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