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October 23, 2017

Lessons From Black Monday

By Charles Rotblut, CFA, AAII

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’sdifficult 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.

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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