Thirty years ago today, the Dow Jones industrial average incurred its largest single-day percentage-point drop. The blue-chip average plunged by more than 22%. The losses were not just restricted to stocks either, as the futures market was roiled by traders who incorrectly bet on arbitrage strategies. The massive losses resulted in October 19, 1987, being infamously referred to as Black Monday.
Since that time, there have been fears about it recurring. Technology makes it faster and easier to trade from anywhere at any time from just about any internet-connected device. Exchange-traded funds (ETFs) and automated trading programs have enabled hedge funds, large trading firms and other big investors to quickly jump in and out of the market. The use of options has expanded. At the same time, it’s difficult to argue that humans have become more rational or less risk averse. The fear-driven herd behavior that drove the Dow down on Black Monday could resurface. At the same time, so could the rapid recovery that followed Black Monday.
While history does not necessarily repeat, it often has many sequels. This is why I believe an understanding of market history can help you better put whatever happens in the future into context and, more importantly, know when to react and when not to. With this in mind, I am republishing some observations about the 1987 crash I wrote five years ago along with a few notes added to them.
High valuations mean more risk—During the first nine months of 1987, stocks rallied by more than 30%. This led to price-earnings 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. (Note: As of yesterday, the S&P 500’s year-to-date gain for 2017 was 14.4% and the price-earnings ratio was 20.2, but interest rates are significantly lower now than they were 30 years ago.)
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. (Note: Congress is now working on a large-tax cut bill and interest rates in developed countries remain extraordinarily low.)
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 futures contracts to limit losses, was 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 to see their strategies replicated and then fail when an adverse event occurred. (Note: As history has shown, simplistic portfolio strategies often work better than complex ones.)
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 would still 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.
- The Sell Decision: What to Do After a Severe Market Meltdown – I’m featuring this 2008 AAII Journal article because it’s best to develop a plan for dealing with downside market volatility before you need to use it.
- The Danger of Getting Out of Stocks During Bear Markets – While it may feel counterintuitive at the moment, the worst thing you can do when the market incurs a steep drop is to panic and sell.
- Missing the Market’s Worst and Best Months – The market’s best and worst months have been clustered together. A trend-following strategy can help investors avoid extreme volatility.
- John Neff’s Approach to Finding Value With Growth Potential – The former Vanguard portfolio manager followed a contrarian value approach in seeking stocks with the potential for earnings growth.
The Model Shadow Stock Portfolio, which is a real-money portfolio of micro-cap value stocks, climbed 11.0% in September. The Vanguard Small Cap Index fund (NAESX) added 4.4% for the month, and the DFA U.S. Micro Cap fund (DFSCX) was up 8.4% in September. Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 16.2% versus the Vanguard 500 Index fund’s (VFINX) gain of 9.3% per year on average over the same period.
The AAII Model Fund Portfolio gained 2.4% in September, compared to a 2.1% increase in the SPDR S&P 500 ETF (SPY). Since its inception in July 2003, the Model Fund Portfolio has a compound annual average return of 9.0%, while the SPDR S&P 500 ETF also has a 9.0% average annual return over the same period.
The week’s first economic report will be the October Composite Purchasing Managers’ Index (PMI), released on Tuesday. Wednesday will feature September durable goods orders and September new home sales. September international trade and September pending home sales index will be released on Thursday. Ending the week, we’ll get the first look at third-quarter GDP (expect the hurricanes to have an impact) and the University of Michigan’s final October Consumer Sentiment Survey on Friday.
Only one Federal Reserve official will make a public appearance this week: Minneapolis president Neel Kashkari will speak on Thursday.
The Treasury Department will auction $26 billion of two-year notes on Tuesday, $15 billion of two-year floating rate notes (FRN) and $34 billion of five-year notes on Wednesday and $28 billion of seven-year notes on Thursday.
Bullish sentiment, expectations that stock prices will rise over the next six months, declined 1.8 percentage points to 37.9%. The historical average is 38.5%.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 0.8 percentage points to 34.1%. This is the 25th consecutive week that neutral sentiment is above its historical average of 31.0%.
Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 1.0 percentage points to 27.9%. Pessimism is below its long-term historical average of 30.5% for the fifth time in six weeks.
This is the 36th week this year with a bullish sentiment reading below its historical average. At current levels, all three sentiment readings are well within their typical ranges.
Political drama in Washington remains at the forefront of many individual investors’ minds. (Many are skeptical about the prospects of tax reform being passed.) Valuations are also playing a role, creating concern among some about stocks being overpriced and potentially leading to a correction. Similarly, there are concerns about the current lack of volatility being followed by a downward price move. Some individual investors, however, are encouraged by the continuing economic and earnings growth as well as the market’s upward momentum.
This week’s special question asked AAII members how the market’s lack of volatility this year has affected their sentiment toward stocks. Respondents were split. Approximately 44% described themselves as being cautious or feeling nervous about a forthcoming drop in stock prices. Many of these respondents do not expect the current low level of volatility to last. The second largest group, representing 42% of respondents, says the lack of volatility isn’t impacting their outlook. Some of these respondents describe themselves as not being swayed by volatility or being long-term investors. Just under 12% are encouraged by the lack of volatility.
Here is a sampling of the responses:
- “It has made me more concerned about a forthcoming correction, which is way overdue.”
- “None. I’m a long-term investor.”
- “My stock allocation has not changed.”
- “It makes me more willing to buy individual stocks.”
- “Nervous. It appears the market is betting on legislative outcomes that are becoming likely to occur.”
Bullish: 37.9%, down 1.8 points
Neutral: 34.1%, up 0.8 points
Bearish: 27.9%, up 1.0 points
Local Chapter Meetings
October 12, 2017 Bill Bengen Discusses His Retirement Withdrawal Strategy
October 5, 2017 What Investments Do You Need?
September 28, 2017 A Big Argument for Buying and Then Monitoring
September 21, 2017 It’s Not Just the Fed’s Balance Sheet That’s Changing