Lessons from Black Monday
Thursday, October 18, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 28.7%, down 1.9 points
  Neutral: 26.8%, down 3.8 points
  Bearish: 44.5%, up 5.7 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Tomorrow will be the 25th anniversary of Black Monday. The Dow Jones industrial average lost more than 22% of its value on Monday, October, 19, 1987. The losses were not just restricted to stocks either, as the futures market was roiled by traders who incorrectly bet on arbitrage strategies.

The events of that day are well documented, and there are many texts about previous panics and market crashes. Developing an understanding of what happened and what factors compounded investors’ losses can help you better manage your portfolio in the future.

Here give some noteworthy observations about the 1987 crash that give lessons for today’s and future market environments:

  • High valuations mean more risk—During the first nine months of 1987, stocks rallied by more than 30%. This led to price-earning ratios on large-cap stocks rising above 20 and dividend yields falling to the lowest levels ever seen during the 20th century at that time, as Richard Fontaine (then a fund manager with T. Rowe Price) explained in the January 1988 AAII Journal.
  • Warning signs that the bull had lost its momentum existed—The bull market peaked in August 1987. On October 6, 1987, the Dow Jones industrial average lost 91.55 points, its largest ever single-day point loss to that date. This record lasted less than a week when the Dow plunged 95.46 points on Wednesday, October 14, 1987. Investors following momentum or technical analysis strategies should have realized that the conditions were not good.
  • Macro headwinds existed—The October 14 plunge has been attributed to legislation from a House committee to remove the favorable tax treatment of debt issued to fund the corporate acquisitions that helped fuel the mid-decade rally. Unfavorable trade deficit numbers were also issued that day, and global interest rates were on the rise. High valuations and negative news flow are never a good mix.
  • Correlations rise during periods of market duress—The declines in stock prices were not just limited to the U.S. Markets worldwide fell during October 1987 with many experiencing far larger one-month losses than the U.S. experienced. When traders and investors panic, they are not picky about what they sell. This is not a failure of diversification, but rather a short-term characteristic of it.
  • Liquidity falls when prices drop—A contributing factor to the severity of the Black Monday drop was the inability to transact. Specialists at the New York Stock Exchange delayed the opening of several stocks because of trade imbalances (too many sellers and not enough buyers). Margin calls on traders limited the amount of cash that could have been invested back into stocks. I’ve also seen suggestions that brokers were hard to reach because of the heavy call volume into them. When an asset is difficult to sell and prices are dropping, a common emotional reaction is to sell as quickly as possible at whatever the prevailing price is rather than wait for more rational conditions to return.
  • Margin is dangerous—Another contributing factor to the crash was the use of margin. Many traders sought to profit by arbitraging the difference between the price of S&P 500 futures contracts and the price of the index itself. Mispricing of futures contracts (due to the delayed opening on stock prices on the NYSE) and panic selling of stocks resulted in large losses, which in turn led to even more selling. Margin compounds the downside of a bad trading decision. In the January 1988 AAII Journal, AAII Founder and Chairman James Cloonan noted that many investors may have involuntarily had investments sold after brokers were unable to reach them regarding margin calls.
  • Risk aversion strategies can backfire—Portfolio insurance, the purchase of options or future contracts to limit losses, were popular in 1987. When the stocks fell on October 19, portfolio managers sold both stocks and futures contracts. As prices fell, the selling intensified, pushing prices down further. Though this was not the primary cause of the day’s large drop, it didn’t help. More importantly, it was just one of various strategies created by people who thought they had things figured out, only see their strategies replicated and then fail when an adverse event occurred.
  • There can be a benefit to riding out the bear—Though the drop in October 1987 was severe, investors who did not panic were rewarded. Large-cap stocks delivered total returns of 16.6% in 1988 and 31.7% in 1989. Even if you invested in August 1987, just as the market peaked, you still would have realized gains by the end of 1989. Those who took advantage of the 1987 crash to rebalance their portfolios and buy stocks likely did even better. Buy fear, even though your emotions will tell you to do otherwise.

More on AAII.com

Though our online archive of past AAII Journal articles is extensive, we do not have copies of the 1988 issues online. I looked at the physical copies we have archived in the office (along with other texts) for this week’s update. There are, however, a few relevant articles on AAII that deal with the subject of market crashes that I am linking to below.

