Is a replay of the 1987 crash a realistic likelihood?

Well, it depends upon who you ask. And even more important, when you ask them.

Consider these two WSJ articles, one published (online yesterday) in today’s print WSJ, one in 2007. A mere 3 years — and a 7,500, 56% Dow crash — separates the two publications. How do you think that impacted participants’ perspectives of the current environment versus 1987?

The 2007 article came four years into a cyclical bull market. Housing and credit was shaky, but the impact on the market was — at the time — only modest. The Dow was approaching 14,000. The dominant psychology bullish, the interviewees upbeat — despite plenty of warning signs.

Yet no parallels to 1987, or any other market dislocation, could be discerned. This article was published on October 15, 2007 — 20 years after the ’87 crash, and a few days after the peak of the 2003-07 bull run — just weeks before the onset of one of history’s ugliest bear crashes.

Flash forward 3 years — after a 56% drop in indices. Given what we know if the Recency Effect, would you be surprised to learn that people are now seeing parallels to 1987?

“On May 6, “The velocity of the volatility was stunning, beyond anything I had ever seen, with the exception of October of 1987, when I was on the trading floor,” said Ted Weisberg, president of Seaport Securities in New York.

“There’s a strong parallel between the Black Monday crash and the flash crash,” said Michael Wong, an analyst at Morningstar who tracks stock exchanges.

That is how we are hard wired. We tend to look backwards, not forwards. We over-emphasize the recent, and extrapolate from there.

After the 2008-09 crash, wouldn’t you guess that the similarities to 1987 are easy to spot?

On Oct. 19, 1987, the Dow Jones Industrial Average tumbled more than 20%, and the swoon extended into the following day, before a rebound. Floor traders, working by telephone, dominated the action and computer-generated trading was still in its infancy. Dark pools and high-frequency trading were the stuff of science fiction. Trading reached 600 million shares, according to the SEC.Fast forward to May 6, 2010: The worst part of the lightning descent lasted roughly 10 minutes and the decline hit 9.8% at its worst. Trades, many executed in milliseconds, reached 19 billion shares.

In both cases, troubles first appeared in the stock futures market, which precipitated a decline in the regular “cash” market. The two created a feedback loop, dragging both markets lower.”

A mere three years earlier, when the same technological factors were driving the markets, we get a different perspective from the market pros, who are all too human. Compare the above paragraphs with what the experts said in this 2007 WSJ article, on the 20th anniversary of the ’87 crash. The subhed noted that “Despite the housing slump, Crashes such as 1987 are likely to stay memories.”

Let’s look at parts of that 2007 article:

“With the stock market booming lately, many investors are putting aside worries about the housing slump and the summer’s credit crunch. At the same time, some are thinking about a looming anniversary. . . .

“But some of the root causes of the 1987 crash appear to be missing today. A big problem 20 years ago was that stocks had risen too far, too fast. At their August high, the Dow industrials were up more than 43% for 1987 alone, a stunning short-term gain. They slipped after that, falling especially heavily just before the crash.

This year, the stock gains have been more moderate. At their record close of 14164.53 last Tuesday, the Dow industrials were up 14% for the year. The Dow finished on Friday at 14093.08. Instead of declining as October wears on, stocks have rebounded.

Stocks don’t look as overpriced today as they did in 1987. Today, the companies in the Standard & Poor’s 500-stock index trade only a little above the historical average of 16 times profits for the past 12 months. In 1987, the S&P 500 was at more than 20 times profits. Interest rates are much lower than they were then and inflation, which was causing the Federal Reserve to fret in 1987, appears to be moderating, at least for now.”

The key differences have nothing to do with who was quoted, or the articles authors or their editors. What had changed was the psychology of the moment. And THAT, more than anything, impacts how people perceive the world . . .

