Alarming Chart of the Stock Markets of 1987 and 2012-2013

By on May 22, 2013

Several days ago I posted a chart showing the S&P 500 index now as compared to 1987 because, although there are major differences, this year’s price action reminded me of the movement which led to the monumental one day crash of over 20%.

In 1987, the S&P 500 and DJIA had appreciated a remarkable 39% and 41% respectively in the first eight months of that year. The stock market actually peaked on August 25th, seven weeks before the infamous and historic drop on October 19, 1987. In those seven woeful weeks U. S. equities dropped 33%.

The collapse was largely blamed on the advent of program trading, where computers were beginning to be implemented in portfolio insurance schemes designed to prevent losses. Other factors were probably more important than the program trading scapegoat. They included the aforementioned euphoria surrounding equities and its inherent margin account boldness. Also, pronounced weakness in the dollar was caused by an alarming rise in the U. S. trade deficit along with a significant increase in global interest rates. These factors led to an aggressive response from a nervous and inexperienced Fed chairman, Alan Greenspan.

Other world markets collapsed in unison (New Zealand crashed a whopping 60%!), where program trading largely had yet to be implemented. It therefore remains a dubious reason for the U. S. collapse.

What do we have now? A stock market juiced not by healthy GDP growth and soaring corporate earnings, but by a Federal Reserve whose aim, through interest rate manipulation, is to increase asset prices in order to jump start a feeble economy and dismal employment market. Bernanke, once again, appears oblivious to the bubbles he is largely responsible for creating in both bonds and equities. This has translated into a dire moral hazard where stocks are currently viewed as the only game in town backed by a monetary authority willing to do anything in their power to encourage psychotic investor behavior. Risk taking via margin buying is reaching its zenith; leading to imbalances and resulting in a treacherous environment which could lead to another market meltdown.

The chart below illustrates the stock market from November 15, 2012 to current, overlaid with January 2, 1987 through October 30, 1987, where the final blow-off advance began and ended in its ultimate buying climax. Both periods represent the culminations of fairly long bull markets. In August of 1982 the bull market began with the Dow at 776. Five years later, in President Ronald Reagan’s second term, the Dow would be at 2,722, a gain of over 200%. Today’s bull market, also in President Obama’s second term, is currently in its fourth year having risen over 100%.

The Shiller PE ratio was about 22 when equities peaked in August 1987. Today the Shiller PE ratio is close to 20.

One major difference between 1987 and the current backdrop is interest rates. The 10 year Treasury was yielding an otherworldly 10% as the stock market was peaking in 1987, and had climbed rapidly from 7 percent earlier in that year. Why anyone would invest heavily in stocks when you could earn that kind of interest is beyond me, but manias cause investors to act in peculiar ways.

Currently the 10 year Treasury yield is under 2 percent, with no prospect for an increase anytime in the near future (although projecting interest rates is a crapshoot). A similar increase (up 40%) in interest rates experienced in 1987 would almost certainly be problematic for today’s stock market, although that appears to be an improbability given the current weak economic state.

One could make the opposite argument today; why would anyone buy a 10 year bond yielding less than two percent when an investor can purchase stock in a stable business such as Johnson & Johnson with a dividend yield of three percent? This is the argument being made daily in the news today and one of the reason stocks like JNJ have skyrocketed 30% and more in the past 6 months.

Of course, in an equity bear market, many years worth of dividend payments can be wiped out in a few days, which makes risk control a primary concern for investors who rely on income. Buying when equities are at low valuations affords investors more income than they would receive when they’re high. These are the conundrums which make investing so challenging.

Where do we go from here? I really have no idea, but it will be interesting to watch how this plays out. I plan on updating this chart periodically for the next few months. I don’t expect a crash, but wouldn’t be surprised to see the market exhibit pronounced weakness in the not-too-distant future.

Click on chart for larger image:

S&P 500 2013 1987 Blowoff Buying Climax

8 Comments

  1. Joshua DeMoss

    May 23, 2013 at 2:19 pm

    Would it be safe to say that having ones savings in corporate bonds is a bad investment? Since, when the corporate/public/national bubble gets it’s first large hole, there will be a massive sell-off as all of these highly rated assets become seen for what they are… nothing more than toxic debt.

    My grandmas savings is in bonds, and being that it’s not a whole lot, I’m afraid for her well being, if it to we’re suddenly evaporate, it would condemn her to poverty..

    If I were her I’d only leave what I needed for bills and immediate food/energy needs in a checking account while turning the rest into real assets,.. or go long on something related to oil? How can one with only 15k or so to invest make it out of this in the best of shape?

    I’m young, say thank you for the insight.

    • Joshua DeMoss

      May 23, 2013 at 2:28 pm

      Here’s a rant:

      I guess the idea would be get liquid and be ready to move in commodities as they correct on the downside of this bubble.. get in cheap, real estate plunges, oil skyrockets?, ETF’s evaporate, real precious metals spike up, sell on the overshoot of the pysical, get into depreciated assets, go long on related industry?, when precious metals correct after their bubble they settle at a moderate intermediary as the world moves towards asset backed currencies and hopefully sound money, not war. Ride those assets while cruising into peak oil/oil production disruptions due to geopolitics, buy island/hide?

    • Barron Maestro

      July 27, 2013 at 9:48 am

      High grade corporate bonds are less volatile than equities, however, you won’t be shielded from losses in the event interest rates rise. It depends on the duration of the bonds. It is not unusual for stocks to appreciate in a rising rate environment. So equities could gain while bonds lose value.

      For a better understanding of the effect of rates on bond prices visit this link:

      http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/Bonds/P204318

      Excerpt:

      The higher a bond’s duration, the greater its sensitivity to interest rates changes. This means fluctuations in price, whether positive or negative, will be more pronounced. If you hold a bond to maturity, you can expect to receive the par (or face) value of the bond when your principal is repaid, unless the company goes bankrupt or otherwise fails to pay. If you sell before maturity, the price you receive will be affected by the prevailing interest rates and duration. For instance, if interest rates were to rise by two percent from today’s low levels, a medium investment grade corporate bond (BBB, Baa rated or similar) with a duration of 8.4 (10-year maturity, 3.5 percent coupon) could lose 15 percent of its market value. A similar investment grade bond with a duration of 14.5 (30-year maturity, 4.5 percent coupon) might experience a loss in value of 26 percent.1 The higher level of loss for the longer-term bond happens because its duration number is higher, making it react more dramatically to interest rate changes.

      • Barron Maestro

        July 27, 2013 at 9:55 am

        Here is some more from the FINRA article regarding the effect of rate changes on bond funds and the importance of duration risk:

        “Duration has the same effect on bond funds. For example, a bond fund with 10-year duration will decrease in value by 10 percent if interest rates rise one percent. On the other hand, the bond fund will increase in value by 10 percent if interest rates fall one percent. If a fund’s duration is two years, then a one percent rise in interest rates will result in a two percent decline in the bond fund’s value. A two percent increase in the bond’s fund value would follow if interest rates fall by one percent.”

  2. Herb Utsmelz

    May 23, 2013 at 4:35 pm

    Could you change the color of you graph lines? I prefer green as opposed to blue. Thank you. And do you know what will happen with the red line? If so, I believe that could be VERY important information.

    • Justin Herass

      May 24, 2013 at 12:20 pm

      Herb does have a point. If you could move the red line from 6 to 8 or 9, it would be very predictive and we would be able to know if the S&P was going to rise or fall. If you do change the color of the lines, I would like green more than blue too. Thanks!

      • Barron Maestro

        May 25, 2013 at 7:35 am

        That’s good. I appreciate your sense of humor. As I said in the post, I have no idea where the market is going, nor does anyone. This is simply an illustration of the potential for the market to make massive gains (and losses) in a short period of time. In other words, the risks inherent in the market are oftentimes underestimated by the investing public and exacerbated by the soothsayers and hysterics frequenting CNBC, Bloomberg and Fox Business News. Stick to your asset allocation and avoid the siren song of the analysts and pundits.

      • Mr. X

        May 25, 2013 at 2:57 pm

        He can’t move the bottom line forward because that would be time travel. He should be able to change the colors, though. Don’t know why he’s so adamant about blue.

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