Yesterday, a broad decline in the U.S. stock market brought the major indices to or near 3-month lows. The Dow Jones Industrials closed at 11,842.69, its lowest close since the Dow fell to 11,740.15 on March 10. The S&P 500 Index closed at 1,317.93. That is its lowest figure since March 28 when it closed at 1,315.22. Since both indices peaked on October 9, 2007, the Dow has fallen 16.4% and the S&P 500 has declined 15.8%. If one factors in inflation, the real decline in these indices exceeds 19%.

The recent decline raises questions as to whether a dire assessment from the Royal Bank of Scotland (RBS) has gained greater credence. On June 19, The Telegraph reported, “The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks.”

In my view, odds remain against such a meltdown. Full-fledged crashes (drops of 10% or more over 1-2 trading days) are rare events. Market psychology plays a leading role in precipitating such events.

At the same time, a sustained recovery that would lift both indices to new all-time highs appears unlikely over at least the next 6 months. Fluctuations are likely. In terms of fluctuations, before the latest retreat commenced, the Dow had recovered from its March depths to 13,058.20 on May 2 and the S&P 500 reached 1,426.63 on May 19.

For now, a sketch of some of the more important factors shaping the present market environment includes:

• Inflation: As the Federal Reserve stands idle in the face of persistently rising inflation, a quickening of producer price inflation, and growing indications of pass-through, the markets are beginning to discount the emergence of a new inflation-tolerant Federal Reserve. Already, surveys such as those conducted by the University of Michigan, inflation expectations are rising.

Such a stance by the Fed would constitute a serious monetary policy error. “Certainly our collective experience strongly emphasizes the importance of dealing with inflation at an early stage, before it assumes a momentum of its own with deeply embedded effects on expectations,” former Federal Reserve Chairman Paul Volcker explained. He also warned hat “procrastination only invites greater difficulty.”

Longer-term persistence of elevated inflation has been unfavorable for stock prices. For example, during the inflationary 1973-81 period, the S&P 500 Index rose 20.0% from 102.09 to 122.55. However, consumer prices more than doubled and the after-inflation return on the S&P 500 Index was -54.3%.

• Oil: In recent weeks, the crude oil price has risen to as high as $139.89 in intraday trading. To date, the price of crude oil has climbed more than 90% this year. While these price trends have given a lift to energy sector profits, they have imposed strains on firms whose products require petroleum-based inputs and/or consume petroleum-based products.

The dramatic rise in crude oil prices is largely the result of a demand imbalance in which world consumption has exceeded world production for two consecutive years. The robust growth in consumption in fast-developing countries such as China and India has offset somewhat greater efficiency and recent modest conservation in the United States and Europe. A persistent decline in the U.S. dollar has aggravated the price rise, as crude oil is priced in dollars.

• Dissipating Housing Bubble: The enormous housing bubble that peaked in 2006 has continued to contract. In its wake, it has had a deflationary effect courtesy of a reverse “wealth effect.” It is entirely possible that the contraction of the housing bubble and ensuing credit squeeze have helped keep a lid on inflation to some extent.

Research by the International Monetary Fund (IMF) shows that the adverse economic impact of a housing bust is more significant and longer-lasting than that associated with a stock market crash. Banks and other financial institutions need time to repair their balance sheets. It takes time to replenish their capital and to regain a balanced appetite for risk-taking. Right now, the overall financial system post-bubble evolution may be near its mid-point. Hence, additional financial sector write-offs are likely.

That a deflationary contraction of an asset bubble is occurring within a larger framework of an increasingly inflationary environment is somewhat unusual, particularly for the United States.

• Iran’s Nuclear Program: Whether there is a military operation against Iran’s nuclear facilities would have profound economic and financial implications. In a best-case scenario, a surgical strike would take out Iran’s facilities, bring about little Iranian retaliation, and produce a brief but painful spike in oil prices, perhaps reaching or exceeding the $150 - $200 per barrel range. In a worst-case scenario, the strike would lead to massive Iranian retaliation, against Israel, the Persian Gulf’s oil infrastructure, and through Iranian operatives and Hezbollah terrorists on a worldwide scale. That development would precipitate a substantial and prolonged spike in the oil price and inflict enormous damage on the world’s economies. It would be that scenario that would provide a high risk of a stock market crash. Given Iranian rhetoric and the ideological nature of some of its senior leadership, an Iranian response in the middle of those scenarios might be likely. The U.S. could mitigate the worst-case scenario by threatening Iran with the “severest consequences” should Iran take such a course. Such a threat would have to lead Iran’s leadership to conclude that Iran might face nuclear retaliation with the hope that rational senior leaders and military commanders would limit Iran's response.

