What can we learn from the 1987 stock market crash?

Today’s financial markets have many resemblances to those around October 1987. We devote this newsletter to a mini study on this event and see what we can learn from it. 

The 1987 stock market crash

First, let’s review how the markets have behaved at that time. Interested readers can refer to this wiki for more detailed background information. 

As many public existing mutual funds didn’t exist at that time, we chose whatever that we have in our database as the representatives for the following 4 major asset classes: 

Note, ^TNX represents the 10 year Treasury note’s interest rate. Thus, its price is the inverse of its interest. 

From the chart above, we can see

• Both US stocks (VFINX) and International stocks (PRITX) had risen for a while before the crash
• US REITs (STMDX) had been relatively flat
• Interest rate of the 10-year had been rising, meaning the bond price had been falling.
• After the October crash, stocks continued to lose in November, but it recovered back some in December. However, S&P 500 actually had a positive 5.25% total return in 1987!

Or simply put it, the stock market crash in 1987 is a perfect storm: all major risk assets had been doing well while bonds were declining (or interest rates were rising). 

Today, the consensus of the cause of the crash is the so called  portfolio insurance or program trading.  The so called ‘portfolio insurance’ strategy calls for extending more exposures to stocks if stocks are rising (or whatever the rising assets) and reducing exposure when the asset price is declining. This was implemented using mechanical programs that made exposure adjustment frequently (daily). 

‘Portfolio insurance’ is a momentum strategy, a very popular strategy that is almost semi-high frequency (because of its automated daily adjustment feature) at that time. The major difference lies in the fact that the Tactical Asset Allocation (TAA) adjusts its portfolio allocation monthly or at a longer time interval while the ‘portfolio insurance’ is much more frequent. The other major difference that will be discussed shortly is the risk profile set up by the TAA.

Trend following (or momentum) tactical asset allocation strategy can not avoid the crash

From the chart above, one can see that leading to the October 1987, all of the major risk asset classes (US stocks, international stocks and US REITs) were clearly in an uptrend. The decline started gradually and then from October 14, it had a series of non-stop declines, leading to the largest decline on October 19. On the other hand, the long term bond didn’t give any warning: its price kept declining until October 19, a perfect synchronized (or correlated) act between stocks and bonds. 

A TAA portfolio such as P Relative Strength Trend Following Six Assets or Six Core Asset ETFs Tactical Asset Allocation Moderate would had been fully invested in risk assets in October, thus subject to the loss caused by the crash. It wouldn’t be able to react to the sudden and  synchronous decline (or rise in terms of bonds). 

Proper risk profile or risk level is the key to limit the loss to your comfort level

So what we can draw from the above study is that both Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA) can not escape from the crash. This tells us it is paramount to set up a proper risk profile for your portfolio, regardless whether it is an SAA or TAA. 

To refresh the concept of risk profile, it is a percentage number that an asset allocation portfolio should at least  put at any time. For example, a risk profile 40 means:  

• For an SAA, 40% of the portfolio is in bonds or cash all the time.
• For an TAA, 40% or more of the portfolio is in bonds or cash all the time. 

We have found many our users are still confused with the risk profile, especially in a tactical portfolio. A tactical portfolio can dynamically invest in various assets based on the prevailing market conditions. It is possible at some point of time, all or most of the portfolio can be in cash or bonds. However, without a risk profile limitation (or risk profile 0), a tactical portfolio can invest all of its capital in risk assets if these risk assets have been doing well. 

The consequence of putting all or most of a portfolio’s capital in risk assets is that during a sudden decline like the 1987 crash, the portfolio will suffer from a large loss, a loss that you might not expect and what is worse, you can not withstand. 

On the other hand, if you have a proper risk profile setup, you would be ok even during the crash. For example, say your risk profile is 40 (a moderate level), your portfolio would have been in 60% stocks and 40% cash entering October in 1987. This is because for the 40% fixed income, since bonds had been declining all year long, the tactical strategy would have put the 40% to cash instead of bonds. 

What that means is that during the crash, you only suffered 60% of the stock loss instead, or about 60% of 22.61%, i.e. 13.57%, on October 19, 1971, a level presumably you should feel comfortable with. 

So, we urge everyone to understand and setup a proper risk profile. Note that on other hand, a way conservative risk profile can limit your investment gains. So ‘proper‘ is the key. 

Today’s environment

Today’s environment bears many resemblances to 1987:

Many have started to warn about this similarity (for example, see Marc Faber’s CNBC interview). As many might have known, we do not claim to be an expert nor we claim that we can forecast the future with accuracy. However, with weak fundamental and excessive optimism (for example, see the AAII’s survey), we feel that it is important for our users to understand the current risk. Especially important, utilizing the current good market conditions to adjust your risk level if you have not done so. 

Note that we are certainly not forecasting a 1987 style stock market crash is imminent. However, what we would like to point out is the weakness of the strategies we are using and caution our users the possible risk so that we can be well prepared one way or the other. 

Portfolio Performance Review

Here are some Lazy Portfolios performance comparison (as of 10/28/2013):

See latest detailed comparison >> 

All of the portfolios have done comparably well, other than the permanent portfolio (PRPFX). It is no surprise that in a good market, a rising tide raises all boats. 

Market Overview

As bond markets continued to recover, REITs also recovered and now showing somewhat renewed strength. We still see that commodities are weak. Emerging market stocks are still a major concern: without their participation, it is hard to imagine how far the markets can go. For more detailed, please refer to  360° Market Overview. 

We again copy our position statements (from previous newsletters): 

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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