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Sources:
How the ‘Flash Crash’ Echoed Black Monday
SCOTT PATTERSON
May 6 Selloff Had Parallels to 1987; Electronic Trading Magnified Selling Pressure This Time
WSJ, MAY 17, 2010
http://online.wsj.com/article/SB10001424052748704314904575250602626326346.html

Exorcising Ghosts of Octobers Past
E.S. BROWNING
Despite Housing Slump, Crashes Such as in 1987 Likely to Stay Memories
WSJ, OCTOBER 15, 2007
http://online.wsj.com/article/SB119239926667758592.html

Category: Markets, Psychology

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

14 Responses to “1987 Redux: Impossible or Likely?”

  1. call me ahab says:

    “In both cases, troubles first appeared in the stock futures market, which precipitated a decline in the regular “cash” market. The two created a feedback loop, dragging both markets lower.”

    the future’s market sets the tone to the start of the trading day however- the flash crash happened later in the afternoon-

    having said that- tin foil or no tin foil- I do believe the futures were the means by which the market has been redirected to a positive bias –

    by mysterious dark forces- or maybe just the Fed

  2. DM RTA says:

    “What had changed was the psychology of the moment. And THAT, more than anything, impacts how people perceive the world . . .”

    If you ever have time, reading the front page of the WSJ sections from the week of and surrounding that time in 87′ is very interesting.

  3. mathman says:

    Anyone ever hear of Hauser’s Law regarding tax revenue vs GDP?:

    http://www.financialarmageddon.com/

  4. rktbrkr says:

    Hugh Hendry betting on China bubble burst, he had a nice home video showing off empty towers in a Chinese city last year

    Hugh Hendry Shorts China, Betting on 1920s Japan-Like Crash
    Share Business ExchangeTwitterFacebook| Email | Print | A A A

    By Bloomberg News

    May 18 (Bloomberg) — British hedge fund manager Hugh Hendry is betting China’s “credit bubble” will burst, causing its economy to contract and triggering a global crisis.

    Hendry’s Eclectica Asset Management has bought options on 20 companies in international markets that will profit from “a dramatic collapse” of China’s growth that’s been fueled by an unprecedented lending boom, Hendry said in a May 17 telephone interview from London.

    Hendry joins hedge fund manager James Chanos and Harvard University professor Kenneth Rogoff in warning of a potential crash in China. The nation’s 13 trillion yuan ($1.9 trillion) of new lending in the past 16 months, bigger than the economies of South Korea, Taiwan and Hong Kong combined, is spurring industrial capacity expansion in the same way Japanese credit built inventory during and after World War I, Hendry said.

  5. SINGER says:

    1) a waterfall decline is a waterfall decline is a waterfall decline…

    2) if this is 1987 then we are about to tear higher….

  6. constantnormal says:

    I look at the likely causes of the flash crash, and see that nothing thus far has been done to alter the game. Same thing with the 2008 plunge.

    In 1987, changes were rapidly put in place (improved circuit breakers, more liquidity) that addressed the root causes of the instabilities then. While we have certainly poured a boatload of money into the system, we have not forced the zeroing out of the mountains of toxic assets.

    Seems to me that all the causes of the recent significant plunges remain poised to repeat the process.

    Same tune, another verse.

    So yeah, I think a repeat is as likely as not.

  7. constantnormal says:

    When 60% of the trading volume is due to programmed trading, I’m not sure that “psychology of the moment” has much to do with events in the market.

    Fer sure, the sideline cash had the bejezus scared out of it in the flash crash, but then it’s not as if they could pull back any further from being in the market, is it?

  8. ironman says:

    BR wrote:

    The key differences have nothing to do with who was quoted, or the articles authors or their editors. What had changed was the psychology of the moment. And THAT, more than anything, impacts how people perceive the world . . .

    Looking at the 1987 Black Monday crash a bit differently, that’s exactly correct, although there were fundamental reasons for doing so. The current state of the market is such that it’s more reminiscent of the 1930s than 1987 – especially since April, when the future expectations of investors appear to have sharply shifted, for which we don’t yet have the data to confirm if that shift in sentiment is a reaction to a fundamentals or is simply noise. My thinking is that it’s more fundamentally driven.

