Searing lessons from the crash of 1987

You may know intellectually that playing video games in the swimming pool is a bad idea, but if you actually experience it, you’ll learn a lesson you won’t quickly forget. Nearly thirty years ago, on Oct. 19, 1987, investors and advisers learned a lesson about stock market volatility that has stayed with them to this day.

“My first day as a Merrill Lynch financial consultant was Aug. 11, 1987,” said Hank Mulvihill, director and senior wealth advisor with Smith Anglin Financial, LLC. “I was beyond excited. Then came Monday Oct. 19. The Dow Industrials closed down 508 points that day. The phones went crazy with panicked clients. All day long we took calls. SELL! Program trading! Dollar panic! Nobody really had any idea. At the end of the day I took a photo of my screen and wondered what the hell I had done with my career.”

The Dow’s 508-point translated into a 22.6% plunge, the equivalent of a 5,510-point drop today. The one-day plummet was simply the worst day of a string of rotten days. If you include the three days before Black Monday, the Dow plunged 769.42 points, or 30.7%, according to Dan Wiener, editor of The Independent Adviser for Vanguard Investors. From its top on Aug. 25, 1987, to its Black Monday bottom, the Dow shed 984 points, or 36%, in just 39 trading days.

DEBATE GOES ON

Academics still debate what caused supposedly steely-nerved professional investors to dart away from their positions like a school of minnows. One probable cause was the Federal Reserve Board, which had raised the discount rate from 5.5% in August 1987 to 6% in October 1987. At the same time, the yield on the 10-year Treasury note soared from 7.23% at the start of 1987 to 10.15% on Oct. 19.

Another likely culprit was program trading, a relatively new innovation that used computer algorithms to buy or sell stocks in large blocks to lock in relatively small profits. The stock market, and particularly technology stocks, were expensive, and the Dow had soared 22% in 1986 and 43% in 1987 through Aug. 25. Two Iranian attacks on U.S.-owned shipping in early October didn’t help, either.

(More: Momentum is on a roll. But will it last?)

Whatever the causes, the Oct. 19 crash left a huge impression on anyone who was in the financial industry at the time. “No one could move that day; we were all paralyzed,” said Howard Erman, president of Erman Retirement Advisory, RIA. “Who could possibly imagine this kind of drop? We made no calls and just stared at the TV.”

Mark Germain, founder of Beacon Wealth Management, who celebrates his birthday on Oct. 19, was in a client conference on Black Monday. “On the same day the VP of my firm was orienting my new assistant,” he said. “At approximately 10:30 a.m. I opened my office door and yelled OMG the market is crashing! At that moment the new assistant looked at the VP and said, ‘Who the heck is that?’ ”

LESSONS

What can we learn from the crash of 1987? For many advisers, it was that crashes aren’t the time to be too clever. Leon LaBrecque, a financial planner and CEO of LJPR Financial Advisors, had been short the market with puts – until Friday, Oct. 16, when he cleared his position and bought calls. “Well, Monday happened, and I, like many, looked foolish and was scratching my head,” Mr. LaBrecque said. “I then remember saying, ‘If it doesn’t make sense, bet against it.’ ”

And exceptionally sharp crashes often have sharp – albeit short-lived – rebounds. The Dow rallied 5.9% and 10.2% the next two days. “The market was UP 5.81% for the year if you were in the whole time,” Mr. LaBrecque said. “So my clever long-short was dumb. There are always short-term trends, and playing them requires being right a lot, a whole lot.”

Stock panics tend to breed, well, panic, which makes it a tough time for people in the financial services industry. “I had recently graduated from graduate school with an MBA,” said Chris Chen, a financial planner with Insight Financial Strategists. “Everyone I knew who went to Wall Street that year got laid off.”

And getting new accounts? Fuhgeddaboutit. “For the next few months, nobody was interested in opening an account,” said Mr. Mulvihill. “Today, no one remembers that in those two months, the DJIA dropped almost a thousand points – 36%! But I stayed at it and survived and 30 years later, I am enjoying the business and very grateful to be serving clients, several of whom I still have from those days.”

OMENS EVERYWHERE

Newspapers and market strategists will tend to interpret a market crash as an omen for the future – which was correct in 1929, but not in 1987. The short-lived crash resulted in a short-term recovery, and those who bought were amply rewarded.

“I was in China,” said Patrick Renn, president of Renn Wealth Management Group. “When I got to Hong Kong, in the early evening and checked into my hotel room, I turned the TV on to CNN and saw that all the worldwide markets were crashing. The next morning several of my peers and I had breakfast with Mark Mobius, the legendary emerging markets money manager. His fund was at 30% cash and he could not wait for the Hong Kong market to open, which was to be closed for 3 days to avoid a panic, so that he could invest some of the cash.”

No two crashes are the same. The crash of 1929 led to the Great Depression, with the Dow ultimately falling 89%. The Japanese stock market has yet to recover from its 1989 bear market. Your best plan is to try and remain calm, take tax losses when you can, and make sure that the portfolios you have tailored for your clients are durable enough to let your clients – and you – sleep at night.

“We learned to persevere, that even terrible events have a shelf life and the essential growth of the U.S. economy is what we rely on,” said Mr. Erman. “People go to work every day and as long as they do, stocks will do well, as they are only a reflection of the production of hardworking Americans.”