black monday

Published: Friday, October 19, 2007
If you are wondering why strategists, economists and journalists are making such a fuss about the 20th anniversary of the 1987 stock market crash, dubbed "Black Monday," the answer comes down to one word: nervousness.

Few investors would care about today's anniversary if stocks were mired in a bear market right now. Indeed, they would probably skip the anniversary altogether and wait another five years before taking a sober look back.

But with most major stock market indexes at or near record highs amid a slowing U.S. economy, soaring energy prices and a Chinese investment bubble, 1987 looms large.

Email to a friend

Printer friendly
Font:****Could a crash of that magnitude happen again?

It certainly looks like a hard record to beat. The Dow Jones industrial average defined the crash with its harrowing 22.6% one-day plunge, taking other world indexes down with it and creating fears of a global recession and a permanent change to the way investors look at financial markets.

True, there are a number of similarities between then and now. In 1987 and today, stock markets had enjoyed about five years of solid gains, the U.S. dollar was getting whacked, private-equity buyout firms were remarkably active and sophisticated investors were relying on computer models to give them direction.

However, the world is also a very different place than it was 20 years ago. The U.S. economy has shrunk in relative importance to the world thanks to the arrival of China, Russia and India, which means that trouble on Wall Street will not necessarily translate to trouble around the world. As well, bond yields are substantially lower, which gives investors a big reason to favour stocks over bonds. And some stock markets have built-in stabilizers.

But the biggest reason why 1987 will continue to stand as a record-breaking day is the simple fact that central bankers around the world have a far better understanding of markets than they did 20 years ago.

"There are a lot of people who believe it was really a function of mistakes made by the Fed in the summer of '87," said Mark Kamstra, a finance professor at the Schulich School of Business at York University. He is referring to the fact that the U.S. Federal Reserve raised rates to head off inflation prior to the crash and did not lower rates until after the damage had been done. "And I think they have learned from that."

Today, the Fed -- not to mention many other central banks --are largely on the side of the investor, quick to free up liquidity in times of trouble and often in remarkable co-ordination with one another. The response from central banks to this summer's credit crisis, including the half-percentage-point cut in short-term interest rates by the Fed, stands as a good example.

"I've never seen a co-ordinated, aggressive central bank action to that degree--not just by the Fed but by the European Central Bank and other central banks around the world," said Nick Majendie, strategist at Canaccord Capital, referring to this summer's actions.

Will stock markets continue to be volatile? You bet, and current concerns such as the U.S. dollar could easily create big problems in the months ahead. But as for nightmares like Oct. 19, 1987, the odds of a repeat look very slim. Three of the five best days the Dow Jones Industrial Average has ever experienced occurred within a single 10-day stretch: Oct. 20, 1987 (up 5.88%), Oct. 21, 1987 (up 10.15%), and Oct. 29, 1987 (up 4.96%).

But that was not a great week for investors. It came in the wake of Black Monday (Oct. 19, 1987) -- the single worst day in the Dow's history -- when, by 4:00 p.m. ET, the market overall became $500 billion less valuable. The Dow dropped 22.61% that day and followed it up a week later with an 8% drop -- the second largest single-day drop in history.

When the dust settled, the very bluest of blue chips had taken a bath. Wal-Mart (NYSE: WMT), General Electric (NYSE: GE), and Pfizer (NYSE: PFE) each lost 24% of their value in Oct. 1987.

We bring this up not only because today is the 20th anniversary of Black Monday, but also because the current investing landscape is strikingly reminiscent of that day. The term bubble is omnipresent. Corrections are predicted to be forthcoming, followed by opposing bullish predictions driven by fundamentals.

Bring on Black Monday?
So what's it all mean? Full disclosure: We're not sure it's possible to make much sense out of these conflicting short-term signals.

But whether Monday is going to be another "black" trading day or one of the best in history, we try to remember that there are only three things that matter when it comes to investing successfully:

The quality of the companies you buy.
The price at which you buy them.
The length of time you own them.
For those reasons, patient long-term investors should be eagerly awaiting the next Black Monday even more so than the next Microsoft or whatever.

Say what?
Let's face facts: There will be but a handful of the next great growth stocks, and the odds of picking just one are ... not good. But when the next Black Monday hits, hundreds of quality companies will suddenly become available at prices that all but assure success for long-term-minded investors.

That's what history has taught us. As Wharton Professor Jeremy Siegel wrote, there is one reason why Standard Oil was a better investment than IBM despite IBM's superior growth: "Valuation, the price you pay for the earnings and dividends you receive."

The most expensive book ever written
The Internet bubble was another painful reminder of that lesson. Our research showed that if you took a stake in each of the stocks highlighted in Greg Kyle's 100 Best Internet Stocks to Own when it was published in the spring of 2000, you lost 62% of your capital.

For a book that cost about $15, that hurts. While Amazon.com (Nasdaq: AMZN), TD Ameritrade (Nasdaq: AMTD), and 11 other companies simply earned a positive return, 18 names went entirely bankrupt.

The culprits? Quality and valuation. Many of these were poorly run and profitless companies that were nonetheless selling at stratospheric levels. But even well-run businesses Schwab (Nasdaq: SCHW) and Check Point Software (Nasdaq: CHKP) disappointed shareholders because they were simply priced too aggressively.

And that's the irony of the chase: You're far more likely to find the next big bust than the next big thing.

But that was seven years ago at the height of the "Tech Bubble." It's got nothing to do with today. Right?

Right?!
The Dow and S&P 500 are near all-time highs. We're seeing the media report on bubbles in China, India, and even in the tech sector again. But remember, just three things matter for a successful investment plan:

The quality of the companies you buy.
The price at which you buy them.
The length of time you own them.
If you insist on buying quality companies at good prices for the long term, it's tough to overpay even in a bubble.

Easy-peasy
We're not trying to make successful investing sound easy. It's not. It takes time, effort, and resources.

But successful investing is also not outside the realm of any person willing to devote some time, effort, and resources to building a brighter financial future. At Motley Fool Stock Advisor, Fool co-founders David and Tom Gardner have a stellar track record of recommending quality businesses at good prices. Their stock recommendations are beating the market by more than 40 percentage points on average since 2002.

You can see their five favorite stocks for new money now, as well as all past stock ideas and research, for free with a one-month guest pass. There is no obligation to subscribe, but we're confident the service can help make you a better investor.

Tim Hanson does not own shares of any company mentioned in this article. Brian Richards owns shares of Microsoft. Both Tim and Brian wear plaid on the outside 'cause plaid is how they feel on the inside. Amazon.com and Schwab are Motley Fool Stock Advisor recommendations. Wal-Mart, Pfizer, and Microsoft are Motley Fool Inside Value picks. The Motley Fool's disclosure policy is writing checks its body can't cash.