"1987"

Authored by Michael Lebowitz via RealInvestmentAdvice.com,

The 1987 stock market crash, better known as Black Monday, is frequently deemed a historical anomaly. Unlike the crashes of 1929, 2000, 2008 and other smaller ones, many investors are under the false premise that the stock market in 1987 provided no warning of the impending crash. On Black Monday, October 19, 1987, the Dow Jones Industrial Average (DJIA) fell 22.6% in the greatest one-day loss ever recorded on Wall Street. Despite varying perceptions, there were clear fundamental and technical warnings preceding the crash that were detected by a few investors. For the rest, the market euphoria raging at the time blinded them to what in hindsight seemed obvious.

As of just last week, the market was in a state of euphoric complacency, donning a ‘what could go wrong’ brashness and extrapolating good times as far as the eye can see. While we respected the bullish price action, we also appreciated that investors were not properly assessing fundamental factors that overwhelmingly argue the market is grossly overvalued. Whether prices revert to more normal levels via a long period of market malaise or a single large drawdown as we are seeing, we do not know. Historically situations with the largest fundamental imbalances ended with powerful failures that quickly erased years of gains.

Frankly, it is easy to demonstrate the fundamental factors that could cause a meltdown, but it is difficult to predict when it might occur. In this series of articles, we explore the market peaks of 1929, 1987, 1999 and 2007 and the fundamental and technical conditions that prevailed during those periods. Since each episode has different attributes, we cannot provide a comprehensive checklist of the fundamental and technical conditions that must occur before the market peaks this time. However, history provides us with the gift of insight, and though history will not repeat itself, it may rhyme.

Fundamental Causes

Below is a summary of some of the fundamental dynamics that played a role in the market rally and the ultimate crash of 1987.

Takeover Tax Bill- During the market rally preceding the crash, corporate takeover fever was running hot. Leveraged Buyouts (LBOs), in which high yield debt was used to purchase companies, were stoking the large majority of stocks higher. Investors were betting on rumors of companies being taken over and were participating in strategies such as takeover risk arbitrage. A big determinant driving LBOs was the acquirer’s ability to raise the necessary capital through debt issuance. The enthusiasm for more LBO’s, similar to buybacks today, fueled speculation and enthusiasm across the stock market. On October 13, 1987, Congress introduced a bill that sought to rescind the tax deduction for interest on debt used in corporate takeovers. This bill raised concerns that the LBO machine would grind to a halt. From the date the bill was announced until the Friday before Black Monday, the market dropped over 10%.

Inflation/Interest Rates- In April 1980, annual inflation peaked at nearly 15%. By December of 1986, it had sharply reversed to a mere 1.18%.  This would be the lowest level of inflation from that point until the financial crisis of 2008. Throughout 1987, inflation bucked the trend of the prior six years and hit 4.23% in September of 1987. Interest rates demonstrated a similar pattern as inflation during that period. In 1982, the yield on the ten-year U.S. Treasury note peaked at 15%, but it would close out 1986 at 7%. Like inflation, interest rates reversed the trend in 1987, and by October, the ten-year U.S. Treasury note yield was 3% higher at 10.23%. Higher interest rates made LBOs more costly and takeovers less likely, put pressure on economic growth and, most importantly, presented a rewarding alternative to owning stocks.

Deficit/Dollar- A frequently cited contributor to the market crash was the mounting trade deficit. From 1982 to 1987, the annual trade deficit was four times the average of the preceding five years. As a result, on October 14th Treasury Secretary James Baker suggested the need for a weaker dollar. Undoubtedly, concerns for dollar weakness led foreigners to exit dollar-denominated assets, adding momentum to rising interest rates. Not surprisingly, the S&P 500 fell 3% that day, in part due to Baker’s comments.

Valuations- From the trough in August 1982 to the peak in August 1987, the S&P 500 produced a total return (dividends included) of over 300%, or nearly 32% annualized. However, earnings over the same period rose a mere 8.1%. The valuation ratio, price to trailing twelve months earnings, expanded from 7.50 to 18.25. On the eve of the crash, this metric stood at a 33% premium to its average since 1924.

Technical Factors

This section examines technical warning signs in the days, weeks and months prior to Black Monday. Before proceeding, the chart below shows the longer term rally from the early 1980’s through the crash.

Portfolio Insurance- As mentioned, from the 1982 trough to the 1987 peak, the S&P 500 produced outsized gains for investors. Further, the pace of gains accelerated sharply in the last two years of the rally.

