It wasn’t quite the Kennedy assassination, “9/11”, or the O.J. verdict, events where time seemed to stand still for a few moments. But don’t tell that to the Wall Street traders and advisers who lived through “Black Monday,” the bloodiest day in stock market history, October 19, 1987. On that day, the Dow Jones Industrial Average plummeted 22.61%, the NASDAQ lost 11.35%, and the S&P fell by 20.46%. The unfathomable drop of 508 points had everyone asking, how could this happen? A 508 point drop today would hardly get much attention given the run-up of stock prices over the last 30 years, but what would you do if the Dow plunged over 5,000 points tomorrow? That would be today’s equivalent in percentage terms. I imagine that would get your attention, and mostly likely the attention of even the most casual bystander as well.
As we approach the 30-year anniversary of Black Monday, do signs point to a similar fate for the markets? Are the conditions ripe for another major collapse? It would seem that we are long overdue for a pullback of some significance. After all, the U.S. stock market is in the middle of an unprecedented 9-year bull run, the second longest on record. The S&P is up more than 12% YTD and 270% since March 2009. Interestingly, the market was up a whopping 35.5% YTD at its high in early October of 1987, and stocks had surged 220% since August 1982 until that fateful Monday in October. Pretty similar based on these stats.
The Economy Then and Now
However, one of the most significant differences between 1987 and present day is inflation. Inflation was out of control in 1987, having doubled over the course of the previous year. Today, inflation lies in sharp contrast, where worries abound that it’s too low. Inflation today is almost non-existent, having averaged a puny 1.3% per year over the last five years.
Like 1987, however, the Fed is in somewhat of a tightening mode, having instituted three rate hikes in the last year. But that’s where the similarities end. The difference today is that rate hikes are an effort to normalize monetary policy following a near-zero rate policy set in motion after the fallout of 2008, rather than an attempt to combat soaring inflation. Normally higher interest rates have a predictable impact on the economy, but there is nothing normal about the great Fed experiment that kicked off in 2008. Understandably, there has been considerable uncertainty and hand-wringing at many levels over the unwinding of the Federal Reserve’s $4.5 trillion balance sheet. With its intention of saving the U.S. economy from an unprecedented and historic meltdown and in an effort to preserve the financial markets, the Fed purchased bonds as part of its “quantitative easing” program, commonly referred to as QE. The central bank deemed this necessary as an additional monetary policy lever since the Fed funds rate was near zero, and there was virtually nothing that could be done on the rate front. QE was designed to have the same effect as lowering interest rates.
But now a very interesting chapter begins for the Fed and for the markets as the process of raising interest rates has been established and will soon be followed closely by the unwinding of the Fed’s bond portfolio, likely to begin this year. The concerns are warranted given that the authors of this book, the Fed, can’t know exactly how this story will end. No one can know because such a massive bond sell-off has never occurred before. Former Fed chair Alan Greenspan resides in the camp of those who are concerned and has warned of a bond market bubble. He worries that the unloading of fixed income assets into the market could send bond prices drastically lower, causing yields to soar. The Fed, of course, has stressed that the unwinding process will be gradual, occurring over the course of several years, and will be implemented largely by allowing maturing assets to simply run off.
Earnings and Volatility
Stock market P/E (Price/Earnings) ratios today are also similar to 1987, at the expensive end of the spectrum by historical standards. Some would even say stock prices are approaching extreme levels. According to monthly data from Nobel Prize-winning economist Robert Shiller, Ph.D., the S&P 500 P/E ratio rose from a low of 7:1 during the 1981-82 recession to a high of 18:1 right before the 1987 crash. Fast-forward to March of 2009, where stocks bottomed out at 13:1. Since then the stock market has basically done nothing but go up, and the Shiller P/E now stands at 30:1. For some perspective, the P/E is very close to the peak of 32:1 seen just before the market crash of 1929, but not quite as high as the 44:1 seen just prior to the dot-com bust of 2000-2002.
In addition to high P/E levels, many market observers today are concerned about ultra-low market volatility. The CBOE Volatility Index (VIX) is a popular measure of expected volatility for the S&P 500. Historically, the VIX average is 19.5, but so far this year, the index has averaged 11.5. Some analysts warn that low VIX levels are a sign of market complacency and point to research indicating that periods of extremely low volatility often precede market crashes.
Like 30 years ago, we are seeing a weakening U.S. dollar, and its value remains a highly politicized issue. In 1987, the value of the USD was closely monitored by government officials, as Japan accounted for roughly one-third of the total U.S. trade deficit. On October 14, 1987, after the release of worse-than-expected trade deficit figures, Treasury Secretary James Baker publicly suggested that the dollar needed to depreciate further. The Dow fell by 3.8% that day, beginning a four-day decline that ended with Black Monday. According to the Fed’s broad trade-weighted dollar index, as of October 1987, the dollar had weakened by 11.8% from its peak in March 1985.
Today, although the dollar remains strong by historical standards, we have seen a depreciation of about 9% since the beginning of the year. As noted earlier, a weaker dollar leads to higher inflation. But the lag time of the price impact is difficult to predict. The dollar strengthened significantly following the U.S. presidential election, surging to a 14-year high on a trade-weighted basis by the end of 2016. The post-election surges in the dollar and the stock market reflected optimism for the implementation of fiscal stimulus under the new Trump administration. But as 2017 has progressed, the lack of movement on health care legislation, tax reform, and regulatory changes (on top of strong economic performance in Europe), has weighed on the dollar.
Ongoing legislative delays in Washington could continue to negatively impact the dollar and may at some point affect equities. U.S. international relations, especially rising tensions with North Korea, have resulted in higher market volatility in recent months, and the prospect of the U.S. pulling out of NAFTA is perceived as negative for U.S. stocks.
In conclusion, 1987 and 2017 are different times, each with unique areas of concern. Today, the Fed’s immense program of unwinding its bond portfolio and its unknown impact on the world’s capital markets is front and center. And while no single factor indicates conclusively that a stock market correction is imminent, a rapid erosion of market confidence can occur very quickly, possibly brought on by a confluence of factors and events like we saw 30 years ago this month. The lesson should be that it’s wise to have a plan in place for both good times and bad.