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Three decades later, watching for signs of another '87-style market cataclysm

  • Thursday marks the 30th anniversary of the day the Dow Jones industrial average plummeted 22.6 percent, the worst single session in Wall Street history.
  • It was no bolt from the blue. Stocks were caught in a grueling, treacherous decline in the months leading up to the crash.
  • Today's tightly anchored interest rates, soft but range-bound dollar, sturdy credit conditions and steady equity advance are in stark contrast to what prevailed back then.

The 30th anniversary of the 1987 crash is a perfect occasion to take in the vivid accounts of a headlong bull market skidding violently off course.

"The bull is dead," a senior trader at the old Shearson Lehman told a reporter. "I've been in the business 33 years and it's one of the worst corrections I have ever seen."

His counterpart at the former Donaldson Lufkin & Jenrette added, "We have young traders out here with their eyes popping out of their heads."

An analyst at Josephthal & Co. reported, "My guts are numb. It's unreal; it's just unreal."

But here's the thing: All of those accounts of market carnage were made the Friday before the crash on Monday, Oct. 19, 1987, when the Dow Jones industrial average plunged 22.6 percent in the worst single session in Wall Street history.

That's right. While the '87 crash is commonly recalled as a singular event that blindsided an ebullient bull market, it was no bolt from the blue. Stocks were caught in a grueling, treacherous decline in the months leading up to the crash.

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In fact, global capital markets had been under enormous stress for most of that year even as stocks surged through the summer, before reaching a breakpoint on Oct. 19 — a cataclysmic crack that was exacerbated, to an unknowable degree, by then-new trading technology and over-popular hedging strategies.

The wild action in financial markets before the crash is often forgotten, but important to recognize, especially as some market observers try to handicap the chance that such a jolt could hit the current bull market.

The traders quoted above were recounting the week before the crash, when the Dow shed 9.5 percent, taking the blue-chip benchmark down 17.5 percent from its all-time high, set less than two months earlier.

As the chart here shows, the broader Standard & Poor's 500 index had barreled higher through most of 1987 as the U.S. economy ran hot and buyout mania reached fevered levels. As of Aug. 25, the S&P was sitting on a huge gain of nearly 40 percent for the year.

That's one of several important differences between today's U.S. equity market and the one that led up to the crash: This year, the rally has been steady and impressive, but has traveled at a more gradual angle. The S&P 500 is up more than 14 percent in 2017 and about 20 percent from a year ago.

The five-year run from the start of the great '80s bull market in August 1982 was also far more ecstatic than the past five years have been. The average annual gain in the S&P from August '82 to the August '87 top was 24 percent; over the past five years, the yearly average rise is less than 12 percent.

Besides climbing at a more moderate trajectory, today's market appears more stable in a couple of other ways. In the months leading up to the '87 crash, an increasingly narrow group of stocks were carrying the market, as market breadth flagged before the August peak and on subsequent rally attempts. LPL Financial notes that market breadth lately has been making new highs along with the indexes.

Stocks grew substantially more volatile in late summer, as well, as they tend to do in advance of a major peak. That should provide some comfort to those alarmed by the extreme calm blanketing today's market. Yes, such unusual steadiness can't last forever, and we're overdue for a pullback of some consequence. But it would be extremely unusual to have a brutal sell-off strike before the tape grows more jumpy.

Perhaps more important than what was going on in stocks is the tumult in bond and currency markets in 1987. The 10-year Treasury yield ramped from 7 percent in January to above 10 percent by late August, as inflation fears raged and a new Fed chairman, Alan Greenspan, tightened policy that summer. Such a surge in the cost of money made stock valuations seem untenable, at what were then unusually high levels.

The ongoing collapse of the dollar, encouraged by Treasury Secretary James Baker, was also a major part of the context. Without getting into the macroeconomic forces behind these swirling markets, the point is over the course of 1987, highly valued stocks buoyed by reckless investor behavior became caught in a storm of global risk aversion and capital flight out of dollar-based assets.

Today's tightly anchored interest rates, soft but range-bound dollar, sturdy credit conditions and steady equity advance represent loose and forgiving financial conditions, and are in stark contrast to what prevailed 30 years ago.

We can debate whether today's elevated valuations, hyper-automated markets and popular volatility-trading strategies will put stocks in a risky place before long. But what can't be denied is that the extreme stress buildup that culminated in the '87 crash is now nowhere to be seen.

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