As the 1980’s progressed, some investors were increasingly concerned that the massive gains were outpacing the fundamental drivers of stock prices. Such anxiety led to the creation and popularity of portfolio insurance. This new hedging technique, used primarily by institutional investors, involved conditional contracts that sold short the S&P 500 futures contract if the market fell by a certain amount. This simple strategy was essentially a stop loss on a portfolio that avoided selling the actual portfolio assets. Importantly, the contracts ensured that more short sales would occur as the market sell-off continued. When the market began selling off, these insurance hedges began to kick in, swamping bidders and making a bad situation much worse. Because the strategy required incremental short sales as the market fell, selling begat selling, and a correction turned into an avalanche of panic.

Chris Cole of Artemis Capital estimates that, in 1987, portfolio insurance strategies comprised about two percent of the market. Currently, he estimates that short volatility trades, which if unwound would have a similar effect as portfolio insurance, is between six and ten percent of the market.

Price Activity- The rally from 1982 peaked on August 25, 1987, nearly two months before Black Monday. Over the next month, the S&P 500 fell about 8% before rebounding to 2.65% below the August highs. This condition, a “lower high,” was a warning that went unnoticed. From that point forward, the market headed decidedly lower. Following the rebound high, eight of the nine subsequent days just before Black Monday saw stocks in the red. For those that say the market did not give clues, it is quite likely that the 15% decline before Black Monday was the result of the so-called smart money heeding the clues and selling, hedging or buying portfolio insurance.

Annotated Technical Indicators

The following chart presents key technical warnings signs labeled and described below.

  • A: 7/30/1987- Just before peaking in early August, the S&P 500 extended itself to three standard deviations from its 50-day moving average (3-standard deviation Bollinger band). This signaled the market was greatly overbought. (description of Bollinger Bands)
  • B: 10/5/1987- After peaking and then declining to a more balanced market condition, the S&P 500 recovered but failed to reach the prior high.
  • C: 10/14/1987- The S&P 500 price of 310 was a point of both support and resistance for the market over the prior two months. When the index price broke that line to the downside, it proved to be a critical breach from a technical perspective.
  • D: 10/16/1987- On the eve of Black Monday, the S&P 500 fell below the 200-day moving average. Since 1985, that technical level provided dependable support to the market on five different occasions.
  • E: August 1987- The relative strength indicator (RSI – above the S&P price graph) reached extremely overbought conditions in late July and early August (labeled green). When the market rebounded in early October to within 2.6% of the prior record high, the RSI was still well below its peak. This was a strong sign that the underlying strength of the market was waning. (description of RSI)

Volatility- From the beginning of the rally until the crash, the average weekly gain or loss on the S&P 500 was 1.54%. In the week leading up to Black Monday, volatility, as measured by five-day price changes, started spiking higher. By the Friday before Black Monday, the five-day price change was 8.63%, a level over six standard deviations from the norm and almost twice that of any other five-day period since the rally began.

Over the course of the rally from 1982, the average daily difference between the high and low (true range) of each trading day was just under 1.50%. In the week leading up to the crash, the average daily range doubled. On the Friday before the crash, it expanded to over 6%, or four standard deviations from the norm. A longer average true range is shown above the longer term S&P 500 at the start of the technical section.

Similarities and Differences

While comparing 1987 to today is helpful, the economic, political and market backdrops are quite different. There are however some similarities worth mentioning.

Currently:

  • Interest rates are rising
  • Federal deficits are increasing
  • Weaker dollar policy was recently affirmed by Treasury Secretary Mnuchin
  • Equity valuations are above almost every instance of the last 100+ years, regardless of how those valuations are measured
  • Sentiment and expectations are at or near record levels.
  • The use of margin is helping investors lever their holdings.
  • Trading strategies such as short volatility positions can have a snowball effect, like portfolio insurance, if they are unwound

There are also vast differences. The economic backdrop of 1987 and today are nearly opposite.

  • In 1987 baby boomers were on the verge of becoming an economic support engine. Today they are retiring and do not have the same economic effect.
  • Debt to GDP has grown enormously since 1987.
  • The amount of monetary stimulus in the system today is extreme, leaving one to question how much more can the Fed do.
  • Productivity growth was robust in 1987, and today it has nearly ground to a halt.

While some of the fundamental drivers of 1987 may appear similar to today, the current economic situation leaves a lot to be desired when compared to 1987. After the 1987 market crash, the market rebounded quickly, hitting new highs by the spring of 1989.

We fear that, given the economic backdrop and challenging circumstances of both monetary and fiscal policy, recovery from an episodic event like that experienced in October 1987 may look vastly different today.

Summary

Market tops are said to be processes. Currently, there are an abundance of fundamental warnings but few if any technical signals that the market is at or near a peak. In fact, most technical indicators are waving the all-clear flag. It is worth noting that longer-term interest rates, a key driver of economic activity, have begun rising while shorter-term rates have been rising since late 2015. Given the role debt has played in economic growth and in supporting stock buybacks, it is likely that equities will not take kindly to further increases in interest rates.

