The broad market has performed well for the last few months. During May, following a strong start to 2012, the S&P 500 (SPY) declined by 8.57 percent. Following that, from the start of June until earlier this week, the index appreciated about 11 percent. The benchmark has also appreciated by about that same amount since the start of 2012. Also, selling out of the S&P 500 on May 1 would have locked in an 11.79 percent gain and provided an investor with the opportunity to re-allocate that capital shortly thereafter at a discount.
Whether or not it was a good idea to sell is somewhat irrelevant now, as you either did or you did not. In either case you really only need to consider where the market may be going next. While history is often irrelevant in economics and repeating patterns are not necessarily accurate indicators of future events, the 2012 chart has looked similar to the 1987 chart.
Both 1987 and 2012 started off somewhat similarly for the broader market, with the S&P 500 making strong gains into May and then declining during May. In both years, from June through late August, the S&P 500 appreciated considerably. See the YTD comparison charts below.
While the two are far from mirror images of one another, the general pattern is reasonably close and consistent, both overall and on a month-to-month basis. Both started the year off with impressive gains, appreciating by over 10 percent within the first third of the year, followed by a cooling off period and then a strong summer rally.
Because broad equity correlations are so high right now, just as they were in 1987, the other large and popular benchmark ETFs such as the Powershares QQQ (QQQ) and SPDR DJIA (DIA) have similar chart patterns to the SPY. See a 2012-to-date performance comparison chart for these benchmarks.
The tech heavy QQQ outperformed the two broader benchmark ETFs, but all three have followed very similar patterns. Correlations between equities are high and the last time broad market correlations were so high was in 1987.
Much of the market's 2012 strength has been based upon the strength of the technology and financial sectors, both of which corrected downward in May and rebounded starting in June. A large contributing force to QQQs outperformance is the heavy weighting the index gives to Apple (AAPL). The tech giant now represents 19% of the index, with no other member having even half Apple's weighting. Within 2012, Apple is also the best performing QQQ constituent of those that make up at least one percent of QQQ. Apple is also the largest constituent in the S&P 500. The largest constituent of Dow Jones Industrial Average is International Business Machines (IBM), another technology powerhouse, representing about 11.6% of the DIA.
If 2012 really is following a similar pattern to 1987, then we could be getting ready for a major correction. In 1987, the market sustained one of its most intense short-term declines when Black Monday occurred on October 19. The chart, below, shows the S&P 500 from mid-May through mid-December of 1987, and the significant sell-off that was Black Monday:
A noteworthy point is that the market actually appreciated by about 15 percent over the summer of 1987, before stalling in September and crashing in October. Those three months would have made a good year. In 2012, the S&P 500 appreciated by about 11 percent over the summer and the Nasdaq 100 appreciated by about 13 percent. Despite the appreciation the market saw over the summer of 1987, those gains were wiped out on Black Monday, and then some.
As to the precise cause of the 1987 crash, opinions differ, but many of the commonly accepted causes have the potential to affect the broader market. The most popular explanation for Black Monday is that a series of events caused continuous selling by programs performing rapid stock executions, driving down prices. Such an explanation seems very similar to what recently occurred to Knight Capital Group (KCG) when it updated its software and accidentally caused a loop of selling that drove down equities. Under this popular theory, such an action may have triggered other computerized high frequency trading systems to join the initiator in selling. If that was the case, then the fact that KCG's recent blunder did not trigger a cascading domino effect may mean the modern programs corrected that problem. Nonetheless, the 2010 flash crash happened and many subsequent mini flash crashes have hit individual equities.
Another popular theory for the cause of the 1987 crash is that there was a dispute in monetary policy between the G7 nations that created confidence issues across all currencies. This theory presumes that because the United States tightened policy faster than European nations, market gyrations created a flight to safety that affected the stock market broadly and in a major way. This theory largely presumes that significantly increased interest-rate risk and a crashing Hong Kong market triggered broad selling of equities and other risk assets.
In 1987, there was also an issue regarding aggression between the U.S. and Iran, and on Black Monday, two U.S. warships shelled an Iranian oil platform in the Persian Gulf in response to a missile attack. This hostility was also clearly influential in the risk profile of most equities, currencies and commodities, and particularly to the price of oil.
Whether the 1987 crash was caused by proprietary computerized trading, conflicting U.S. and European monetary policy issues, interest rate changes, an Asian crash, aggression in the Persian Gulf, or a combination of all of the above, these most commonly accepted causes are the very same fears that now plague the 2012 markets. If the market continues to follow the 1987 pattern, it would likely peak out some time between this week and the middle of September and remain range-bound for a few weeks before the trap door springs open.