80 Years Later - Are We Due For Another Black Monday?

• By Simon Maierhofer
• On 12:11 pm EDT, Wednesday October 28, 2009

They occurred in October and they came unannounced. If you are thinking that a Black Monday, Tuesday, Wednesday or any other black day is unlikely, keep in mind that 'black' strikes when least expected.

Black Mondays

In finance, Black Monday refers to Monday, October 19th, 1987. But did you know there were actually three Black Monday's?

1) Black Monday, October 19th, 1987: The largest one-day percentage decline in recorded stock market history. The Dow plummeted 19.65% in one day.

2) Black Monday, October 28th, 1929: This Black Monday was one in a sequence of black days that ushered in the Great Depression. The Dow Jones (NYSEArca: DIA - News) closed down 11.70% that day.

3) Black Monday, October 6th, 2008: The Dow Jones (DJI: ^DJI) fell as much as 819 points intraday.

As you can tell, all Black Mondays occurred in October and none of the Black Mondays came announced.

In fact, last year's October 6th Black Monday came on the heels of a respectable summer rally. The Dow had gained nearly 1,000 points and the much anticipated bailout was expected to fix the financial system.

Just a few days before this Black Monday, the ETF Profit Strategy Newsletter released a special report on financials. This report described the financial sector as a 'downward spiral with no stop-loss provision. Within six months of the report, the Financial Select Sector SPDRs (NYSEArca: XLF - News), Vanguard Financials ETF (NYSEArca: VFH - News), and SPDR KBW Bank ETF (NYSEArca: KBE - News) had lost 70% of their value.

Are we ripe for another Black Monday?

Seventeenth century French dramatist Pierre Corneille hit the nail on the head when he said that 'danger breeds best on too much confidence.'

Confidence in yet higher prices ahead is one of the major ingredients, even requirements , for a black day, whether it'll be Monday, Tuesday or any other day. The S&P 500 (SNP: ^GSPC) just climbed to a 1-year high on speculation that improving corporate earnings will extend a seven-month rally. The Nasdaq (Nasdaq: ^IXIC) rallied some 70% from its March lows.

According to Bloomberg, the S&P 500 (NYSEArca: SPY - News) companies are projected to report a ninth straight quarter of declining profits, the longest streak since the Great Depression, before returning to earnings growth in the final three months of the year.

Good job paying attention if you caught the contradiction in the above two paragraphs. Yes, stocks are expected to rise on speculation of improving earnings, even though companies are expected to report a ninth straight quarter of declining profits.

The 'new normal'

Below is the formula that describes the 'new normal:'

Falling profits = rising stock prices (as long as future projections are positive)

Until last week, marginally good news was enough to propel the indexes higher. This is reminiscent of September 2008, when investors relied on similar glimmers of hope right before the Dow shed 3,000 points in 30 days.

Hope was also rekindled at the turn of the year, right before the Dow fell 30% within 30 days (Dow 9,100 to Dow 6,450 from January - March 2009). In January, the ETF Profit Strategy Newsletter warned of an impending down-turn and recommended to buy short ETFs such as the UltraShort Financial ProShares, (NYSEArca: SKF - News), UltraShort S&P 500 ProShares (NYSEArca: SDS - News) and others above 9,000.

The curious case of declining P/E ratios

Corporate U.S. earnings have been declining for years resulting in skyrocketing P/E ratios. The P/E ratio is created by the interaction between stock prices and earnings. Declining earnings will result in higher ratios, while falling prices will contribute towards lower ratios.

Historically, the market is viewed to be over-valued when P/E ratios move above 20 - 25. Market bottoms are not reached unless P/E ratios fall to rock bottom levels (more about that in a moment).

As per the most recent data published by Standard & Poor's, the P/E ratio for the S&P 500 is 139, based on the reported earnings. In other words, current P/E ratios are six times higher than what's normally considered over-valued.

The curious case of investor confidence

Despite the over-valuation issues, investors are feeling giddy about their portfolios. To explain this paradox fully would take another few pages, but in short, the pent- up urge to buy, which was suppressed from October 2007 to March 2009, caused prices to rise. Rising prices, in turn, resurrected investor's faith in the market and increased optimism. Investor optimism is thereby the result of nothing more than rising prices, and climbing prices increase optimism; a classic snowball effect.

There is, however, a turning point where extreme optimism will actually cause a decline, just as extreme pessimism will result in a market bottom. The ETF Profit Strategy Newsletter pointed to such a market bottom when it sent out the March 2nd Trend Change Alert, which predicted a rally towards Dow 9,000 - 10,000.

Extreme optimism indicates that most wanna-be buyers have become buyers, thereby depleting the pipeline of new stock owners. This provides a fertile environment for major market declines and/or Black Mondays.

The long-term outlook

As mentioned earlier, P/E ratios are a reflection of value, as are dividend yields. Major market bottoms are reached when valuations are reset from over-valuation to fair valuations. An analysis of P/E ratios and dividend yields shows that no major market bottom has been recorded unless P/E ratios and dividend yields reached rock-bottom valuation levels.

Just as the human body is not healthy unless it runs at 98.6 degrees; the stock market is not healthy unless valuations reach levels indicative of fair prices. A P/E ratio of 138 is the equivalent of a 104 degree fever and requires serious attention.

The ETF Profit Strategy Newsletter includes a detailed analysis of P/E ratios, dividend yields, the Dow measured in the only true currency - gold (NYSEArca: GLD - News) and investor sentiment, along with target ranges for the ultimate market bottom based on those indicators and weekly commentary on the market's whereabouts.

In connection with the 1929 Black Monday, Economist Richard M. Salsman noted the following: 'Anyone who bought stocks in mid-1929 and held onto them saw most of his or her adult life pass by before getting back to even.'

Keep in mind that it doesn't take a Black Monday to reset valuations to levels indicative of a lasting market bottom. A persistent decline in prices will get the job done just as well. Based on our analysis though, we expect some Black Monday-like days during the worst part of this bear market, probably in Q1/Q2 of 2010.

Buzz up!