Those looking back at 1987 may blame the tax legislation and warnings of a weaker dollar as the catalysts for the severe declines. In reality, those were just the sparks that started the fire. The market was overly optimistic and had gotten well ahead of itself. When the current market reverses course, investors are also likely to blame a specific catalyst or two. Like 1987, the true fundamental catalysts are already apparent; they are just waiting for a spark.

We leave you with an appropriate tweet from David Rosenberg, Chief Economist, and Strategist at Gluskin Sheff.

 

Comments

Endgame Napoleon quadraspleen Tue, 02/06/2018 - 17:31 Permalink

Gordon reproduced and passed on his greedy ethos, although maybe not. When I had a shop, my clientele was mostly Baby Boomers, and they really fueled the shop, whereas Gen X customers, my generation, were not as good for business, not even close. I think it is the same way with Millennials. At the time, my product was way too expensive for most of them and probably still is, even for the 35-year-old Millennials. The Baby Boom on the cusp of fueling the economy does not equal a generation with greater numbers, the Millennials, on the verge of revving up the economy...........or not.

In reply to by quadraspleen

MK ULTRA Alpha Tue, 02/06/2018 - 16:27 Permalink

Three key Jews didn't signal? Yellen wasn't a cheerleader? She was last to signal.

Greenspan, Katz and Yellen didn't say the markets were going to crash before the markets crashed? That didn't happen, right?

Before this, the Fed and Yellen were cheerleading, nothing to worry about, why the ABRUPT change?

Yeah, the Jew apologist will not answer the question.

Chupacabra-322 Tue, 02/06/2018 - 16:27 Permalink

My hope is everyone stay focused & not distracted by the Scripted False Narrative PsyOp of the Russia Dossier to the new Scripted False Narrative PsyOp of an Economic Collapse.

 

The latter being a Criminal Deep State bluff of blowing up the economy to escape from the Tyrannical Lawlessness, High Crimes, Treason & Sedition committed by Highly Compartmentalized Levels of FBI, DOJ, CIA, NSA, GCHQ.  All being Qaurter Backed now by the Criminal Federal Reserve.  Unaccountable to no one as per Greenspan.

 

Interested Times.

 

Yen Cross Tue, 02/06/2018 - 16:29 Permalink

  I think the next massive hit, and leg down, is coming from the emerging markets, and corporate, MBS, CRE, over levering.

  It seems based on the eur/usd trading levels, that the e/m traders have doubled down, and when that trade unwinds[it will] all Hell is going to break loose.

ted41776 Tue, 02/06/2018 - 16:41 Permalink

the only thing you need to know to trade this market is this:

 

there is no market. there are only front runners and manipulators and if you are not one, you will lose

Janet smeller Tue, 02/06/2018 - 17:03 Permalink

“Higher interest rates made LBOs more costly and takeovers less likely, put pressure on economic growth”. Stopped reading here. High interest rates don’t pressure REAL economic growth and low interest rates don’t stem REAL economic growth

MrSteve Tue, 02/06/2018 - 17:13 Permalink

 "few if any technical signals that the market is at or near a peak"...

I profoundly disagree. When the world's largest mutual funds, retirement account managers and ETF brokers crash their websites and shut down due to trade volume selling down, the shit has hit the fan. A volume spike of this magnitude is both a fundamental and technical signal. The peakiness was clearly signaled by margin, valuation and sentiment measures.

lucyvp MrSteve Tue, 02/06/2018 - 19:02 Permalink

vanguard was inoperable about 3:45 EST on 2/5.  Fidelity gave up the ghost about 9:50 this morning 2/6

As advice to you folks out there.  Put your orders in before open.  I put in a few orders at > 9% down from the close just to catch any vertical moves.  Don't bet the farm though.  Enough for a weekend get-away comes to mind.

In reply to by MrSteve

SilvaDolla Tue, 02/06/2018 - 17:23 Permalink

Funny thing about these make beLIEve markets: If one doesn’t have any money, he or she barely feels a thing when they tank. 

Except when their line of work happens to be in housing and, like in 2008, half of the activity in then housing market was ground to a halt and never came back after that crash. 

I am thankful that they don’t trade Rock music on WallStreet. 

The music business isn’t  perfect, but it doesn’t just suddenly run out of funding due to the whims of madmen. 

Son of Captain Nemo Tue, 02/06/2018 - 17:49 Permalink

WTFO!...

Why are you comparing a "fall from a second story roof" (1987) to a "fall from the highest peak of Mt. Everest (2018) as if there are similarities?...

Stop eating the "Tide pods", with the opioid chasers!

