How to spot the next stock market crash

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A trader reacts to the Flash Crash on May 6, 2010.

Investors have learned that “it’s different this time” is the most dangerous rationale for buying into a market bubble. It’s easy to believe that the United States’ stock market has been fundamentally changed by the technology of trading itself or by one of the new contraptions that is supposed to make trading easier and investing safer but it just isn’t so.

What investors haven’t learned, and what may help them avoid some of the damage from the next crash, is that rather than focusing on how the next bubble might be different, they should remember all of the modern stock market crashes are astonishingly similar and they should watch for those similarities.

The genesis of my latest book, “A History of the United States in Five Crashes,” was the realization that each of the five modern stock market crashes, beginning with the Panic of 1907 and ending with the Flash Crash of May 6, 2010, exhibit astonishing similarities that we should be alert for. This doesn’t mean another crash is imminent. In fact, it’s probably years off. But less than two years passed between the meltdown of 2008 and the Flash Crash of 2010 and another crash is inevitable while we hope it is far off.

The market always rallies strongly before a crash – this is easy to recognize. The other similarities are camouflaged by changing circumstances but include the appearance of some external catalyst – the San Francisco earthquake of 1906 led to the Panic of 1907 when the rebuilding of the financial capital of the western United States vacuumed up liquidity around the world – and the appearance of some new financial contraption that is poorly understood and untested under stress and which injects leverage into a system that is on the ragged edge of equilibrium, pushing it into chaos. In 1987, that contraption was portfolio insurance; in 2008 it was the alphabet soup of mortgage-backed securities; and in 2010 it was algorithmic trading.

Ingredients for a recession all there: Ip

Another similarity is the presence of villains. Each crash has at least one and often several. Benjamin Strong was President of the newly-formed Federal Reserve Bank of New York during the 1920s and Strong’s misguided efforts to help his friend, Montague Norman, who was Governor of the Bank of England, return England to the gold standard following World War I caused Strong to recklessly lower interest rates in the United States despite knowing that low rates were fueling a “speculative orgy” in stocks and despite being repeatedly warned of the approaching danger. The result was the quintessential crash of October 1929.

With the advantage of perspective provided by the nearly ten years that have passed since the worst of the meltdown of 2008 it’s possible to recognize that villain. We now know about the abuses in the mortgage market which started with mortgage lending and ended with stupefyingly complex mortgage-backed derivatives including synthetic collateralized debt obligations and credit default swaps. The villain was the one responsible for regulating the entire mortgage process, from origination to securitization but who did nothing as all these mortgages were being written and all these mortgage derivatives were being ginned up and foisted on supposedly savvy institutional investors?

“[T]he real danger for investors is that the time between the catalyst and the crash is contracting.”

The Federal Reserve was that one regulator with the broad responsibility to rein in the entirety of the abuses in the American mortgage and it was led by Alan Greenspan, a devotee of Ayn Rand and a believer in the notion that banks would self-regulate because “the self-interest of market participants generates private market regulation.” What Greenspan failed to recognize was the “I’ll be gone, you’ll by gone” atmosphere that had seeped into every bit of the mortgage market. Mortgage brokers could stretch the truth when writing mortgages and investment bankers could stuff those inferior mortgages into mortgage-backed securities because by the time the damage was discovered, the broker and the banker would have been paid and would likely have moved on, they would “be gone.”

The Home Ownership and Equity Protection Act of 1994 (HOEPA) required the Fed to enforce the Truth in Lending laws as they applied to mortgages. Sheila Bair, who served as Chair of the FDIC during the worst of the crisis, called HOEPA the “one bullet” that could have prevented the financial crisis. But Greenspan refused to regulate.

Many pushed him to fulfill his statutory responsibility. Robert Gnaizda and John Gamboa, founders of the Greenlining Institute, begged Greenspan to regulate the mortgage business. Edward Gramlich, a Fed governor, warned of the abuses going on in the mortgage market. While Gramlich had warned Greenspan in private, Susan Bies, another Fed governor, went public with her concerns in 2006. And Bair made public warnings as well. Even Ben Bernanke, who was left to clean up the mess as Greenspan’s successor at the Fed, called the Fed’s failure to fulfill its duty as the regulator of the mortgage market “the most severe failure of the Fed in this particular episode.”

Book cover A History of the US in Five Crashes

As our stock market idles near all-time highs it’s timely to wonder what catalyst might destabilize the stock market and who might be the villain who deserves the blame if we were to experience another crash?

There are plenty of candidates if the catalyst is geopolitical. Venezuela is one of the largest oil exporters in the world and their society is crumbling, North Korea is again being belligerent, and Russia is an overt danger in Syria and a covert danger in potential election tampering. Maybe the villain will be the leader of one of these floundering countries. Maybe it will be the creator of the next feat of financial engineering which metastasizes when the market is under pressure and behaves in a manner never imagined by those who turned it loose.

But the real danger for investors is that the time between the catalyst and the crash is contracting. The Panic of 1907 took place more than a year after the San Francisco earthquake vacuumed up the world’s liquidity. The Crash of 1929 took place nearly two months after a fraudster in London demonstrated how silly the faith in the stock market had become. Black Monday of 1987 took place one weekend after it seemed we were finally at war with Iran. And the Flash Crash of May 6, 2010, took place less than a day after rioting, arson, and murder in Athens led the world to believe that Europe was coming apart politically and economically.

The American stock market has financed retirements and college educations for decades. American investors have done more good in this world than any group with the exception of American soldiers. If we can warn investors about the course and cause of the past stock market crashes we’ve begun the process of minimizing the damage. At least for those paying attention.

Commentary by Scott Nations, president and chief investment officer of NationsShares. He is also the author of several books, including his latest, “A History of the United States in Five Crashes.” Follow him on Twitter @ScottNations.

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