In the summer of 1987, the U.S. stock market was advancing for its 5th straight year following a historic low posted in August 1982. While some on Wall Street cautioned investors at that time that "valuations" were relatively high and that a "correction" was possible, and maybe there were a few credible pundits who were more bearish than most (i.e. Elaine Garzarelli & Joe Granville), I don't think there was anyone who predicted what actually happened between August 25, 1987 and October 19, 1987. In 55 calendar days, the Dow Jones Industrial Average fell 41.16% while the S&P 500 Index plunged 35.94%. More than half of these losses were sustained in a single trading session on October 19, 1987.
I was an index options trader in the giant OEX pit at the Chicago Board Options Exchange in 1987. The collapse on October 19th was monumental. The CBOE did not publish official VIX numbers until the early 1990's, but if the VIX was calculated on October 19, 1987, it would have been near 250.00! The official VIX closing price this past Friday, July 21, 2017 is just 9.36! Wow, quite a difference!
We've had almost 30 years to figure out what caused the Great Crash of 1987. While I have my own view about what happened on October 19th and the negative impact of the extraordinary opening delays and unprecedented 2nd rotation that morning prior to free trading in the OEX Index options, I think there is a general consensus that a concept called "portfolio insurance" contributed greatly to the Crash. The idea was simple: Rather than maintain normal "cash" reserves of at least 5% (as was historically customary), portfolio managers would aggressively allocate 100% of their funds to the stock market and then sell S&P 500 futures contracts against their investments if/when there was a significant correction. While each manager who followed this approach had a different exit plan, a typical exit plan might include hedging 2% or 3% of your portfolio with each 5% correction in the market. If the market fell another 5%, a portfolio manager would then sell another 2% or 3% in the futures market. If the market corrected 20%, you would then have effective "cash" reserves of 8% to 12% depending upon your individual exit plan. Sounds easy and it even made sense in a theoretical world. However, what if the market corrected more than 20% in a single day? Of course, this is what happened on October 19, 1987. Massive stop-loss "hedging" sales of S&P 500 futures were triggered by unprecedented declines in all major stock market averages that day which caused even greater selling in almost every individual equity share price which then caused even lower index prices. Crash!
Is there a lesson here? While some veteran market watchers are now warning investors again today about historically high (and unprecedented) valuations in the U.S. stock market, in my humble view no one is really talking about the potential root cause of the next possible market crash. In 1987, portfolio managers purposely "over-weighted" U.S equities in their portfolios because they incorrectly thought that they could easily hedge their equities with liquid stock index futures executed by a simple phone call (yes, you had to phone in your orders back then; there was very limited electronic trading available at that time). When the correction finally came in 1987, there were very few buyers and almost no real "liquidity"!
Today, I think we have a very similar problem. Index funds, by definition, HAVE NO CASH RESERVES! They are 100% invested !! Depending upon who you talk to, "passive" index funds represent about 40% of the total market valuation right now. If we also count "active" managers (with zero cash reserves) who are really closet "index" fund investors, I suspect there may be another 10% added to this 40% published estimate. If we also count "risk parity" hedge fund managers who are betting heavily on the continuation of "low volatility" price action in the U.S. equity markets, then we can probably add another 10% here.
Bottom Line: It looks to me like we have another "portfolio insurance" situation here today in the U.S. stock market that has an eerie comparison to the 1987 crash scenario. If my math is correct, then "effective" cash reserves that would be needed to cushion any significant stock market correction are almost non-existent. In fact, I strongly suspect that the same or similar open derivatives risks that contributed to the 1987 Crash (i.e. unhedged put option sales) are even more pervasive and dangerous today!
In terms of valuation, the Russell 2000 is now trading at 92 times trailing twelve months earnings. And if we believe the current estimates for this year's 2nd quarter by Thomson Reuters, earnings among companies in the Russell 2000 are expected to drop 8.3% year-over-year in the 2nd quarter just ended (which means that this 92x P/E is really higher and probably near 100x). The so-called "Forward 12-month P/E" is forecast at 26 times earnings (which is still historically high), but I just don't believe this number!!
Here are the latest charts of the Russell 2000 Index, which posted an all-time record intra-day high this past Friday. Buy and Sell Signals from my computer trading system have been automatically reflected. Please note the Daily Chart Sell Signal that was triggered at Friday's close, July 21, 2017.
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| Russell 2000 Daily Chart with Computer-generated Buy & Sell Signals |
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| Russell 2000 Weekly Chart with Computer-generated Buy & Sell Signals |
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| Russell 2000 Monthly Chart with Computer-generated Buy & Sell Signals |
