Lessons from the Biggest Crash Ever

10/29/2007 12:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack, editor of InvesTech Research, who predicted the 1987 stock market crash before it happened, makes some connections between then and now.

A week and a half ago we celebrated the] 20-year anniversary of Black Monday, or the Crash of 1987. What appears as a small "blip" at 2,700 on the Dow Jones Industrial Average on a historical wall chart was, at the time, easily one of the most traumatic investment events in over 50 years.

Here are a few things I distinctly remember about the 1987 Crash and the days immediately preceding it:

1. By late August, when the stock market peaked, numerous warning flags were already flying. The bellwether Dow Jones Utility Average had been declining since February, breadth was negatively diverging, and interest rates were rising. Yet all this was invisible to Wall Street, which was focused only on rosy corporate earnings.

2. September was a volatile tug of war between bulls and bears, with big one-day moves in both directions-the biggest being a 3.0% one-day jump (equivalent to a 420 point Dow gain today).

3. Two weeks before Black Monday, bears took decisive control with declining stocks outnumbering advancing stocks in nine out of ten sessions. Yet reassurances were coming from everywhere that "this was just a healthy correction."

4. Black Monday itself was basically a numbing event for most investors. You couldn't get through to your broker, because the phone lines were completely clogged. And even for the minority who could get through, their broker couldn't give any quotes or execute trades because there were no buyers.

The days immediately following the Crash were preoccupied on laying blame-with most of it going to "program trading" and the twin deficits, instead of the Federal Reserve where fault truly belonged. Miscues by a newly appointed Fed Chairman named Alan Greenspan allowed interest rates to soar in the 90 days leading up to Black Monday as the US dollar fell precipitously.

Above all, the 1987 Crash was a valuable lesson in how unexpected consequences can result when liquidity suddenly disappears. It was ludicrous to think the deficits caused the Crash (just look where they are today!). And computerized program trading didn't trigger the decline, though it did exacerbate the consequences of illiquidity.

We are not naive or foolish enough to say another similar crash couldn't occur again. In fact, we believe the two primary ingredients are already in place that could make liquidity instantly disappear under the right (or wrong) circumstances. These are the hedge funds that dominate daily trading volume today, and the gigantic derivatives market-what Warren Buffet calls "financial weapons of mass destruction."

Fortunately, from our analytical viewpoint, we do not have the catalysts in place for a market crash. But all this does keep us wary of blindly investing with the crowd. In other words, don't rely on seasonality, the election cycle, rosy earnings, or any other single fundamental factor for your safety net. A safety net is only achieved through a carefully planned investment strategy.

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