This read is FULL RETARD!!!

roddy6667 Tue, 02/06/2018 - 20:14 Permalink

Writers like to bring up the 1987 crash as an example of a terrible thing. The market returned to normal in a few months. Almost all of the people who got hurt in the crash were the money lenders in the temple who make a living buying and selling pieces of paper and making nothing of substance. In the real world, life went on. An investment portfolio was worth less for a few months, then it was OK.

Not a big F'n deal.  

Salmo trutta Tue, 02/06/2018 - 22:09 Permalink

Total Tripe.

 

1987 was the litmus test for Central Bank stupidity (no black swan). Even Robert Prechter’s Elliott Wave International got it exactly right.

 

Monetary flows (volume X’s velocity), fell from 16 in AUG, to 4 in NOV (See G.6 release – debit and demand deposit turnover). [ Δ, not Δ Δ ]  Note, money flows, bank debits (money actually exchanging counter-parties), turned negative during the S&L crisis.

 

http://monetaryflows.blogspot.com/2010/07/monetary-flows-mvt-1921-1950…

 

Conterminously (3 months prior to the crash), the rate-of-change in RRs (the proxy for R-gDp), was surgically sharp, decelerating faster than in any prior period since the series was first published in January 1918. The proxy declined from 11 in JUL to (-)4 in OCT.  [ Δ, not Δ Δ ]

 

Accompanying this sharp deceleration in the RoC for M*Vt (proxy for all transactions in American Yale Professor Irving Fisher’s truistic: “equation of exchange”, the monetary authority mis-judged macro-economic strength (like the last half of 2008), and on Sept. 4 the FOMC raised (1) the discount rate, which was not yet a penalty rate, 1/2 percent to 6%, & (2) the policy FFR 1/2 percent to 7.25% (up from 5.875% in Jan).

 

Black Monday began when the target FFR was increased to 6.5% on 9/4/1987.  The effective FFR began to trade above the policy rate c. 9/22/1987 (constrained by reserve demand).  The effective FFR spiked on Thursday (the very first day of the reserve maintenance period).

 

On Sept. 30 the effective FFR spiked at 8.38%; fell to 7.30% by Oct. 7; then rose to back to 7.61% Oct 19 (Black Monday). Thus, the effective FFR spiked 36 basis points higher than the FOMC’s official target, it’s policy rate on “Black Monday”.

 

The shortfall in the quantity of legal reserves supplied by the FRB-NY’s trading desk (which had already dropped at a rate not exceeded at any time since the Great Depression) bottomed with the bi-weekly period ending 10/21/87. This was the trigger.  However, the Fed covers: The Nattering Naybob’s “Elephant Tracks”.  So you can't run a regression against the historical time series.

 

At the same time, the 30 year conventional mortgage yielded 11.26%, up from 8.49% in Jan. 87, & Moody’s 30 year AAA corporate bonds yielded 11.06% on 10/19/87, up from 9.37% in Jan. 87.

 

The preceding tight monetary policy (monetary policy blunder), i.e., the sharp reduction in legal reserves (mirroring the absolute decline in our means-of-payment money), had effectively forced all rates up along the yield curve in the short-run (when inflation and R-gDp were already markedly subsiding).  I.e., interest is the price of loan funds, the price of money is the reciprocal of the price level. 

 

Note: interest rates may either rise or fall during the short-run, in response to the FOMC tightening policy, depending upon the “arrow of time”, and the monetary fulcrum (the thrust of inflation).

 

On 10/19/87 the CBs had to scramble for reserves (too stringently supplied relative to demand) at the end of their maintenance period (bank squaring day), to support their loans-deposits (it is noteworthy that contemporaneous reserve requirements were then in effect exacerbating the shortfall & response time).

 

A significant number of banks, with large reserve deficiencies, tried to settle their legal reserve maintenance contractual obligations at the last moment. But the FRB-NY’s “trading desk” failed to accommodate the liquidity needs in the money market – until it was already way too late (i.e., ignored their perversely coveted interest rate transmission mechanism).

 

I.e., it was a major monetary policy blunder by the Maestro, Chairman Alan Greenspan.  And economists don’t talk about what the ABA doesn’t want them to.  See - Sent: Thu 11/16/06 9:55 AM “Spencer, this in an interesting idea. Since no one in the Fed tracks reserves (because the ABA and stupid economists want to eliminate them)…” and “Today, with bank reserves largely driven by bank payments (debits), your views on bank debits and legal reserves sound right!” – Dr. Richard G. Anderson

 

Oh wait, wasn’t the crash blamed on programmed trading (reflecting academic censorship and fake news).  It’s not: Don’t fight the Fed.  It’s: Don’t fight the ABA.