Model Portfolios Updated on AAII.com

The Model Shadow Stock Portfolio continued its upward trend in September, gaining 5.8%. The Model Shadow Stock Portfolio outperformed both the Vanguard Small Cap Index fund (NAESX), which gained 2.7%, and the DFA US Micro Cap Index fund (DFSCX), which gained 4.2%. For the year, the Model Shadow Stock Portfolio is now up 25.8%, outpacing the 14.9% gain achieved by the Vanguard Small Cap Index fund and a 15.2% gain for the DFA US Micro Cap Index fund.

The Model Fund Portfolio gained 2.2% for September. This compares to a 2.6% gain for the Vanguard Total Stock Market Index fund (VTSMX). For the year, the Model Fund Portfolio is up 11.5%, while the Vanguard Total Stock Market Index fund is up 16.1%.

2013 401(k) and IRA Contribution Limits

The Internal Revenue Service announced today the new 2013 tax year contribution limits for retirment plans and individual retirement account.

Employees participating in a 401(k) or similar type of plan will be able to contribute a maximum of $17,500 next year. Catch-up contributions for those aged 50 and over remain unchanged at $5,500.

The deduction for making contributions to a traditional IRA will be phased out over an adjusted gross income (AGI) range of $95,000 to $115,000 for married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan. The AGI phase-out range for taxpayers making contributions to a Roth IRA is $178,000 to $188,000 for married couples filing jointly.

401khelpcenter.com has a complete listing of the new contribution limits and IRA phase-out ranges.

The Week Ahead

Computerized Investing Editor Wayne Thorp will speak at our Los Angeles chapter this Saturday, October 20. Not near Los Angeles? Visit our local chapter page to find an upcoming meeting near you.

More than 130 members of the S&P 500 are scheduled to report earnings. Included in this group are Caterpillar (CAT) on Monday; 3M (MMM) and United Technologies (UTX) on Tuesday; AT&T (T) and The Boeing Company (BA) on Wednesday; and Merck (MRK) on Friday.

The Federal Open Market Committee will hold a two-day meeting starting on Tuesday. Elsewhere on the economic calendar, September new home sales will be published on Wednesday. Thursday will feature September durable goods orders and September pending home sales. The initial estimate of third-quarter gross domestic product (GDP) and the final October University of Michigan consumer confidence survey will be published on Friday.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

AAII Sentiment Survey

Pessimism rose to its highest level since last June as optimism fell for the fourth consecutive week in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 1.9 percentage points to 28.7%. This is the lowest level of optimism registered by the survey since July 26, 2012. It is also the eighth consecutive week and the 28th out of the last 29 weeks that bullish sentiment is below its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 3.8 percentage points to 26.8%. This ties June 7, 2012, for the lowest reading of 2012. The historical average is 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, jumped up 5.7 percentage points to 44.5%. This is the highest pessimism has been since June 7, 2012. It is also the eighth consecutive week and the 24th out of the last 28 weeks that bearish sentiment has been above its historical average of 30%.

The bull-bear spread, which measures the difference between bullish and bearish sentiment, is at -15.8. This is the most negative the spread has been since July 19, 2012.

Bearish sentiment is at unusually, but not extraordinarily, high levels. Though stocks pulled back last week, the market has rebounded this week. The economic data released over the survey period (Thursday morning through Wednesday night) has mostly matched or topped expectations.

There are a few factors at play. The first is that this year's rally has been disliked, or at least not trusted, by many individual investors. The readings in our survey and the outflows from domestic equity mutual funds reported by the Investment Company Institute both suggest this. Some investors are worried about the potential outcome of the presidential election. There are also ongoing concerns about the pace of economic growth, Europe's sovereign debt problems and the possibility of the fiscal cliff occurring.

It should be noted there are still individual investors who are encouraged by the year's rally in stock prices and improvement in economic data.

This week’s special question asked AAII members if they think consumers will spend more or less on holiday shopping this year. (The National Retail Federation forecasts a 4.1% increase in sales.) By an approximate 2-to-1 ratio, respondents thought holiday sales will rise this year. The primary reason cited was better economic conditions and improved consumer confidence. Several responds also thought that many consumers are simply tired of austerity. Among those who thought spending would decline, a weak economic recovery was the most cited reason.

Here is a sampling of the responses:

  • “People want to spend more and buy things. They think they have been frugal enough.”
  • “More. The overall economy is improving, so spending will improve accordingly.”
  • “More people are employed than last year, so overall spending should increase.”
  • “Consumers will spend slightly less. Too many are unemployed or underemployed.”
  • “Less, many consumers are hurting.”
  • “I just walked through the mall and noticed in the window displays that hemlines are rising. That’s all the evidence I need to believe that the market and holiday sales are going up!”

» Take the sentiment survey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor