October 19, 2007 / 4:28 PM / 12 years ago

'Black Monday' redux? Global rally makes some sweat

NEW YORK (Reuters) - The 20th anniversary of the stock market’s brutal 1987 crash has triggered explosive debate about whether today’s raging, yet dubious, bull market in world stocks is headed for the same fate.

Traders work on the floor of the New York Stock Exchange, September 18, 2007. REUTERS/Brendan McDermid

Who can blame them, right?

After all, investors know all too well that there is a persistent common thread in each and every financial crisis over the last 20 years: All collapses have been caused by excesses.

Many economists and investors call them “bubbles.”

Just look at the current examples:

* MSCI’s main index of world stocks is up 14 percent in 2007 and has notched double-digit gains in three of the past four years.

* China's Shanghai Composite Index .SSEC has more than doubled this year on top of a 130 percent gain in 2006.

* MSCI’s index of Asia-Pacific stocks excluding Japan .MIAPJ0000PUS has risen more than 40 percent so far this year, and is up 260 percent since the end of 2002.

In the United States, where stocks earlier this month completed the fifth year of a bull market, the bubble is of a different variety.

Here, it happens to be in the housing and credit markets, whose deterioration continues to threaten world financial markets and rattle nerves.

“All asset bubbles formed and imploded for the same reason: naive extrapolation,” said Jeffrey Gundlach, chief investment officer of TCW Group in Los Angeles, which manages assets worth $160 billion, commenting in a recent letter to clients.

THE VOICE OF EXPERIENCE

“Choose your crash,” Gundlach said. “Some of us witnessed the collapse in precious metals in 1980. More folks probably can recall the emerging market debt crisis of 1998. All but the most inexperienced among us lived through the tech stock and corporate bond debacles which opened this decade.”

Of course, Gundlach is referring to American homeowners who in this cycle took advantage of rock-bottom interest rates, buying a slice of the property boom.

That was aided by Alan Greenspan’s Federal Reserve, which slashed benchmark interest rates to 1 percent in 2003 to pump the economy back to life after the 2001 dot-com bubble burst, and kept them there for a year.

But then the Fed raised rates 17 times, ending the cycle in late June 2006, when it had taken the fed funds rate back up to 5.25 percent, and the housing boom lost steam.

Delinquencies are still rising on subprime mortgages and defaults piling up at record rates as home prices sink, pressuring consumers’ desire to spend.

The housing turmoil continues to exact a heavy toll on hedge funds and Wall Street banks that used leverage to invest in pools of bonds tied to the risky subprime mortgage market.

NATURE OF THE BEAST

As Robert Arnott, chairman of Research Affiliates LLC, a Pasadena, California-based investment management firm, describes it: “We are coming off the greatest lending bubble — not housing bubble! — in U.S. history.”

But while the good times in housing and credit markets are over, the lessons from this and past boom-to-bust cycles or crashes continue to reverberate.

“A continuous rotating bubble is the result of wealth creation,” said Tom Sowanick, chief investment officer of Clearbrook Financial LLC in Princeton, New Jersey. “Think about the Nikkei 1989, the savings and loan crash of the early 1990s, Orange County and the Mexican peso crisis, LTCM and Asian Tigers, the tech wreck and corporate scandal of 2000-2001, and now the credit bubble. Rotating bubbles are the nature of capitalism.”

That said, it's worth noting where the three major U.S. stock indexes stood for the year to date on Friday -- even after the blue-chip Dow Jones industrial average .DJI lost nearly 367 points. The trigger for Friday's slide was a comment from the chief financial officer of Caterpillar Inc (CAT.N), who said there is a 50 percent chance the United States will fall into a recession in 2008. Caterpillar's earnings rose, but missed analysts' expectations, and the company, the world's top maker of earth-moving equipment and a Dow component, on Friday cut its full-year earnings outlook.

Nevertheless, after Friday's swoon, the Dow average was still up 8.5 percent for the year so far, while the broad Standard & Poor's 500 Index .SPX was up 5.8 percent, and the Nasdaq Composite Index .IXIC was up 12.8 percent.

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