Is it 2003 or 1987 on Wall Street?
John M. Moser
Pretend for a moment it's the summer of 1987, need a little memory jog? The hit song was "La Bamba" by Los Lobos. Steffi Graf won the French Open, Nick Faldo won the British Open and Tiger Woods was about to enter the 6th grade. "Moonstruck" starring Cher and "Wall Street" starring Michael Douglas were hit movies. Iran Contra hearings were airing everyday, the antidepressant "Prozac" was introduced and Alan Greenspan succeeded Paul Volckner to become the chairman of the Federal Reserve. Last but certainly not the least; the US stock market was experiencing its biggest rally since 1933.
From January 1987 until its peak on August 25, 1987, the Dow Jones Industrial average rose 795 points or 41%. The S&P 500 rose 37% and the NASDAQ 29%. Money was being made hand over fist on Wall Street and the euphoria was evident by the constant parade of bullish headlines in the financial press. The most noteworthy coming from the Wall Street Journal the day after the market peaked on August 26, 1987, "In a market like this, every story is a positive one. Any news is good news. It's pretty much taken for granted now that the market is going to go up." The masses were in the bull camp and any hint that things were about to unravel was only found in obscure articles and commentary from individuals like Jim Shepherd and Elaine Garzarelli whom correctly predicted a stock market crash of huge proportions was looming on the horizon.
First and foremost, the prices of 30 year Treasury bonds were declining. Yields began rising significantly in April of 1987, (higher yields equate to lower prices for bonds) and continued unabated right into the fall of 87' as depicted in the following chart:
Chart (A)
This in turn drove up long term interest rates and substantially widened the rate spread between short and long term Treasuries. In addition, the US dollar was in a freefall, losing nearly 21% prior to the crash and another 7% after. The following chart shows the major decline in the US dollar in 1987:
Chart (B)
Adding to the weakness in the US dollar, the trade deficit was growing larger thus driving up inflation. The deficit peaked at an all time high of 3.4% of GDP in the 4th quarter of 1987. Meanwhile, real estate was booming with annualized appreciation of over 10% for single family homes nationally, particularly in the northeast. In most regions residential real state prices nearly doubled from 1985. Meanwhile, a rally in gold and commodities was also ongoing during the same time period, quite striking given the immense upward move in the stock and real estate markets, (depicted in the chart below). However, to the keen observer, there were flashing red lights on the nation's economic dashboard.
Chart (C)
On August 25th, 1987 the DJIA closed at 2722 points, an all time closing high for the index. It would not be until December of 1989 that the Dow would close at that level again. From October 7th to October 19th, 1987, the stock market gave back 35% of its gains with 24% being lost on Black Monday, October 19, 1987. This chart of the DJIA clearly depicts the magnitude of the event which surpassed (in percentage terms on a daily basis) the October crash of 1929:
Chart (D)
Note: The Crash of 1929 while not as large the one in 1987, resulted in much lower stock prices months and years after the crash occurred whereas in 87', the market quickly recovered in the years that followed.
As with most financial markets, history usually repeats itself and a cursory glance at the stock market today has me wondering what year it is. At the time of this writing we are still in the midst of stock market rally that has taken the DJIA, S&P 500 and the NASDAQ up over 30% from the lows of last October.
Chart (E)
Complacency is high with sentiment reaching bullish extremes as measured by the VIX for the DJIA and the VXN for the NASDAQ. The VIX and VXN measure sentiment of the markets by gauging the ratio of derivatives being waged that profit when the market declines versus derivatives that profit when the market rises (puts and calls). In addition, bullish headlines abound in nearly every financial journal and magazine with most financial commentators, economists, analysts and fund managers succinctly bullish labeling the current rally as "the new bull market". Equity exposure is being increased by brokerage firms and day trading volumes and margin debt have increased dramatically. With the immense rally in stocks, P/E's, (price to earnings ratios) for trailing earnings has risen to 26 for the S&P 500, (a historical high). Just prior to the crash of 1987 it was at 22.
Chart (F)
However, in light of this stellar rally in stocks things are not so bright elsewhere. Just as in 1987, bonds have been getting slaughtered. As of today, the (30) year Treasury bond has dropped (17%) in price since June, its biggest one month decline since July of 1987, (as noted in the chart below.) Hence, it is not surprising as to why 30 year fixed rate mortgages have risen so dramatically recently-they are driven by the price of the 30 year Treasury bond.
Chart (G)
The gains of the last 14 months in the 30 year Treasury have been wiped out in just (4) weeks of trading and they continue to decline. In addition, the spread between short and long term Treasury bond rates has reached a distance not seen since 1987. Coinciding with the increase in yields in the Treasury bond market, the value of the US dollar has been declining steadily all year in the same percentage loss that occurred in 1987. In addition, the trade deficit has widened to its greatest level in our nation's history at nearly 41 billion dollars:
Chart (H)
If that similarity is not enough to make you wonder what year it is, note the following graphs for the US dollar in 2003 and compare it with the graph for 1987, (Chart (B):
Chart (I)
Last but not least, there are striking similarities in the commodities and real estate markets. The annualized price of single family homes has risen 12% this year in a majority of the northeast with most homes having doubled in price since 2000. Additionally, in 1987 gold and silver were gaining in price and the general commodities, as reflected in the CRB index, were in a strong bull market. This is also true in 2003 and is clearly visible in the following chart for the price of an ounce of gold:
Chart (J)
In summary, we all know what year it is, "Cheers" is not the primetime hit show and Oliver North is no longer the butt of Letterman and Leno jokes, however, the prudent investor needs to pay very close attention to the parallels between the 1987 and 2003 economic landscapes. The rally in stocks that began back in March has been based primarily on speculation and "hope" for a profit and earnings recovery in the second half of 2003; a "hope" that Wall Street has been touting for (3) consecutive years. Sadly, most investors are not reading much beyond the financial headlines. Companies have increased earnings by cost cutting, not by strong sales and revenue growth. This is the main reason it has been a "jobless" recovery. Companies are running leaner and capital spending (which creates jobs) is still contracting. The truth of the matter is most corporations, (as well as individuals and families) are saddled with excessive debt and thus pricing power has deteriorated which in turn crimps corporate profits. Hence, the most proactive thing people should be doing right now is becoming debt free and preparing for the financial storm that is brewing. While some may call me a fool for taking you on this trip down the memory lane of 1987, it is my belief that the current rally on Wall Street is doomed. The magnitude of the rally has not taken the stock market above the downtrend trading channels that have been in place since the market peaked in January of 2000. Hence, the DJIA, S&P 500 and the NASDAQ will likely make new lows this fall and it is my hope that investors take the necessary precautions before the next downturn in the markets ensues.
John Moser is an individual investor in the equity and bond markets and is not affiliated with any financial Institution. He can be reached at jmoser37@comcast.net. This article cannot be reprinted without the written consent of the author.
17 August 2003
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