Friday, October 19th, is the 25th anniversary of the stock
market crash of 1987. I was a mere three weeks into my new job as
research director for a group of market makers at the Chicago Board
Options Exchange. It was a dramatic experience. Mrs. OldProf was
visiting both to celebrate our anniversary and to look for an
apartment in the city. We met friends, hit some shows, and dined at
Al Capone's favorite restaurant. Great fun on Friday.
On Monday, things looked a lot different. We decided to put the
move from Wisconsin on hold for a little longer, not signing any
leases just yet!
Fortunes were made and lost that day, sometimes the result of
what seemed like very small decisions a few days earlier. Like
everyone else who lived through those days, I have quite a few
stories. While those are interesting, I want to focus on the
lessons that might be relevant for today's investors.
Causes of the Crash
In October of 1987, there was an explosive mixture of an
overvalued stock market, rampant and ill-advised program trading,
and extreme over-confidence on the part of many investors. A
growing trade deficit and falling dollar caused many to believe
that higher interest rates were necessary. The spark seemed to
occur on Friday, October 16th, 1987, with the effects rippling
around the world over the weekend. Mutual funds had large sell
orders on the morning of the 19th, necessary to meet
I am sure that the paragraph above will sound to some just like
a description of current conditions. I wrote it with that in mind.
I suspect that you will see more than one article pursuing that
theme. It is true that some problems seem to persist for decades,
or to re-emerge in different forms. The exact causes of the Crash
are still being debated. The combination of my academic curiosity
and personal stake inspired me to study the subject very carefully.
Here is a brief summary of my conclusions.
The stock market was wildly overvalued, even by the most bullish
To avoid getting bogged down in the question of the best
valuation measure, let's pick one and use it both for 1987 and for
today. Those who are most concerned about current market valuation
are very critical of using 12-month forward earnings and taking
account of interest rates -- variously called the "Fed Model" or
the equity risk premium. Today's forward earnings on the S&P
500 are about $108, so the earnings yield is about 7.6% compared to
a ten-year Treasury note yield of 1.8% or an ERP of 5.6%.
Right before the Crash, the forward earnings were $22.45 for a
forward yield of about 7.0%. The difference is that the ten-year
yield was 9.42%, so the ERP was not a premium at all, but a
negative 2.42%. Even if you aggressively believed that the earnings
yield should be the same as the Treasury note, stocks were
overvalued by 33%. The decline on the day of the crash was 22%.
Inflation was running in the 4.5% range, but was moving
The valuation situation is not similar. If you think the market
is overvalued now, it was awesomely overvalued then! (And please
don't substitute what you think the CPI or interest rates should
be. It is better to evaluate data than opinion).
Trading and Market Rules
In 1987, many big fund managers embraced a concept called
"portfolio insurance." Simply stated, the idea was that you should
hold a very aggressive allocation in stocks -- more than your
normal risk tolerance would suggest. If the market started lower,
you would then (and only then) sell short futures on the broad
stock market. These short futures would hedge your position. If the
market declined further, you would sell more futures. You did not
want to hedge in advance, since it would be a drag on your
The result was that the instant decline in stocks triggered the
sale of index futures. The futures, which responded more quickly
than the cash market, gapped lower. Arbitrageurs attempted to buy
futures and sell stocks to profit from the spread. This pushed
stocks even lower, causing another leg down in this deadly
While we still have program trading, the highly-publicized
events of the last few years do not rival 1987 either in breadth or
magnitude. The portfolio insurance concept has been abandoned.
Various circuit breakers limit the possibility of a cascade of
futures and stock trading. Electronic markets have improved
liquidity. In 1987, the Nasdaq market was based on telephone calls,
and the market makers were not even answering! Options traders
settled up at the end of the day with "outtrades" checked in the
morning. In 1987, some traders dropped their cards on the floor and
left the building. Some, who had escalated risks to their backers
during the day, simply headed for O'Hare, spawning the term
"airport play." Now the trades are electronically transmitted
throughout the day, so backers and clearing firms always know what
Most importantly, we should note that the 1987 crash was not
associated with a recession, either before or after. Some have
suggested that rhetoric about the weakening dollar was the
proximate cause. The easiest way to evaluate this is by looking at
a chart of the trade-weighted dollar. Look at the long-term trend
as well as the specific time in 1987 and now.
The 1987 crash was not an economic phenomenon. We do not
currently face similar risks.
The Real Lessons
- A better understanding of risk and reward. Before the crash,
the individual investor was a happy seller of naked puts. The
"crash" issue of Barron's had classified ads for trading systems
that showed you how to print money. People sold puts based not on
how much risk they could afford, but how much money they wanted
to make. Options clearing firms evaluated positions based upon a
three-standard deviation move -- a real extreme. This was a big
lesson in the fat tails of the stock return distribution. The
aftermath was the greatest opportunity in history to sell put
premium, something that I pointed out to my new boss. The rules
had changed! Even professional traders were on a short leash for
- The importance of margin. Those who had accounts on margin of
any sort suffered the greatest cost. Positions were ruthlessly
liquidated to satisfy the margin call. This included futures
positions and option contracts that were trading far from
anything resembling fair value. Taking on excessive margin risk
proved to be a big mistake.
And the Most Important?
Simply put, the crash destroyed objective analysis for
This most important lesson of the Crash is not commonly
understood. For the next few years, any stock system, whether based
on fundamentals, technicals, or a computer program, had an acid
Did it call the crash?
We saw dozens of pitches. No one even bothered with a method
that did not include a successful "crash call." The event was so
important, and had such a great impact on results, that you could
not make a persuasive case for a system that did not have a "tweak"
that would have predicted the crash.
Similarly, analysts who had given warnings were celebrated as
heroes. This turned out to be fifteen minutes of fame for some.
This final lesson is probably the most important, and the most
difficult to understand. Excessive emphasis on the "crash call"
warped the thinking of portfolio managers and individual investors
alike. The life-changing events from 25 years ago punished some of
the smartest traders and rewarded some of the, ahem, least skilled
who happened to have the right position for the wrong reason.
Those who took the wrong lessons from this got to double down in
lost opportunity. They followed the wrong gurus and the wrong
systems for many years thereafter. They never recovered.
2008 is an echo of 1987. Another generation of investors may be
A Final Word
Can stocks decline from current levels? Of course, and for
various reasons. A 2008-style decline came for reasons much
different from 1987. We now know more about those risks as well,
something that I track every week.
Markets can decline, but it will not be from a scenario like
that of 1987.
I 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.
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