On The 30th Anniversary Of 1987’s Black Monday, Today’s Market Looks Eerily Similar. Should You Prepare For A Crash?

October 18, 2017

On The 30th Anniversary Of 1987’s Black Monday, Today’s Market Looks Eerily Similar. Should You Prepare For A Crash?

  • The data indicates that the likelihood of a crash similar to October 1987 is the same today as it was then.
  • This doesn’t mean the stock market will crash tomorrow.
  • It only means that you should know yourself extremely well and relate your investments to your risk reward appetite. Only this can prevent you from the biggest mistake investors usually make, i.e. sell at the bottom of a bear market in total panic and capitulation.



Introduction

On Monday October 19, 1987, the stock market crashed a whopping 22.6% in one day. Is it possible that the same could happen tomorrow? Well, let’s compare the current market and to the one back then.

Figure 1: S&P 500 from October 1980 to October 1987. Source: Author’s data.

From 1982 until Black Monday in 1987, the market had been in an uninterrupted 5-year climb, not that dissimilar from today’s market.

What’s also very interesting is that valuations had the same pattern then as they do now. The S&P 500 price to earnings ratio had increased from 10 in October 1982 to 20 in September 1987, thus up 10 valuation points.

Figure 2: S&P 500 PE ratio from October 1982 to September 1987. Source: Multpl.

Since 2010, the story is almost identical. The S&P 500 PE ratio has increased by 10 points, from 15 in 2010 to 25 today.

Figure 3: S&P 500 valuation from 2010. Source: Multpl.



Additionally, back then, the FED had just started to raise interest rates just as they are starting to do now.

Figure 4: Interest rates can no longer save the market. Source: FRED.

Fortunately for investors, the federal interest rate never reached the level it did in 1987, but the difference between now and then is that the interest rate can’t be lowered by 500 basis points as it was from 1987 to 1993.

Comparing The Current Environment To 1987

A large part of the blame for the 1987 Black Monday crash was attributed to programmed stop loss sales. A stop loss is a market order that activates itself automatically when a stock drops below a certain price. As everybody was protecting themselves with this mechanism, once the stock market started dropping, computers started selling stocks automatically on huge volumes. When the panic started spreading, people were calling their brokers to sell as soon as possible and many brokers didn’t even pick up the phone because they were too busy which probably prevented an crash of an even greater magnitude.

Nevertheless, the 1987 market crash is a perfect example of how something as rational as a stop loss for portfolio protection can be totally irrational when used by the majority.

The situation today isn’t much different. Most investors are complacently long with the hope that they will be able to exit the market before the next market crash. This makes things look excellent and safe as long as stocks continue to go up. However, with the liquidity provided by the FED drying up and everybody long, a market panic could lower the S&P 500 to an even greater extent than the crash in 1987. Remember that today, anyone can sell with a click while back then you needed a phone.

Given this, I believe the risk of a Black Monday situation is the same now as it was back in 1987. The only difference is that stocks probably won’t recover afterward because interest rates can’t go much lower. This doesn’t mean you should sell everything and stick to cash, it really all depends on what your goals and risk appetite are.



October Is A Good Time To Think About What You Should Do

Don’t forget that 10 years ago, the S&P 500 reached an all-time high just before crashing in 2008 and 2009. But given the similarities of then, 1987, and now, what should you do about it?

My goal isn’t to make you sell your portfolio by proclaiming an imminent market crash. The whole point of this article is to discuss the risks and to provide you with something concrete that can help you make your own investment decisions as everyone’s individual situation is unique.

For example, if you need your stock market money in the next year or two, then I would advise you to put it in cash because, as you can see above, a crash the magnitude of 1987 could happen in the stock market though no one can know when.

If you’re invested for the long term, you have to be aware of the fact that the current earnings yield is around 4% and that will be the return from your current portfolio. So see if the risk reward puzzle fits your financial goals.

If you just started investing and are on a dollar cost averaging strategy, then you should be happy if the market crashes because you would be able to buy more stock for less money.

What I’m doing is keeping stocks where the earnings yield is over 10%. That might sound impossible, but if you look diligently in the U.S. and around the world, you’ll find it’s possible to find low risk high reward investments that will yield 10% or more.

Conclusion

As I’ve outlined above, the market today looks eerily similar to the market of 1987, and based on that, one could expect another crash soon. However, the truth is that no one could predict what the market will do, and therefore the only thing you can do is understand the risk reward profile very well and to invest accordingly.

If you don’t know yourself well enough, it’s very likely that you will capitulate in the next market crash and sell at the worst possible time, so be careful and be prepared.