What we can learn from Black Monday 1987

The current sell-off has a similar feel to October 1987, where the crash was was precipitated not by a single external shock or tectonic shift but by an accumulation of bearish sentiment that led to a major sell-off. Here is a brief timeline (with thanks to Wikipedia):

  • August 25, 1987, the Dow peaked at 2,722 points after a strong 44% run-up over the previous 12 months, with low inflation and falling crude oil prices boosting the recovery.
  • October 14, the index dropped 95.46 points (3.8%) (a then record) to 2,412.70.
  • October 15, Iran attacked the American-owned (and Liberian-flagged) supertanker, the Sungari, with a Silkworm missile off Kuwait’s Mina Al Ahmadi oil port. The Dow fell another 58 points (2.4%), down over 12% from its August high.
  • October 16, Iran hit another ship the next morning, the U.S.-flagged MV Sea Isle City, with another Silkworm missile. The Dow fell 108.35 points (4.6%) to close at 2,246.74 on record volume. Markets in London were closed due to the Great Storm of 1987.
  • Monday, October 19, 1987, the crash began in Hong Kong and spread West. By 9.30am the Footsie (FTSE 100) had fallen over 136 points. Later that morning, two U.S. warships shelled an Iranian oil platform in the Persian Gulf in response to Iran’s earlier attack. The sell-off reached the United States, with the Dow Jones Industrial Average falling a record 22.6% or 508 points to 1,738.74.

Dow Jones Industrial Average, October 1987

The total draw-down of 36.1% was at least partly attributable to fears that conflict with Iran would impact on oil prices but there were also underlying tensions relating to exchange rates after the 1985 Plaza accord as well as fears of rising inflation and higher interest rates. What should not be underestimated, however, is the effect of programmed trading as institutional investors dumped stock in response to falling prices.

We are currently witnessing a similar herd mentality, where investors sell because others are selling, without heed to the merits of the stock they hold. Just not as severe (so far).

Dow Jones Industrial Average

The Dow correction is secondary but a lot will depend on this week. Whether primary support holds at 23,500 and whether institutional sellers join the melee.

The Moral of the Story

Compare Dow values today to those in 1987. The recent peak of 27,000 is almost ten times higher than the peak of August 1987. There is a lot to be said for sitting tight.

Black Monday, October 1987

Cross-posted from Goldstocksforex.com:

What caused the Black Monday crash of 1987? Analysts are often unable to identify a single trigger or cause.

Sniper points to a sharp run-up in short-term interest rates in the 3 months prior to the crash.

3 Month Treasury Bill Rates

Valuations were also at extreme readings, with PEmax (price-earnings based on the highest earnings to-date) near 20, close to its Black Friday high from the crash of 1929.

S&P 500 PEmax 1919 - 1989

Often overlooked is the fact that the S&P 500 was testing resistance at its previous highs between 700 and 750 from the 1960s and 70s (chart from macrotrends).

S&P 500 1960 - 1990

A combination of these three factors may have been sufficient to tip the market into a dramatic reversal.

Are we facing a similar threat today?

Short-term rates are rising but at 40 basis points over the last 4 months, compared to 170 bp in 1987, there is not much cause for concern.

13-week T-Bill rates

PEmax, however, is now at a precipitous 26.8, second only to the Dotcom bubble of 1999/2000 and way above its October 1987 reading.

S&P 500 PEmax 1980 - 2017

While the index is in blue sky territory, with no resistance in sight, there is an important psychological barrier ahead at 3000.

S&P 500

Conclusion: This does not look like a repetition of 1987. But investors who ignore the extreme valuation warning may be surprised at how fast the market can reverse (as in 1987) from such extremes.