Tomorrow marks the 30-year anniversary of the 1987 stock market crash when U.S. shares plunged over 20% in a single day. The 1987 crash was blamed on a new innovation in financial markets at the time—portfolio insurance. Since the crash, controls have been put in place to prevent sharp one-day declines in markets, but risks remain.
Volatility strategies that have been adopted by many investors have characteristics similar to those of portfolio insurance and market structure has shifted. Index-based ETFs that are bought and sold by investors with little regard for the value of the underlying holdings are now a dominant force in markets.
The FT outlines a number of other similarities between today and 1987.
No two market eras are alike, yet the “buy the dips” mentality — something that has been stronger than ever on Wall Street this year — is only one of a number of striking parallels with 1987. After hitting a succession of fresh all-time records, valuations are stretched. Now, as then, the US is engaged in sabre-rattling with foreign foes, including Iran. Trading strategies designed to protect investors could end up exacerbating any correction, just as in 1987, while regulators could be as ill-placed to monitor risks as they were back then.
“There are similarities, and lots of them,” says Rob Arnott of Research Affiliates and the global equity strategist at Salomon Brothers in 1987, although he does not expect severe market turbulence in the near future.
The biggest red flag is the most obvious: US stocks look historically expensive. The cyclically adjusted price-to-earnings ratio kept by Yale economics professor Robert Shiller is at levels topped only by the peaks before the dotcom bubble burst in 2000 and the Great Crash in 1929.
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Jeremy Jones, CFA
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