Does This Market Have The Ingredients For A "Black Monday" Crash?

Amber Hestla's picture

Wednesday, May 22, 2019 - 12:00am

by Amber Hestla

I've been thinking a lot about October 1987 recently. 

I'm sure many of you remember that month. But for those of you might be a little too young (or maybe the memory just isn't what it used to be), that was the month where we saw a one-day decline in the stock market of more than 22%.

That day would later become known as Black Monday.

At the risk of bringing up a painful memory that's seared into mind of many investors, let's take a look at what happened then -- because I think it can be instructive when thinking about where we're at in the market today.


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Let's start with this chart... 

Dow 1987 chart

From a technical perspective, the chart shows that prices peaked in August 1987 and broke support near 2,520 in the week before the crash. In the bottom panel of the chart, you can see that my Profit Amplifier Momentum (PAM) indicator turned bearish in August, two months before the crash. 

Like many other market analysts, I've spent time researching this event. For me, research includes reviewing original source documents, especially newspapers from that time. Part of The New York Times' front page from the Saturday before the crash is shown below. 

NYT front page
Source: The New York Times 

The headlines on the right side of the page are about the stock market. The Dow had declined 4.6% that Friday and had fallen 9.5% for the week. The Times noted that it was the largest weekly decline since the end of World War II. 

What I found more interesting, from a research perspective, was the headline on the left side of the page. There were problems with Iran in 1987 that had led to U.S. warships escorting oil tankers through the Strait of Hormuz. 

The attack detailed in the article was an escalation of a problem that traced back to 1984 when Iran began targeting tankers carrying oil from Iraq. The two countries were at war at that time. U.S. Navy ships began protecting tankers against Iranian attacks in July 1987. 

Now, this action wasn't the sole cause of the weak stock market, but oil weighed heavily on the mind of traders in the fall of 1987. They remembered the oil embargo of the 1970s, which had led to gas lines, a recession, and the worst bear market since the Great Depression. 

Newspapers from 1987 are filled with stories quoting government officials citing the fact that the United States had built a strategic oil reserve that could meet the country's needs for months, even if imports were completely stopped. They were trying to ease concerns and prop up sentiment. 

To some degree, these efforts seemed to work. 

In June 1987, the American Association of Individual Investors began surveying its members about their feelings on the market. In August 1987, 66% of the respondents were bullish. Sentiment remained wildly bullish into September, just weeks before the crash. 

AAII chart​ 
Source: AAII.com 

Sentiment is important because the market rarely moves in the direction most investors expect. The most bullish markets generally follow periods when the majority of investors are neutral, unsure what to expect with money available to invest that pushes prices up. 

In 1987, the extreme bullishness was an indicator that many investors were fully invested and had little money on the sidelines to buy the dip. (That strategy wouldn't be popular until the 1990s, but that's a story for another day.) 

There were a number of different factors for the crash, but it's impossible to pin it all on one culprit. The market crash occurred because all the conditions were right for a selloff. The speed of the decline was due to structural changes in the market. 

Futures were being used as portfolio insurance by investment managers, and the insurance created a cascade of sell orders that no one realized was possible. In hindsight, the massive decline of October 19 was exactly what the portfolio insurance products were designed to do. But no one had thought through what would really happen in the new futures markets when the insurance was triggered. 

The fact that so many investment managers were buying insurance shows that market conditions were bearish. Global events, as we saw, were tense. Fundamentals were overvalued and at their highest level since 1929 by many measures. And sentiment was too bullish. 

Fast-Forward To Today
Right now, just 30% of investors are bullish while 39% are bearish and 31% are neutral. Sentiment isn't flashing a warning as it was in 1987, but valuations are high and global events are eerily similar. 

In addition to Iran, investors should worry about Venezuela, where the economy has collapsed and an estimated 10% of the country's citizens have left to pursue other opportunities. 

That sets up a potential immigration crisis in Central America that could cause problems in the United States that mirror the European migrant crisis of 2015. That crisis eased after the European Union reached a deal with Turkey to fund Turkish efforts to stop the tide of immigrants. 

Right now, Turkey is in crisis again, with inflation accelerating and the government struggling to support the Turkish lira from collapsing. It is possible Turkey could need more resources to continue its efforts to help its European neighbors, which makes me think another crisis is likely in that region. 

There's a lot to watch in the world, and I am confident that PAM will turn bearish before the market, as it has before every significant downturn in stocks for decades. 

DJIA current chart

Action To Take
Right now, as the chart above shows, PAM is bullish, and I will continue to follow my indicators expecting new highs. But I am prepared for a reversal. 

From a strategy perspective, this means my readers and I expect to see signals on both calls and puts over the next few weeks. Selectivity will be important until the trend clearly reverses as it did months before the crash in 1987. 

That's why my Income Trader system is so important in a market like this. Whether the market is up, down, or even sideways -- my subscribers and I are able to make money, thanks to the award-winning indicator we use to identify our trades. If you're interested in tilting the odds in your favor -- and making hundreds, even thousands of dollars in extra income each week, learn all about it right here.

Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.