Prepare Now for a Possible Crash in October
Many investors view the month of October with a sense of dread. Some remember 1987, the year when the Dow Jones Industrial Average suffered its largest single day decline in history. Others think back to the historic crash of 1929. While these are just two years, there were other crashes in that month.
It’s actually the autumn season that has historically been the time of crashes. There were actually good reasons for autumn crashes in the fall in the nineteenth century.
At that time, business was conducted in cash. But, the supply of cash was limited. These were the days before the Federal Reserve and money was limited by a strict gold standard. This created problems at harvest time.
In the fall, farmers harvest crops in what was the western part of the country in the nineteenth century. They would bring the crops to the local granary and be paid in cash for the year’s production. This cash was then used to pay bills and much of it quickly found its way back to banks in the eastern region.
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But, the cash moved slowly at that time of year. Wall Street also needed cash to function at that time and regulation was lax. Speculators could create crises by accident and cash would be needed to meet margin calls. If cash wasn’t readily available, a crash was possible.
This pattern played out repeatedly in the 1800s. But, three crashes in the twentieth century stand out in history.
The Panic of 1907
This crash followed the typical pattern of the previous century. There was a bear market underway and there was a general shortage of cash available. The market was plummeting and was down nearly 50% from its 1906 peak. The economy was in recession, and the worst was yet to come.
The Dow Jones Industrial Average (DJIA) would fall almost 15% in October 1907.
The immediate cause of the crash in October 1907, was the fact that a single speculator used too much leverage in an attempt to corner the market in a stock called United Copper. Knickerbocker Trust, the bank which made the loans, suffered a liquidity crisis.
The looming failure of this bank threatened the entire financial system. Treasury Secretary George Cortelyou provided $35 million of federal money to ease the crisis. He also enlisted the help of banker J.P. Morgan.
Teaming up with other bankers, Morgan redirected money between banks, found additional sources of credit, and bought oversold stocks of healthy companies. Within weeks the panic was over. Seeing this as a success, Congress created the Federal Reserve to formalize the role Morgan played in the crisis.
The Great Depression
In 1929, once again stocks were falling but were just 9% below their peak. The crash began to accelerate on October 24, a day that came to be known as Black Thursday. The following week brought Black Monday and Black Tuesday when the Dow fell more than 20% over those two days.
For the month, the Dow fell more than 30%. By the time stocks, bottomed in 1932, the Dow was more than 90% below its 1929 high. The Federal Reserve failed to pass its first major test.
In October 1987, there was no sign of trouble. But, on October 19, the Dow fell by more than 22%.
This crash was global with markets in Asia and Europe also suffering large declines. The Federal Reserve and central bankers around the world guaranteed liquidity for the market and the decline stopped.
There would be other crises, including a steep drop just two years later in October 1989. But, the Federal Reserve had proven that central bank intervention could stem the tide of the market.
Are We Safe in October?
Of course, central bankers are not infallible. They failed to stop the internet bubble in the late 1990s and they were nearly helpless as the subprime mortgage crisis escalated in 2008 and 2009. But, these crises were less predictable and no longer tied to the calendar.
Cash no longer needs to be transported from east to west in preparation of the harvest season and it no longer takes weeks for cash to move back east after the crops are out of the field. That means there is no rational reason to expect a cash crunch to affect Wall Street in the fall.
But, the calendar still points to a potential reason for a crash in October, at least for this year.
Treasury Secretary Steve Mnuchin recently informed Congress that Congress must take action to raise the debt ceiling by September 29.
“Based upon our available information, I believe that it is critical that Congress act to increase the nation’s borrowing authority by September 29, 2017. I urge Congress to act promptly on this important matter,” Mnuchin wrote in a letter addressed to the Speaker of the House of Representatives Paul Ryan.
This date is especially ominous this year. The Treasury Department is estimating that the government will run out of money to pay its bills and meet its debt obligation on that date. That is also the last business day of the government’s fiscal year and Congress needs to pass a budget by then to fund operations past the end of September.
If Congress fails to act on the debt ceiling, the US is at risk of defaulting on its debt. If Congress fails to act on the budget, as they have numerous times in the past, the US is at risk of a government shutdown.
These factors point to additional market risks in the month of October.
Looking around the world, the European Central Bank (ECB) will have a policy meeting that month. The ECB has recently indicated it could be considering an end to its quantitative easing program. Any upcoming announcements by the ECB could be market moving.
OPEC will also be conducting meetings in that month to prepare for their major policy meeting in November. In the past, leaks regarding the negotiations in the months leading up to that meeting have been market moving.
There are also other “black swan” risks with the popularity of the Japanese prime minister plunging and the missile development program of North Korea attracting additional attention.
A Specific Trading Strategy
There are a number of reasons the stock market could crash in October this year. Of course, it could continue higher. It is possible that Congress could pass a budget and avoid a debt crisis. Problems in Europe, Asia and the Middle East could remain on the back burner.
But, volatility in the stock market remains relatively low for now. That means protection against a market crash is relatively inexpensive.
Options are available on the SPDR Dow Jones Industrial Average ETF (NYSE: DIA), an ETF that tracks the Dow. Options expiring in December provide protection against the October danger zone on the calendar and a few additional weeks where a crash is certainly possible.
Buying a put option is one way to protect against a market downturn. For DIA, a put option with an exercise price of $200 and an expiration date of December 15 is trading at about $2.65. If the market crashes, falling more than 20%, this put option could be worth $25 or more.
Each options contract covers 100 shares so this trade would cost $265 to enter, ignoring the cost of commissions which should be only a few dollars at a deep discount broker. If the Dow crashes, this option could be worth more than $2,500, a potential gain of more than 1,000%.
This is a low probability trade, however could be a “sleep at night” trade for investors worried about a possible crash.