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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!

3 comments:

  1. In 1987 the Dow had peaked in August and then began to drop. It had dropped about 15% before the October 19 crash. So the market had showed considerable weakness for a couple of months before the crash. Such is not the case today. So while anything is POSSIBLE, today's technical conditions do not resemble Octoberof 1987.

    ReplyDelete
  2. Thanks for the comment Dangib. I will try to get a chart for the market added to the article today. I have permission from Stockcharts to put charts in my blogs which should make the articles better.

    So we have two things in favor of a continuation of the bull market:

    #1 Fundamentals look great via the simple Fed Model

    #2 Technicals per your comment.

    One of my partners with The Retirement Advisor newsletter is now 50% short with his DOW timing system and looks to go 100% short if we see the market continue higher and the DOW transports don't confirm (plus many other things he covers in his newsletter) so not everyone agrees with "the bulls."

    ReplyDelete
  3. That's great, Kirk, because if EVERYONE agreed with us bulls, I'd start to worry a lot! :-)

    ReplyDelete

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