Investors learned several hard lessons from the Crash of 1987, most of which were blithely ignored during the bull market of 1999. Nevertheless, as we observe the 20th anniversary Friday of the worst financial catastrophe of the post-war era, it makes sense to go over them again.
One big lesson: Despite a few notable successes, market timing probably won’t help you sidestep a calamity the size of the 1987 crash. Trying to predict the next crash is often as rewarding as trying to predict the next earthquake. You’re better off investing the bulk of your stock portfolio in a low-cost index fund and using your free time for something more productive, such as reading to the kids or knitting scarves for the homeless.
The Dow Jones industrial average plunged 508 points, or 22.6 percent, on Oct. 19, 1987. Just why the Dow sank like a lead life raft is still a matter of some debate. People were worried about the dollar (it was falling), interest rates (they were rising) and stock prices (they were high, relative to earnings).
The best explanation, though, is that the crash was a moment of mass hysteria. It’s a bit like a story by James Thurber called “The Day the Dam Broke.” The story describes a day in Columbus, Ohio, when a man began running down the street because he was late to work. Someone assumed he was running because the dam had broken, and soon the entire town was running down the street, too, yelling, “The dam has broken!” Of course, it hadn’t.
We’ll never know who began the selling on Oct. 19, 1987 – some companies began dumping stocks in Europe before the markets opened that day – but once the crash started, it took on a life of its own. Whether the crash was caused by fact or fiction, by the end of the day investors were sitting on horrifying losses.
One thing we can learn from Black Monday is that in the short term, the stock market is about as efficient as an old Soviet grain collective. Crowd psychology often rules intraday trading. Absent any material news, there’s no reason why IBM should have been worth $135 a share on Friday, Oct. 16, and $100 a share at the end of the next trading day.
Another is that only a very few market timers got their investors out of the market before the crash. Fewer still did so at the market peak on Aug. 25, 1987.
Robert Prechter, perhaps the most celebrated timer to pull his money out of stocks before the 1987 crash, thought the market would be ugly but not “that” ugly. “No one predicted a crash, including me,” says Prechter, president of Elliott Wave International. He was expecting merely a correction.
A few other timers also sold in time to avoid the crash: Jim Stack of InvesTech Research and Richard Russell of Dow Theory Letters. Stack was bearish because he thought the monetary situation was terrible.
“Short-term interest rates had risen 1.5 percentage points in the 90 days leading up to the crash,” Stack notes. “The Fed, with a new chairman at the helm, had the most to do with creating anxiety before the crash,” he says. (Alan Greenspan, who retired as Federal Reserve chairman this year, was a rookie in 1987.)
Russell bases his calls on venerable Dow Theory, which looks at the relationship between the various Dow indexes.
But effective market timing requires two calls: getting out of the market and getting back in. Russell, who put out his call within three days of the market’s 1987 top, didn’t get investors back into the market until August 1989 – at which point the Dow had already surpassed its 1987 top, says Mark Hulbert, founder of the Hulbert Financial Digest, which tracks timers.
Market timing requires one other thing: money. If you pay for market-timing advice, you reduce your overall return. You may also have to pay your broker for executing your trades. And if you’re investing in a taxable account, you’ll owe taxes on your gains.
Hulbert isn’t willing to say market timing is impossible. He uses the 80/20 rule, which is that about 80 percent of market timers aren’t very good, while 20 percent are right more often than they’re wrong. “It’s difficult but not impossible,” Hulbert says. The five best market timers – adjusted for the risks they take – are in the box.
If you’re considering doing your own market timing, the best advice is this: Don’t. Instead, find a mix of stocks, bonds and money market funds that you can live with. Keep your expenses as low as possible. And add as much as you can to your portfolio. In the end, you’ll beat most market timers – and most mutual fund managers, too.
If you really want to try market timing on your own, at least do it with only a small portion of your overall portfolio, preferably in a tax-deferred account. If you discover a good system, you’ll have bragging rights and, perhaps, a bit of extra money. If your system blows up on you, well, you’ll have learned one lesson the crash didn’t teach you.
