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October 21, 2012

What We Learned from Black Monday

By Charles Rotblut

Friday the 19th marked 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.

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.
About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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