Opinion: Six similarities between today and 1987, when the Dow plummeted 23% in one day

Posted by jbrumley on October 3, 2017 8:10 AM

Are we headed for another crash in stocks? We could be, so here’s a way to protect yourself while remaining invested

By Nigam Arora, MarketWatch

It was 30 years ago this month. I had millions of dollars of my own money invested in the stock market. Other investors did too, and everyone was making money.

On Oct. 19, 1987, the Dow Jones Industrial Average fell 22.6%. The S&P 500 Index dropped 20.5%. It’s known as Black Monday, or the Crash of ’87.

Three decades on, could the stock market fall at a similar rate? If so, what should you do to protect yourself? These are the key questions investors ought to ponder now that U.S. stocks are collectively trading at record highs. History does not always repeat, but we must still learn from history. Let’s explore.

The similarities

Please click here for a table showing the six similarities in the stock market between today and 1987.

The first similarity, but not others, needs some explanation. In 1987, money managers were buying stocks with impunity because they thought the stock market was a one-way street — large profits and little risk. They were sold portfolio insurance by the wizards of Wall Street that, in theory, should have protected them against losses. Portfolio insurance was accomplished through derivatives such as options and futures. With the benefit of hindsight, we now know that portfolio insurance not only failed to protect them, but it also accelerated selling.

A similar danger exists now in the popularity of exchange traded funds (ETFs), especially large flows of money in ETFs by passive investors. At this time, most investors do not have any appreciation for the risks in passive ETF investing, just as when, in 1987, most portfolio managers had no appreciation for the risks in portfolio insurance.

When it comes to sentiment in the stock market, investors need to be careful. Those numbers, such as those from the American Association of Individual Investors (AAII), are based on surveys. At The Arora Report, our research shows that in this bull market, there are significant differences between what investors say and what they do. For this reason, the proprietary sentiment measures that we use at The Arora Report in our complex timing model give heavier weight to what investors are actually doing and less weight to what they are saying.

Based on the proprietary measures at The Arora Report, sentiment in the stock market is now very bullish but not extremely bullish. That’s not splitting hairs. Extremely bullish sentiment is often a contrary indicator and often precedes a decline in the market.

Just like in 1987, valuations are high and earnings are rising. And in recent days, interest rates have risen. Rising interest rates have driven up popular bank stocks such as Bank of America, Citigroup, J.P. Morgan and popular brokerage stocks such as Schwab, E*TRADE Financial Corp, and Ameritrade In her last speech, Federal Reserve Chairwoman Janet Yellen indicated a determination to raise official rates in December. The market is giving only about a 60% probability to a rate hike in December, essentially not believing Yellen. In 1987, the absolute level of interest rates was much higher, but they were rising, just like now.

Sell signal

In view of the similarities, should you sell your equities? If not, how would you protect yourself? To analyze the situation, we must look not only at the similarities but also at the differences between today and 1987. I will be writing separately on the differences between 1987 and now.

The prevailing wisdom now, like in 1987, is to be bullish and not dump equities.

My longtime readers know my track record of going against the prevailing wisdom and giving unequivocally clear sell signals. For example, in the fall of 2007, The Arora Report gave a sell signal for the stock market, calling for going 100% into cash. Later on, The Arora Report gave signals to aggressively short-sell ETFs such as the small-cap stock ETF IWM, financial stock ETF XLF, China stock ETF, S&P 500 stock ETF and India stock ETF INP. For those who could not short-sell, The Arora Report called for buying inverse ETFs. Subsequently in 2008, most investors lost half the value of their stock portfolios, while The Arora Report portfolios generated significant profits.

When gold was hitting highs and everybody was bullish on gold, The Arora Report gave a clear sell signal at $1,904 an ounce, which turned out to be the exact top. These days, I use adaptive the ZYX Global Multi Asset Allocation model with 10 inputs for timing and risk control. The timing model at this time is not giving a sell signal but warrants some caution.

What to do now

As the first order of business, investors now more than ever need access to a reliable and proven model such as the ZYX Global Multi Asset Allocation model to control risk and know when to sell. Investors ought to consider not relying on mere opinions, as opinions are a dime a dozen.

It is important for investors to look ahead and not in the rearview mirror.

Consider continuing to hold existing positions. Based on individual risk preference, consider holding cash or Treasury bills, 19%-29%, and short- to medium-term hedges of 15%-25% and very short-term hedges of 15%. That is a good way to protect yourself and participate in the upside at the same time.

It’s worth remembering that you can’t take advantage of opportunities if you are not holding cash. When adjusting hedge levels, consider adjusting partial stop quantities for stock positions (non-ETF); consider using wider stops on remaining quantities and also allowing more room for high-beta stocks. High-beta stocks move more than the market as a whole. Please note that today’s popular tech stocks such as Apple, Amazon and Tesla are high-beta stocks.