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Is Wall Street Partying Like It’s 1987?

The major stock market indices closed slightly higher on Thursday, as strong third-quarter corporate earnings kept the bull market alive. The Dow Jones Industrial Average still hovers above the lofty landmark of 23,000.

The euphoria brings to mind a date that occurred 30 years ago: “Black Monday,” the market crash of October 19, 1987.

What does Black Monday teach us today? And could it happen again? Below, I’ll answer those questions. First, let’s do the numbers.

Thursday Market Wrap

Markets took a breather after record highs, with falling tech stocks weighing on the Nasdaq. After the closing bell:

  • DJIA +0.02%, to 23,163.04
  • S&P 500 +0.03%, to 2,562.10
  • Nasdaq -0.29%, to 6,605.07

Thursday’s Big Gainers

  • Adobe Systems (NSDQ: ADBE) +12.24%

The software giant issued guidance for earnings per share in 2018 of $5.50, far above consensus expectations of $5.21.

  • Envision Healthcare (NYSE: EVHC) +10.90%

The hospital-based physician group enjoys bullish analyst sentiment. Tailwinds include health industry growth and survival of the Affordable Care Act.

  • Verizon Communications (NYSE: VZ) +1.15%

The telecom posted third-quarter operating results that exceeded expectations and soothed Wall Street’s fears.

Thursday’s Big Losers

  • United Continental Holdings (NYSE: UAL) -12.04%

The air carrier reported a generally solid third quarter, but the key metric of passenger revenue per available seat mile is decelerating.

  • Genuine Parts (NYSE: GPC) -8.50%

The auto parts distributor posted a decline of 15% in third-quarter earnings. Management also lowered its earnings outlook for full-year 2017.

  • Hewlett Packard Enterprise (NYSE: HPE) -5.85%

The IT firm announced mixed guidance for 2018. A new reorganization plan is likely to cause large-scale layoffs.

This Day in History: The End, My Friend

Three decades ago, stock markets around the world crashed. The meltdown started in Hong Kong and spread west to Europe. The United States was hit after other markets had already plunged.

The S&P 500 plummeted 20.5%, from 282.7 to 225.06. The Dow Jones Industrial Average fell 508 points to 1,738.74, a one-day decline of 22.61%. At current market heights, a percentage plunge of that magnitude would knock more than 5,200 points off the Dow.

Black Monday represented the single largest drop the U.S. stock market has ever experienced. Stocks crashed so far and so fast, Wall Street traders started to eye the ledges outside their offices.

During the mid-1980s, insider traders such as Ivan Boesky and Michael Milken were the Gordon Gekkos of their day. The market manipulation of the era echoed the roaring 1920s. Boesky, on whom the fictional movie character Gekko is based, famously said “Greed is good.”

Program trading bears much of the blame for the crash. Institutions use these programs as a hedge against market weakness. Thirty years ago, this complexity was new and little understood. By today’s standards, the computers were something out of The Flintstones.

On Black Monday, as loss targets were reached, these programs automatically liquidated stocks. Lower prices caused more liquidation. The dominoes fell at a quickening pace.

Feeding the downward spiral was the widespread use of portfolio insurance, a hedging tactic that employs futures and options to offset movements in prices. This “insurance” gave traders a false sense of security, opening the door to greater risk taking.

Portfolio insurance was supposed to prevent major loss of principal if the market collapsed. Far from the case.

On Black Monday, as computers dictated the sale of more and more futures, the buyers of those futures demanded significantly lower prices and at the same time hedged their positions by selling the underlying stocks. That drove prices down further, producing more sell orders from computers… and so on. The chain reaction sparked a financial Chernobyl.

Animal Spirits Bite Back

The bull market had begun in 1982, as President Reagan’s free-market policies unleashed “animal spirits” in the economy. After the malaise of the Carter years, vibrancy had returned to American capitalism. By the autumn of 1987, the markets were humming.

But leading up to the crash, warning signs were abundant.

The economy was slowing. Inflation was reigniting. Interest rates were rising. International tensions were worsening. Political unrest was growing in Europe. The U.S. and China were at economic loggerheads.

Nuclear tensions were flaring between East and West. Stocks were grossly overvalued. The strong U.S. dollar was hurting U.S. exports. The White House was dismantling financial rules designed to brake a market collapse. The business culture insisted that investment returns surpassed all else. Passive algorithmic trading was spreading as a substitute for active stock picking.

Yikes! Sound familiar? It should.

After Black Monday, it looked as if America faced another depression. The Federal Reserve came to the rescue by serving as a source of liquidity.

The Fed eased short-term credit conditions. The central bank also lent freely to banks, enabling them to provide loans to cash-strapped brokerages. Within a few months, the market resumed its ascent (see chart):

The Big Plunge

Dow Jones Industrial Average (June 19, 1987 – January 19, 1988)

Source: S&P Capital IQ

It’s fitting that the 30th anniversary of Black Monday occurs on the day after the Dow exceeded the 23,000-mark. This overbought bull market is approaching its ninth year and investors are partying like it’s, well, 1987.

Number of the Day: $500 billion

On October 19, 1987, the stock market lost an estimated $500 billion in valuation. In a single day. Could it happen again? The fearmongers say definitely; the Pollyannas say never.

I’m in the middle. I think a correction is long overdue and likely, but probably on the order of 5%-10%. Don’t shun stocks altogether. Instead, stay cautious. The four most dangerous words in the investment world are: “This time it’s different.”

Maybe you’re nervous about this frothy market but you don’t want to sit on the sidelines. Here’s an all-weather tip: use stop/loss orders.

One of the most widely used devices for limiting the level of loss from a dropping stock is to place a stop-loss order with your broker. Using this order, the trader will pre-set the value based on the maximum loss the investor is willing to tolerate.

If the last price drops below this fixed value, the stop loss automatically becomes a market order and gets triggered. As soon as the price falls below the stop level, the position is closed at the current market price, which prevents any additional losses.

A “trailing stop” and a regular stop loss appear similar as they equally provide protection of your capital should a stock’s price begin to move against you, but that is where their similarities end.

The trailing stop provides an advantage over a conventional stop loss because it’s more flexible. It allows the trader to continue protecting capital if the price drops. However, when the price increases, the trailing feature becomes active, enabling an eventual protection of profit while still reducing the risk to capital.

Over time, the trailing stop will self-adjust, shifting from minimizing losses to protecting profits as the price reaches new highs.

By using stop/loss orders, you don’t have to leave the stock market party but you’ll stay reasonably sober.

And don’t let today’s alarmist headlines spook you into selling. The last thing you want to do is prematurely dump stocks out of panic. Long-term investors should not be spurred into impulsive actions by short-term declines.

Sure, greed is good. So is common sense.

 

 


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