So How Predictable Was 1987?

Twenty-five years on, any investor has to wonder, “how predictable was the market crash of 1987?” We’ve never seen anything quite like it. Following the meltdown, of course, we soon learned that lots of folks had apparently warned us. After the financial crisis of four years ago, I was surprised to hear how obvious it all was. (Unfortunately, no one ever told me.)

But what I find interesting in 1987 is seeing how arbitrary it all seemed. In 1987, there were several unusual events that all seemed to coalesce before the plunge. Southern England, for example, had one of its worst storms in centuries. The morning of the crash, the WSJ ran a chart showing the rise in the Dow compared with the rise during the 1920s. Alan Greenspan had only been on the job for two months before the crash.

On October 14th, the market was rattled by the high trade deficit report. The bond market took a big hit the next day. On Friday the 16th, the Treasury bond broke the critical 10% mark.

Over the weekend, Jim Baker, who was the Treasury Secretary, told the Germans to “either inflate your mark, or we’ll devalue the dollar.” Gary Alexander writes:

On Sunday, October 18, Baker went on the Sunday morning talk shows, where he said that the U.S. “would not accept” the recent German interest rate increase. Later, an unnamed Treasury official said we would “drive the dollar down” if necessary. These were fighting words that panicked the market.

Some said that Baker’s rash words, more than anything else, caused the Monday market crash: Jacques Delors, president of the European Commission, compared Baker’s remarks to “a pyro-manic fireman. When you’re living on the edge of the volcano, you don’t light matches.” Economist Pierre Rinfret also blamed Baker for the crash: “The Secretary of the Treasury started one of the worst panics in the history of the stock market.” Noted trader Jimmy Rogers agreed: “The crash had nothing to do with program trading or arbitrage or investment insurance. Greenspan and Baker simply panicked and blew it.”

The rest of the world crashed long before New York opened that Monday. The market day began in Asia, where Monday opened with a 33% drop in Singapore, a 17% loss in Tokyo and 11% down in Hong Kong – a market which closed for the rest of the week. Europe fared no better, with a 22% drop in London, 14% in Zurich and 13% in Frankfurt. Hearing this news over their breakfast coffee, New York traders were bearish from the start, as the market dropped 104 points in the first hour alone. By the middle of the day, the market held its losses to between 100 and 200 Dow points. But after 2:00 p.m., the market lost 100 points each half hour, reaching a 376 point drop by 3:30pm and a 508-point drop at the closing.

Here’s a chart showing the relative strength of utility stocks and transportation stocks in the period leading up to the crash. It’s simply the Dow Transportation Average divided by the Dow Industrials (red), and the Dow Utility Average divided by the Dow Industrials (blue). When the lines are heading up, the sectors are outperforming the market. When they’re going down, then they’re trailing the market.

In the months leading up to the crash, investors dramatically rotated out of Utilities and into Transports. In other words, they were abandoning safe sectors with high dividends and crowding into riskier cyclical sectors. This is a good way of tipping us off that the market was becoming riskier. In fact, the two lines seem to be perfectly negatively correlated.

Once the crash happened, everything shot back to normal. Still, this only tells us that investors had become more aggressive. It never told us when it would end.

The 1987 crash also showed strange numerical connections. For example, people who follow the Elliott Wave stuff which is based on Fibonacci numbers saw lots of signs. For example, the year 1987 came 55 years after the massive low in 1932, plus 21 years after the downturn of 1966, 13 years after the big low in 1974 and five years after the low in 1982. Personally, I think this is another example of people trying to find patterns in randomness, but some people take it very, very seriously.

Historically, the stock market’s one-day standard deviation is about 1%. A drop of 22% is 22 standard deviations below the mean. Statistically, that’s so rare it would take eons for it to happen. The issue, of coure, is that financial markets don’t follow normal distributions but they can appear to. With finance, as with many areas, we don’t know what we don’t know.

The case of 1987 is another reason for my investing philosophy of investing in high-quality companies and not being rattled by short-term volatility — even extreme moves. Twenty-five years on, the Dow has gained 679.2%.

Posted by on October 19th, 2012 at 10:02 am

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