Wednesday January 30, 2008

Lessons from the 1987 market crash

Personal Investing
By OOI KOK HWA

Investors need to be cautions and hold more cash because cash is king when the market is down.

ARE we heading for a bigger market crash like the one in 1987 or have we seen the worst of the market corrections?

The recent global stock market crashes, especially the big sell-off on the Hong Kong market, prompted investors to recall the big market crash in 1987. In this article, we will look into the causes of the US crash.

In 1987, the rapid technological progress and reduction of entry costs to the market caused a real expansion and entry of many new investors into the US stock market.

As a result, the crash in 1987 was partly attributed to over-inflated prices generated by a speculative bubble during the first nine months. The US market experienced more than 30% gains during the period. At the peak, the average price-earnings ratio was about 30 times.

G. William Schwert, in his research titled Stock Market Crash of October 1987, postulated that the various strategies involving stocks with options or futures contracts on stock indices (called “programme trading”) led to an unusual level of selling volume on Oct 19, 1987.

As a result, the specialists were unable to find enough buyers to meet the demand of sellers. The lack of liquidity caused further big drop in prices. Traders were caught by surprise by the speed of the price drop.

On Oct 14, 1987, the US reported the largest trade deficit. To a lot of investors, it was hard to understand how the announcement of its largest trade deficit could cause such a big sell-off in stocks. One of the possible reasons was the potential reversal of the trade deficit. Lowering trade deficit might imply lower capital inflows, which would cause lower stock prices.

The largest fall in the US stock market happened on the Black Monday of Oct 19, 1987. The Dow Jones Industrial Average tumbled 22.6%, or 508 points, within a day. It was the largest single fall since 1929, in both absolute and percentage terms.

In Malaysia, the KL Composite Index (KLCI) tumbled 12.4%. The main reason behind the fall was on the night of Oct 18, a soldier ran amok with an M16 in Kuala Lumpur. This triggered a panic. Then, as a result of the overnight crash in the US, the KLCI plunged another 15.7% the following day.

Could we have predicted the recent market crash?

A lot of investors were unable to escape the recent crashes. Retailers did not know how to deal with their money after selling stocks. Furthermore, most of them would not sell anything as they could not spot the exact top of the bull market and sell out in time.

Harry D. Schultz, in his book titled Bear Market Investing Strategies, highlighted that there were signs of the ending of a bull market or the beginning of a bear market.

According to him, one of the most important indicators was investor sentiment remained bullish while the economic fundamentals started to get worse. Investors ignored all the negative aspects of the companies’ fundamentals.

Besides, business leaders, brokers and advisory services were bullish as well. They would view any downturn in the stock market as a temporary setback and healthy correction.

In addition, the aggressive rate reductions by the US Federal Reserve might confirm that the US economy was heading towards a recession.

Besides, the stock market might be trading at high volume but not much change in prices. Normally, this implied that long-term investors were selling stocks while short-term traders were supporting the market.

The US bear markets have been as short as two months and as long as five years, the average being about 18 months. Hence, we need to be cautious and hold more cash because cash is king during the down market.

Ooi Kok Hwa is an investment adviser licensed by Securities Commission and managing partner of MRR Consulting.