10 Similarities Between This Stock Market Crash And October 1987

Includes: DIA, IVV, QQQ, SPY, VOO, VTI
by: CrowdThnk

The recent stock market collapse evokes memories of the infamous crash that surprised investors in October 1987, coming during a time of strong growth, full employment and rising inflation.

Financial engineering via Portfolio Insurance in 1987 and Short Volatility today are the hallmarks leading to a price vacuum with sellers overwhelming absent buyers.

Up until a couple weeks ago, Black Monday had been a lost remnant on many investors’ minds. Today, the similarities are too identical to ignore.

Black Monday Crash

“If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience?” – George Bernard Shaw

Extraordinary stock market gains. Low levels of volatility. Full employment and rising growth prospects. Rising bond yields. Bullish market sentiment and record long portfolio holdings. Favorable corporate tax backdrop. Sound familiar? On Black Monday, October 19, 1987, the Dow Jones Industrial Average fell 22.6% in the greatest one-day loss ever recorded on Wall Street. Billions went up in flames. In an event that permanently rattled and changed market psychology, this collapse occurred under blue skies with seemingly no worries in sight. With a historic-record return in January and record-low volatility to boot, very few investors saw this current collapse coming. Up until a couple weeks ago, Black Monday had been a lost remnant on many investors’ minds. Today, the similarities are too identical to ignore:

1. Impact of Tax Reform: Changes of interest deductibility affecting LBOs vs. Trump’s tax change on Deductibility of Interest affecting corporate stock buybacks – In the middle of the 1987s, corporate raiders had implemented a strategy of taking over companies by using high yield debt to purchase companies (think KKR & Gordon Gekko from the movie Wall Street). On October 13, 1987, US Congress, seeking to slow the LBO machine, sought to revoke the tax deduction for interest on debt used for corporate takeovers, rendering the LBO strategy less effective. This occurred just days before the crash on October 19th and inevitably contributed to the sell-off. Likewise in Trump’s new tax law, a company can only deduct interest expense up to 30% of its earnings before interest, taxes, depreciation and amortization. That is to say, financial engineering will become more expensive and all those stock buybacks which has been supporting the rising stock market will become costlier. The net impact is that the new law will punish over-indebted companies and discourage entities from taking on too much leverage, perhaps curbing many potential M&A transactions. Despite the friendly overall corporate tax cut, this changes the equation for debt-funded financial engineering, namely share buybacks and acquisitions.

2. Extremely High Valuations – Before the recent market sell-off, the aggregate Price-to-Earnings Ratio of the S&P had been trading around 23x, rising from a 14x level since 2012. By comparison, this commonly-used measure of measuring a stock’s fundamental value had surged from 10x to 23x from the beginning of 1985 to October 1987 as the market moved exponentially, similar to what has occurred over the past 6 months in the US.

3. Rising Inflation Expectations contributing to Rising Interest Rates – While many pundits point to the recent wage data s being the straw-that-broke-the-camel’s back, Inflation Expectations – a significant driver of interest rates – have been exploding higher from 1.8% to 2.2% in just 2 months. In 1987, Consumer Price Inflation (CPI) increased from 1.1% to 4.5% from the beginning of the year, prompting the Fed to embark on a hiking cycle. Higher Interest Rates slow down economic activity as it becomes more expensive to borrow on everything from mortgages to consumer loans and auto loans to leveraged buyouts.

4. Federal Reserve’s Hiking Cycle – In December 2015, the Federal Reserve hiked rates for the first time since 2004, ending the longest period in history without a change in interest rates and Zero Interest Rate Policy (ZIRP). Currently, the target rate is between 1.25-1.50%. In 1987, the Federal Reserve raised their Target Rate from 6.0% to 7.25% in a span of 6 months, seeking to slow down the booming economy. Soon enough, the new Federal Reserve Chairman by the name of Alan Greenspan was forced to backtrack, lowering interest rates – perhaps in reaction to the market rout – in what was the first sighting of the now-infamous Greenspan Put before resuming their hiking cycle.

5. Extremely Bullish Sentiment & Market Positioning – As the markets in 2017 and 1987 continued to soar at an exponential rate, it continued to suck in more investors as it reach ever-dizzying new heights. Needless to say, the booming economic growth backdrop and favorable regulatory landscape has blown winds in the Bulls’ Sails with seemingly little to fear. This bullish sentiment has been supported by Record-High Market Positioning from Investors as they’ve sought to ride the rising wave, but disconcertingly on narrowing group of stocks.

6. Full Employment & Strong Economic Growth – Today’s unemployment rate stands at 4.1%, close to some of the lowest levels in recent history. Similarly, in 1987 the unemployment rate was continuing to fall and by October 1987, it stood at 6.0% before reaching a cycle-low of 5.1%. In both periods, the Labor Markets were operating at what economists like to call “Full Employment” levels during which economic growth is buoyant. Both periods have occurred during 2 of the longest, most continuous rates of growth in modern peacetime history.

