Image Credit: Christophe Vorlet
By Jason Zweig | Sept. 29, 2017 10:40 am ET
With U.S. stocks hitting all-time highs this past week and the calendar just about to flip to October, think 30 years back with me to Friday, Oct. 16, 1987.
The stock market is up more than 30% for the year so far. But traders are jittery: Interest rates are rising, tax rates are in flux and the U.S. is bickering with international trade partners and skirmishing with Iran.
James O’Shaughnessy, a young investor in St. Paul, Minn., has made a “five-figure” bet on stock-index put options, a way of profiting from a sharp fall in price on a basket of big U.S. stocks. Plugging his phone into a modem that dials up a stock-quotation service, he grows more and more nervous as the day goes on and the Dow Jones Industrial Average falls a record 108.35 points on unprecedented volume of nearly 339 million shares.
The selling is “completely overdone,” he thinks: Stocks are bound to bounce back big on Monday “and then I’ll get killed” for hanging on to the bearish bet. “A feeling of panic washed over my entire body,” Mr. O’Shaughnessy says. “I’ve just got to get out.” He calls his broker a half-hour before the market closes and sells it all.
That weekend, Mr. O’Shaughnessy feels “greatly relieved,” as if “I had just dodged being hit by a bullet.” All the negative talk among investors has convinced him that stocks will have a “relief rally” on Monday; by selling his puts, he has surely averted a huge loss.
Then comes Monday. In New York, the Dow drops 208 points in the first 90 minutes, triggering a wave of selling by institutional investors using a technique called portfolio insurance to minimize losses. Futures traders in Chicago, who would normally buy, step back, expecting a further fall.
By day’s end, the Dow has fallen 22.6%, “the worst day in Wall Street history,” as journalist Diana Henriques calls Oct. 19, 1987, in her excellent new book, A First-Class Catastrophe. An equivalent drop in 2017 would hack more than 5,000 points off the Dow in a day.
You can’t survive a market crash if you think it can’t happen. And something like Oct. 19, 1987, will happen again. In fact, it already has: On May 6, 2010, many stocks dropped 60% or more in a flash, although they bounced right back. On Aug. 24, 2015, the Dow fell more than 1,000 points, or 7%, in six minutes, before closing down nearly 4% for the day. Between the market’s peak in October 2007 and its bottom on March 9, 2009, the S&P 500 fell 55.2%, even after counting reinvested dividends.
Ms. Henriques’ book, and the story Mr. O’Shaughnessy told me, are a reminder that “human nature can’t be repealed,” as she says. “Historical amnesia leaves us doomed to repeat our past disasters, and the only antidote is to remember accurately what happened.”
Take it from Mr. O’Shaughnessy, who today manages nearly $6 billion at O’Shaughnessy Asset Management in Stamford, Conn. Even though he based it on factors he no longer believes in, his original analysis was absolutely right: The stock market was overvalued. Between September 1986 and the end of August 1987, stocks had gone from trading at 16 times earnings to a price/earnings ratio of 21.4, a 33% rise that put the market’s P/E at its highest level since the end of 1961.
His emotional reaction, however, was dead wrong. Had Mr. O’Shaughnessy held his ground for one more day, he would have made roughly 10 times his money, he recalls.
Ms. Henriques attributes the crash of 1987 to ineffectual regulation and breakdowns in the complex mechanics of trading. But no one knows for sure what caused it, or the far more devastating crash of 1929 either, says financial historian and retired Goldman Sachs partner Barrie Wigmore.
History does offer a few clear lessons.
Stocks have been overvalued, by long-term standards, for most of the past three decades. So, on average, you were more likely to have missed consistent gains than to have dodged a crash if you got out of the market entirely.
Investors today who hold large positions in the hottest stocks of the past few years — the so-called FANGs, or Facebook, Amazon.com, Netflix and the parent company of Google — should consider trimming their positions, however. In 1987, as in 1929, the stocks that had previously gone up the most tended to fall the farthest.
Above all, says Staley Cates, vice chairman of Southeastern Asset Management in Memphis, Tenn., “don’t be afraid to hold cash.” On Oct. 19, 1987, he and his young colleagues clustered around a Quotron machine putting in buy orders as they watched the market crash, “and the ultimate comfort we had that day was holding 25% to 30% of our portfolios in cash.”
Without it, “we couldn’t have bought stocks,” he says. Having the cash to buy when others are selling is the surest source of courage in a crash.
Source: The Wall Street Journal, http://on.wsj.com/2fVKSm3
For further reading:
Books:
Definitions of BEAR MARKET, CRASH, PANIC, REGULATOR in The Devil’s Financial Dictionary
Chapter Seven, “Fear,” in Your Money and Your Brain
Chapter Eight, “The Investor and Market Fluctuations,” in The Intelligent Investor
Diana B. Henriques, A First-Class Catastrophe: The Road to Black Monday, the Worst Day in Wall Street History
Fred Schwed Jr., Where Are the Customers’ Yachts?
http://jasonzweig.com/will-you-be-ready-when-the-stock-market-crashes-again/