All said, if one is to witness a near-term stock market crash, certainly within the next 6 months, one would need to create a toxic brew of bad or worsening expectations about fundamental factors and an increasingly fragile market psychology. At present, even as there is plenty of angst among investors and the overall environment is not hospitable to a sustained boom in stock prices, overall market psychology does not appear to be on the proverbial precipice.

The run-up to the 1987 Stock Market Crash:
Key fundamentals driving the markets were decidedly negative in the days and weeks leading up to the 1987 crash. There was concern that foreigners were becoming unwilling to continue to finance the nation’s enormous budget and trade deficits. There had actually been net cash outflows to Japan. Americans were worrying that the nation was losing control over its own economic destiny. The dollar was declining. In response, interest rates had begun to rise. On the political front, there was growing concern about tax hikes that would make merger & acquisition activity less profitable.

Representative of the increasingly dark outlook, the October 16, 1987 edition of The New York Times reported:

Thus far this year net capital inflow into the United States has been zero. That would have caused the dollar to fall even further had it not been for heavy intervention by foreign central banks, which spent $90 billion during the first three quarters of this year in supporting the dollar. How long the foreign central banks will keep on doing this is one of the critical questions for the future…

…seemingly endless stimulus appears to be hurting the market's mood more than helping it -by increased fears of inflation, rising interest rates and a recession that would be hard to stop if it once got rolling.

The newspaper also reported:

Yesterday's and Wednesday's combined drop of 153.07 points was the biggest two-day retrenchment ever and brought the Dow's decline over the last nine sessions to about 285 points. ''The market succumbed to a delayed reaction to the latest prime rate increase,'' said Eugene E. Peroni Jr., chief technical analyst at Janney Montgomery Scott Inc. ''Its psychological posture at this point simply can't bear that burden of higher interest rates.'' About noon yesterday, the Chemical Bank of New York raised its prime rate to 9 3/4, from 9 1/4 percent…

At the same time, the dollar closed lower on remarks by Treasury Secretary James A. Baker 3d that many in the market interpreted as meaning that the United States is prepared to see a lower dollar.

However, market psychology had grown frayed and gloomy, almost sensationalist, news headlines amplified building fears. Some headlines included, “Small investors in rough seas,” “Stocks resume sharp plunge,” “In the aftermath of market plunge, much uneasiness,” “U.S. aides calm, but worried: Baker warns against panic,” “Rates up in wild trading,” “Uneasy market and future,” among others.

In terms of market sentiment, there were references to “nervous investors,” “wild gyrations” in short- and long-term interest rates, “a confirmed major bear market,” “panic,” and a “spectacular drop in the stock market.”

Toward the end of the week ending October 17, what had been a sustained and significant decline steepened. On October 17, The New York Times reported:

Yesterday, harried traders and brokers watched in amazement as the Dow and other market gauges spiraled downward steadily during the day before dropping sharply late in the session. ''Without question, there was panic today,'' said Rudolph P. Carbone, a vice president at Shearson Lehman Brothers Inc. who handles retail accounts.

The newspaper also noted a sudden flight to quality stating, “experts said investors rushed into Treasury securities for reasons ranging from increased tensions in the Persian Gulf to rumors of large trading losses at securities houses. In times of crisis, Treasury securities and gold are considered safe havens. Gold stocks also rose yesterday, reflecting the rising price of the metal.”

On Monday, October 19, investors were greeted by stories that reinforced their unease and rebroadcast the carnage in stocks that occurred the preceding week. The New York Times reported:

Last week's spectacular drop in the stock market - 235.48 points, or 9.49 percent - has left investors searching for ways to hedge their bets and financial leaders hoping for new international policies to solve the problems that led to the plunge.

''I don't think there is reason to be alarmed, but one has to be concerned,'' David Rockefeller, the retired chairman of the Chase Manhattan bank, said yesterday.”

Even worse, the newspaper revealed, “Stocks resume sharp plunge.” That story stated, “Investors in Tokyo, Hong Kong and Sydney, Australia, dumped their shares today in a shocked reaction to Wall Street's massive sell-off last week… ‘There's a jam for the exit,'' one broker said. ''The buyers are running away.’”

With an already fragile market psychology hammered anew by bad news, fear was amplified. Once trading began, the rout was on. By day’s end, the Dow Jones Industrials had plummeted 22.6%.

At present, there are some bad fundamentals and worry about future bad news. There is not yet the kind of evidence of widespread fear, much less, wild volatility that preceded the 1987 crash.

Conclusion:
I believe it is unlikely that the Dow Jones Industrials or S&P 500 will reach or exceed their highs established on October 9, 2007 through the rest of this year. At the same time, while a fairly significant contraction over a period of time is still possible, a crash (10% or greater fall over 1-2 days) is probably unlikely.