Stock Market Crash October 1929, October 1987, October 20??

Posted by David Nelson, CFA on October 16, 2017 in Investment Management | Leave a comment

By David Nelson, CFA

With the 30th anniversary of the 1987 stock market crash just around the corner, Thursday to be exact, it will be hard to not reflect on a day that saw the DOW fall a staggering 22.6% in a single session. Many of us weren’t even trading the market in 87. As for myself, I was still on stage rocking with the Turtles or on an airliner traveling to the next show. Most of us in my profession yawned. A few fat cats on Wall Street lost some money? What’s the big deal?

Well of course price shocks are a big deal. Not just because of the capital loss. History, has shown losses turn into gains if we just stay the course. Unfortunately, countless studies show most will capitulate. Even if urged to hang on by their advisors many will sell hoping to save whatever they can. How many of you reading this post called your broker the day after Lehman collapsed asking them to put more money into the market. Not a lot of hands out there.

Shortly after the 20th anniversary in 2007 we had a different kind of crash. No, it didn’t happen in a single session but over the next year and 5 months the financial crisis inflicted a level of pain I hope I don’t see again in my career.

In behavioral finance, saliency helps explain investor bias. If an event has occurred recently the prospects of it happening again seem much more profound. If it’s been perhaps a decade or more it’s a remote possibility. When I first started my career as a broker at Merrill Lynch in 1992, I couldn’t understand why investors would call me every fall looking to pull money out of the market as the anniversary of the 87 crash approached. Of course by 1999, now running money for Lehman no one was calling to sell, only to buy.

It hasn’t been quite 10 years but despite a toxic political climate and every corner of the planet seemingly a geopolitical hotspot, fear indicators like the VIX say investors have the constitution of a Navy Seal. The press whose motto is “if it bleeds it leads” tries to stoke the fear but at least with their wallets investors go into battle every day chanting “by the dip.”

Maybe the scariest thing about today’s complacency is not that we’ve forgotten events like the financial crisis or even the 87 crash. We’ve forgotten just how we felt and how paralyzed we were. In our minds eye we look at it dispassionately knowing just what we would do if the situation arose again. I’ve got my stops and my rules and my trusty Trade Station software to protect me like a .45 automatic in a  gun fight. Unfortunately, when the first shots are fired you’re probably going to shoot yourself in the foot.

“No battle plan survives contact with the enemy” – Helmuth von Moltke

The above applies to Wall Street too. We have plans, rules and decades of knowledge but the real skill is defined as the ability to change and adapt.

The next financial crisis will likely be caused by something we haven’t seen yet and very hard to predict, the very definition of a Black Swan. 

Talking heads including yours truly will refer to potential challenges for the market. Among them are the Fed’s unwind of a $4.5 Trillion balance sheet or North Korea fearing an attack is imminent, launches a strike on South Korea or Guam. Others point to political and fiscal failure in Washington or too much liquidity comes out of the system as central banks around the world follow the Federal Reserve. How about a good old fashioned flash crash as everyone heads to the exit while market makers walk away?

Chances are it’s none of these and we’ll be forced to adapt to a situation we haven’t seen yet. Knowing that is half the battle. Even more important is never forgetting it could happen tomorrow.