Avoiding the pitfalls of Black Monday: What investors can learn from the crash of 1987

 
Katherine Denham
USA-STOCK MARKET CRASH
On 19 October 1987, the markets suffered their biggest one-day fall (Source: Getty)

As we continue to pick up the pieces after the destruction of the last global financial crisis, it can be easy to forget the crashes that have gone before.

But for investors, it’s worth trawling through the depths of time to look at one crash in particular – because the period leading up to it bears some worrying similarities to now.

It’s been three decades since 19 October 1987 – the day dubbed “Black Monday” after markets suffered their biggest one-day fall, dropping by more than 20 per cent.

Brian Dennehy remembers the investor mania which marked 1987. By August of that year, he recalls feeling unsettled and cautious at the time: “the words ‘instinct’ and ‘gut feeling’ come to mind when we reflect on how we felt, because there was no single overwhelming fact which was making us nervous.”

But the investment veteran and financial adviser also says that the magnitude of the crash came as a shock to many investors, and he reckons a lot can be learnt from that period of time, which could help investors avoid some big pitfalls.

“It is vital that we learn from such periods or we are destined to go through the same pain again,” Dennehy writes in his ebook looking at the history of the 1987 collapse.

The adviser, who embarked on a selling spree to ditch client holdings when the 1987 crash hit, draws comparisons between that period and where we are now.

The start of the 1980s was a time of burgeoning confidence, as the UK recovered from the political, economic and social turbulence of the previous decade. Political chaos might dominate 2017, but global economies are still very much in recovery mode following the 2008 crisis.

Similar to that era, confidence has been growing among consumers – with figures from Deloitte indicating that confidence has recently been bolstered by improvements in the employment rate.

But there are other similarities to 1987, such as the easy availability of credit, booming house prices, and the surge of takeover deals.

The use of computers to trade large numbers of shares was also becoming more prevalent back in the 80s, with programmes like “portfolio insurance” and “index arbitrage” gaining traction.

Programmed to sell futures during stock market falls, portfolio insurance caused the sell-off to snowball.

With the rising popularity of low volatility strategies, which reduce the allocation to equities when markets get choppy, there are now fears that these strategies could prompt a mass sell-off similar to that caused by portfolio insurance.

The amount of money flooding into index-tracking vehicles also creates cause for concern. These products have not yet been tested in a market crash, and some speculators worry that exchange traded funds (ETFs) could exacerbate stock market falls.

Read more: Should investors be worried about an ETF bubble?

Dennehy says the essential foundation for a crash in the 80s was laid by the market running too far too fast. He points out that, in August 1987, the FTSE 100 index was running 30 per cent above the 200-day moving average.

The markets have been rising at a more leisurely pace compared to back then, but the current bull run is now the second longest in history, which has become a worrying sign for many market players.

Current valuations also look extreme, and Dennehy says they are more stretched now than they were in 1987.

And then we’ve got the exuberant sense of confidence in the markets, which dominated the 80s, as investors enjoyed regular windfalls of cheap money. Dennehy describes this confidence as a “behavioural bubble” because investors moved in a powerful herd, believing that the market momentum was unstoppable.

Now, however, the confidence in the markets is being pushed higher by the central banks, and what Dennehy describes as their “extraordinary intervention” since 2009. This confidence is evident in people piling into ETFs, seemingly disregarding that the US stock market is more expensive than it’s ever been.

Investors rush to tap gains, but this confidence to the point of irrationality is the real danger sign.

Dennehy says: “as the market has risen relatively slowly, we might expect the cyclical downturn (whenever it might arrive) to be a long drawn out bear market.

“Yet when ETF investors take fright, this will play a similar role to program trading in 1987, accelerating and deepening falls.”

He says the favourable demographics and political cohesion of the 80s meant the markets were able to bounce back relatively quickly.

But these factors are now totally absent, and he warns: “this time when the market goes down, it is much more likely to stay down.”

It might take a big shock for confidence to crash, but investors would be wise not to throw caution to the wind and take a careful stance until this bubble blows over.

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