7. Weak Dollar Policy – From 1982 to 1987, the annual trade deficit was four times the average of the preceding five years. As a result, on October 14th 1987, Treasury Secretary James Baker suggested the need for a weaker dollar. This led to investors’ concerns for dollar weakness, leading foreigners to exit dollar-denominated assets such as US Government Bonds, adding momentum to rising interest rates and hurting stocks. The US Dollar fell an extraordinary -40% from January 1985 to October 1987 in a span under 2 years. Baker’s contemporary Treasury Secretary counterpart, Steve Mnuchin, recently declared his affinity for a Weak Dollar policy on January 25th at Davos, stating that "Obviously a weaker dollar is good for us as it relates to trade and opportunities." He added adding that the currency's short term value is "not a concern of ours at all." This is coming during a time that the US trade deficit is expected to worsen and climb as Trump’s agenda embarks on a global trade war. Since Trump has taken office in January 2017, the US Dollar has lost -13% against a trade-weighted group of currencies and the trend continues. Underpinning the phenomenal stock market rally, this weak dollar policy has contributed to a not-insignificant proportion of the S&P’s returns as almost 50% of US Corporations generate their profits abroad. The currency-adjusted gains of the stock market would not look as astonishing without this concurrent USD decline.

8. Extraordinary 12-month market gains during which everybody made money – In the 12 months leading up to October 1987, the S&P surged 40% higher, one of the fastest periods of gains in stock market history. Similarly, over the past 12 months before the recent crash, the S&P climbed over 26% to the delight of long-term investors and speculators alike. The investor mentality behind these two episodes, however, were slightly different as 1980s investors sought out ‘Portfolio Insurance’ seeking to protect their gains and sell incrementally as the market moved lower. On the other hand, many of today’s investors have been outright selling volatility, trying to pick up additional profits as the market stays stable and climbs higher.

9. Financial Engineering Special Factor - In the 1980s, as stock market investors continued to reap the benefits bestowed by a rising stock market, they became increasingly concerned as the incredible gains outpaced fundamental drivers. In an attempt to curtail any potential losses on their portfolio, they employed a technique known as Portfolio Insurance which sold short the S&P 500 futures contract if the market fell by a certain amount. These hedging contracts ensured that more short sales would occur as the market sell-off continued, exacerbating the decline because many investors employed this same strategy at the same time. Slightly differing in context but amounting to the same effect, in today’s market, investors have been implementing a Short Volatility Strategy to gain more profits by selling put options while the market rises. These have provided a boon for ebullient investors during good times but a nightmare during bad times as losses become magnified and far exceed the potential gains. The widespread adoption of this Short Volatility strategy is best exemplified by a former manager at Target becoming a multi-millionaire by using this strategy. Needless to mention, the XIV Short-Volatility ETF - the largest ETF by which investors could simply implement this by a click of a button – collapsed 95% during the recent expansion in volatility.

10. Market Positioned Short (Negative) Gamma – Portfolio Insurance in 1987 and Short Volatility Strategies Today both exacerbated the fast and swift sell-offs in an-almost identical fashion. Put simply, Short Gamma positions (also called Negative Gamma) means that when stocks sell off, more investors have to sell. That is, selling begets more selling. This nightmare scenario results in a black hole with no buyers as informed investors know there’s more selling to be continued. Extreme moments of panic can lead to conditions of “trading in a vacuum” leading to magnified losses. While the 1987 episode proved short-lived and didn’t continue more than a couple weeks, the impact scarred on investors’ psyche lasted years, so much so that market participants still reference Black Monday today. The unenviable situation of carrying short gamma positions has been a hallmark of both market crashes.

Looking at History for Clues into the Future

The 1987 crash occurred in what was the longest peacetime economic growth period in US history, the same as today. It was met with a central bank response as newly-appointed Alan Greenspan and the Federal Reserve hastily cut interest rates, presumably to support markets. It would be a huge shot to Jerome’s Powell credibility if he were to do the same and with rates already near all-time lows, the market shouldn’t expect central bank support. The S&P Index took 20 months to recover and regain its losses suffered in October 1987, only reaching those previous highs in June 1989 while the Dow Jones Industrial Average (DJIA) reached that milestone in 11 months. Historically speaking, Black Monday is seen as a stock market anomaly – a saga catalyzed by the unforeseen consequences of Portfolio Insurance. One of the major winners in the most recent saga, Chris Cole of Artemis Capital, estimates that in 1987, portfolio insurance strategies comprised about two percent of the market. Currently, he estimates that short volatility trades such as the XIV ETF is between six and ten percent of the market. He likens the current stock market collapse to an appetizer before the entrée, adding “We are going to have a full-blown financial crisis on the same level as the last one, if not worse. I’m not saying the world is going to end in the next two weeks, but I would be surprised if it doesn’t happen in the next two years.” On the other hand, earnings are rising, corporations just received a historic tax cut and the economy is humming along. Whether this is just a blip on the radar before stocks resume their upward trend or a harbinger of what’s to come within a significantly financially-engineered market, the parallels to Black Monday harkens the ghost of October 1987.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.