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Sunday, October 14, 2007

20 Years After Black Monday: October 19, 1987

As I write this, the stock market is near an all time record high just like it was on Black Monday in 1987. On October 19, 1987 (Black Monday) the US stock market fell 22% in a single day. Can do the market do the same now, twenty years later?

Circuit breakers and trading curbs should prevent another 22% single day fall that came from sellers wanting out at any price while buyers were nowhere to be found, but nothing is impossible.

Back in 1987, the Standard & Poor's 500 traded at over 22 times earnings while Treasury bond yields hit 10%. Today the S&P500 trades at about 18 times earnings and long-term treasury bonds yield less than 5%. The "Fed Model" (that I update each month in "Kirk Lindstrom's Investment Newsletter") says the earnings yield in a fairly valued market should be equal to the ten-year US Treasury Bond rate.

In 1987:
  • PE was 22
  • Earnings Yield = 1/PE
  • 1/PE = 1/22 = 0.0455
  • 0.0455 x 100% = 4.55%
  • 10-year Treasury = 10%
  • Over Valuation = 10% / 4.55% = 2.2

Today:

  • PE is 18
  • Earnings Yield = 1/PE
  • 1/PE = 1/18 = 0.0556
  • 0.0556 x 100% = 5.56%
  • 10-year Treasury = 4.68%
  • Over Valuation = 4.68% / 5.56% = 0.84

According to the very simple application of the Fed Model, the market was overvalued by a factor of 2.2 in 1987 and is under valued today by 16%.

To get more detailed monthly updates on the Fed Model and more, subscribe NOW and get the October issue of “Kirk Lindstrom's Investment Newsletter") for FREE!

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