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The New York Times ran an article in the Sunday paper that pushed me to share publicly what I have been sharing with clients and friends: we are in for extremely trying times in the financial markets.

Alex Berenson, the author, reminded me that both Greenspan and Volcker had to deal with crises very early in their terms as Federal Reserve chairmen. Bernanke’s relatively recent promotion is just one more commonality that I see between the environment today and the one 20 years ago.

Before I go on, let me confess that I am well aware that it is extremely dangerous to make simplistic analogies between different periods of time. It is never the same, and we humans who like to think that we can predict the future, cling to short-cuts like drawing parallels (though it sure helped me in 2002 when I was evaluating 73-74). With that said, though, the similarities are quite eerie.

Besides the aforementioned new Fed Chairmen phenomenon, consider some of these other “coincidences.” 1987 and 2007 both precede presidential elections (1987 too had a lame-duck president). M&A activity ruled the day right before everything came crashing to a halt in 1987. Remember Ivan Boesky, Mike Milliken? KKR ruled the day then (and isn’t doing so badly today!). Like the wicked drop in April of 1987 followed by a sharp rebound, we had quite a scare in late February. My next point is controversial. Many bull market defenders suggest that interest rates were “very high” back then, but they are “low” today. My response is that it depends how one looks at interest rates, which are the cost to borrow money. In a vacuum, yes, they were higher back then, but so was inflation and so was nominal GDP growth. In any event, the Fed has raised rates by 425 bps over the past two years and long-term rates have risen. In the chart below, you can see that while short-term Fed Funds rates were 7.5% before the 1987 Crash compared to 5.25% today, the economy was growing more rapidly. Inflation, too, was running higher then. The middle panel adjusts short-term Treasury rates for inflation and indicates that the real yield in 1987 was almost exactly the same as today (about 2.5%). The point is that current interest rates aren’t stimulative today and weren’t then either.

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Despite the high level of M&A activity and the increasing leverage, credit spreads were pretty low in 1987 as measured by the spread between Baa bonds and Treasuries. The data doesn’t go back for junk bonds, but clearly they were at very low levels recently, especially compared to earlier this decade.

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Chart 2

Many might take comfort from the high level of Consumer Confidence (especially when the consumer represents such a large part of our economy). In 1987, confidence was soaring as it is today. Back then, the confidence was also reflected in the amount of debt consumers were willing to take on relative to income. Curiously, it had started to roll over before the market decline in 1987 as it is today too.

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Chart 2.5

And why not be confident? Back then, and now, everyone was working!

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Chart 3

Curiously, though, Housing back then was almost as big a bummer as it is today. I suppose that people were too busy buying stocks! Actually, it may have had something to do with the tax-law change in 1986.

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Chart 4

The next two parallels are much less controversial. Clearly, we are in the 5th year of a bull market today as we were back then:

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Chart 5

The last chart is the one that worries the most. The dollar today, as it was then, has been steadily eroding in value. In my opinion, this ties the hands of Bernanke to some degree should he feel the need to ease. In any event, like 1987, any sort of easing will probably be short-lived. As you can also see in the chart below, commodity prices were surging in 1987 as they are today as well.

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Chart 6

As you can see, there are many parallels. We all know what happened in 1987. I was working as a bond-trader at Kidder, Peabody, so I certainly remember where I was on October 19th. Will this happen again? The short answer is that no one knows. While many of the circumstances may be similar, there are many differences as well. In some ways, I am more worried today. I believe that the excesses in our economy are greater. 1987 ended up being a blip, though it didn’t feel like it at the time. There wasn’t any real economic distortion. In some ways, we are in an environment like 1998, when LTCB blew up after taking on too much leverage and when the emerging economies were seeing their currency values shrink faster than George Costanza in a swimming pool. Again, the implications to the economy proved to be quite insignificant.

In both of these cases, the Recession didn’t come for another three years (and neither did the Iraqi war). How the Fed and other policy makers react will contribute to the outcome should the markets seize up further in the coming weeks. My fear is that our world is so much more economically and financially integrated than it has ever been that the policy-maker responses from our leaders bear less significance. Further, as I look at the perpetually low savings rate here in the context of a clearly stretched average consumer AFTER a huge run in equities and real estate (from which a lot of the mark-to-market gains have been extracted thanks to the home-equity lenders), in the immortal words of Fred Sanford, this could be the “big one.”

My advice (take it for what it is worth): Steer clear of banks and brokers, Fannie (FNM) and Freddie (FRE) any company that needs to access capital (many REITS). Yes, these things are down a lot, but they can go down a lot more as this credit crunch evolves. I am not sure how it will end, but, like the infamous Chrysler bail-out that culminated the failed presidency of Jimmy Carter, I expect that President Bush will have to deal with the government take-over of Fannie Mae (FNM) and Freddie Mac (FRE).

Source: Ben Bernanke’s Initiation: Flashback to 1987