the market maker).
For example, Asyst Technology was a $47 stock a few weeks ago and since then reported better than expected earnings. However, with the correction and the help of the NASDAQ market makers, this stock hit $20 a share last Tuesday morning. As you all know there are many, many more examples just like Asyst.
Once I saw a stock fall 7% on only 300 shares of volume. I wrote the NASD who wrote me back. The NASD looked for stories to support the drop of 7%, but found nothing significant. What I learned was that the NASD allows market makers to raise prices or lower prices as they see fit. I saw no rules that controlled this price movement. What that means is that on NASDAQ, the market makers decide how much a stock should fall or rise and that the amount of volume comes in second. I feel that volume alone should decide the price change. If the Hong Kong market is falling by 10% and no one is selling XYZ stock, why should the bid and ask prices for XYZ be lowered? However, if you are a market maker you can easily see why you would want the price to be lowered. By lowering the price you create volume, first down volume, and then up volume, this results in a profit to you. If the price of the stock had not change because no one was selling, the market maker would make no profit.
My forth and last reason for the correction is the only fundamental reason. Investors are totally misled by the financial news media regarding my fourth reason which is the overvaluation of some stocks. The financial news media and even the Federal Reserve Chairman like to talk about how the stock market is overvalued, when they should be talking about how certain stocks are overvalued. The fact is at any given time there are numerous stocks that are over or undervalued, and yes, maybe certain stocks were getting too high in valuation in the past few weeks and a correction was needed in those stocks. But, just because Hong Kong was due for a correction, and corrected, was in no way a reason to sell off virtually every listed stock in the U.S.
Even Greenspan himself stated February 6, 1997, "Who owns the stock, how much is moved around, obviously does affect the price in the short run, but in the long run, the price is determined by how good a company it is." That is, fundamentals should determine a stock's value and not a bunch of "sheep" on Wall Street.
ADDENDUM (March 20, 1998)
Guess What? About four months ago everyone on Wall Street: CNBC, CNN's Money Line and It's Your Money, PBS's Wall Street Week and Nightly Business Report, Business Week magazine, The Wall Street Journal, IBD, most fund managers and brokers and anlysts, most mutual fund companies and brokerage houses, they were all saying that Asia's problems meant bad news for the U.S. stock markets.
Oh they didn't? Then explain why the DOW plunged to 7300, and NASDAQ crumbled to 1500? Who else other than these people and institutions have the power to do it. Please don't try to blame it on the small investors. Wall Street you know it. It was you.
And were you right? Well it has been about four months since you all were jacking your jaws about how stocks in the U.S. were going to be in big trouble and guess what? The DOW is up over 1,600 points or $1.6 trillion and the NASDAQ is higher now by 300 points. In fact, all the major market indexes in the U.S. are higher now than before the so call Asian crisis. Guess you were all wrong...as usual.
But, when you really think about it, even though you were all wrong about where the U.S. markets were going, you still got what you wanted: Volatility, stocks falling to record lows only to recover to record new highs in a short time. You all made tons of money off commissions. I guess that's why you can buy those $6 million dollar homes in Connecticut and when the realator asks you, "Who are you going to finance the house with?" You reply, "I'm going to pay cash!"
I bet you guys are already planning the next "crash" and I also bet you those inexperienced fund managers who are mostly sheep will follow you just like they did before.