    Here’s why. The May 6 plunge is a clear, almost perfect example of a disruptive noise event in the market – a dramatic change in prices that aren’t sustained and that are not correlated with changes in the expected growth rate of dividends per share, which means it qualifies as being noise.

    That the market recovered quickly to the level indicated by where the apparent investor future expectations for dividends would place them, neither going significantly higher or lower despite the free and clear opportunity to do so would confirm that observation.

    Instead, how the market is currently acting suggests that something fundamentally altered the future outlook of investors in a way where they now expect the level of dividends per share in the market to fall significantly from their current levels at some, as yet unknown, point in the future, which is why stocks may be expected to continue trending lower in the near term.

    What we know today is that shift in outlook took place in April 2010. What we don’t yet know is to what future point in time investors are looking forward. Sadly, the crystal ball can only see ahead to December 2010.

  9. wally says:

    Just a comment, but I find it very odd that corporations like P&G, 3M, J$J do not have circuit breaker ‘buy’ orders always in place. Those companies often have a standing stock buyback authorizations from their board and if they could pick up their own stock for a bargain price… why not do it?

    P&G could have profitably handsomely from the recent ‘air pocket’.

  10. DisparityFlux says:

    Why not try an experiment. First case – remove human traders from the system (the future) and see what the market indicators do. Second case – remove computer/algo traders from the system (the past) and see what the market indicators do.

  11. PhilB says:

    While sentiment (fear and greed) can be a heck of an influence that is not what the whole story is about. Sorry.

    In April we started to get protest in Greece and Thailand’s long standing protests seem to be escalating. Coupled with China’s attempts to curb property prices and inflation, you had the ingredients for a long overdue correction which we may still be in the middle of.

    It would be remiss to say that the markets nerves are not 50% or more centered on Europe. The markets are very nervous due to long denials and lethargic actions by the EU governments led to a rout in the sovereign credit markets.

    Now all eyes are focused on the ability of Europe to move in the direction implied by the liquidity bailout which is towards greater commitments and fiscal intergration. All markets are keen on governments very visible hand in the US, UK, China and Europe. If it looks like governement policy is going amiss in any of these countries/regions it will have devastating impacts on the markets.

    As we all know, the biggest risk to the markets since governments globally became the biggest players, is the effectiveness of their policies and willingness to get things rights…rebalancing market dislocations/fundamentals while maintaining fertile environment for private sector growth.

  12. Pat Shuff says:

    THE SECOND TOP COMING

    Churning and churning in the widening gyrations
    The fall guy cannot hear the Fabulous Fab;
    Things fall apart; the averages cannot hold;
    Mere algorithms are loosed upon the world,
    The red-inked tide is loosed, and everywhere
    The ceremonies of insolvencies are drowned in liquidity;
    The best are charged but avoid conviction, while the worst
    Are full of flash orders.

    Surely some revelation is at hand;
    Surely the Second Top Coming is at hand.
    The Second Top Coming! Hardly are those words out
    When a vast image out of CNBC
    Troubles my sight: a waste of dark pools;
    A shape with lithe body and the head of a man,
    A gaze blank and pitiless as the sun,
    Is moving its slow thighs, while all about it
    Wind shadows of the indulgent no-fat dessert ads
    The darkness drops again but now I know
    That twenty seconds of stony asleep-at-the-switch
    Were vexed to nightmare by a rocking ticker,
    And what rough beast, its hour come round at last,
    Slouches towards bell-ringing to be born?

  13. contrabandista13 says:

    using gold as a deflator and it’s already happened a few times…. one black monday followed by another and another….

    Ouch….!

    Ciao,

    Econolicious

  14. ACS says:

    We can’t possibly have another 1987 crash. According to EMH it will be another hundred billion years before a move of that magnitude can happen again. LOL