Lessons from the 1987 Stock Market Crash

“Finding fault with others, developing skill at discovering weakness and inconsistency in others, will begin to eat into your peace of mind.  If you keep it up forever, it will eventually rob you of all the joys of life.”  —James Mangan
I plead guilty to finding fault with others.  I hope that some day I will rise above this pettiness and enjoy all the joys of life.  But that day has yet to dawn!
Musing #1338: In response to my critics who claim I defamed either Bush or Obama by referring to them as criminals, I rest my case on one simple fact.  That simple fact is that corn ethanol sponsorship and subsidies are blatant criminal behavior.  On balance it hurts the environment (mainly because ethanol cannot be piped and must be transported over land, and also because growing corn requires toxic waste-producing fertilizers in large quantities).  Clearly it hurts the non-affluent people all over the world who have to pay higher prices for the basic staples in their diet.  It drives the prices higher all along the food chain.  In return a few (mostly large corporate) farmers get rich.  Because both Bush and Obama consider the Iowa Caucus critical to their elections they have abandoned any pretense to principled behavior and sold their souls for a few votes.  I view that as criminal behavior.
The best commentary on The Bernank's appearance at Congress I saw on TV today was simply that old statement:  "Do you know how you can tell when Ben Bernanke is lying?  His lips are moving."  That is the whole story.

I learned many lessons from my experiences subsequent to the 1987 stock market crash.  Dena and I were vacationing on Maui at the time.  I had with me the fictionalized biography of Jesse Livermore, Remembrances of a Stock Operator, which, during that period, I had made a practice of reading every other year.
I went to work at Montgomery Securities at the end of 1982 which was a very fortuitous time to enter the investment banking business.  I flourished as an institutional stockbroker.  I actively traded my own account, used options, margin etc.  I profited in the bull run but was always a market timer at heart.
In '87 I turned bearish near the August highs and did well playing the short side in the ensuing decline. However, I turned very bullish again right before the crash, as I concluded the correction was over.  I headed to Hawaii on the Friday before the crash long stocks on margin and long some OEX calls that I bought just before I headed out the door for the airport.
Monday was a memorable and depressing day for me.  Not only did I absorb huge losses in my account, it appeared that the brokerage business was going to be a disaster going forward and my income was likely to take a big hit.  Most pundits thought the stock market crash presaged a coming depression.
I had a good friend, a retail broker (Charlie–May he rest in peace) who actually got me started in the investment game, whom I called over and over on the Tuesday and Wednesday after the crash to see if I could figure out what was really go on and how I could salvage my precarious financial situation.
The Livermore book was chock full of useful lessons.  Livermore had gone broke and recovered to make fortunes time after time.  The lesson that struck me as most important was that if one is eclectic in his markets and able to rationally sort things out; there was almost always "the right trade to make".
After Dena persuaded me not to swim out to sea and drown myself, the first thing I did was liquidate my long stock and option positions and move into cash in order to get a fresh start.  That was necessary to clear my mind and try to be objective.
My cash was limited but I was determined to make a winning move.  Two things went up on the day of the crash, bonds and gold and the related equities.  It seemed to me that the implications of a stock market crash were deflationary not inflationary so I thought the knee jerk reaction into gold was "wrong". I had been bearish on gold since 1982 but had mostly left it alone.  I took my limited resources and bought as many puts on ASA and Homestake Mining (the two major gold stocks of that day) as I could afford.
As it turned out that was a great move.  In a couple of weeks my puts did well, and I scaled out have doubled, tripled, or even quadrupled my money on the sales I made until I was again back in cash.
This was very important for two reasons.  First, I now had increased capital with which to work, and secondly I got my confidence back.  Confidence is a critical commodity for any and every speculator!
After having read tons of commentary and having looked at many statistics concerning both the economy and the stock market I came to the conclusion that the crash was a "one-off" event, with portfolio insurance having poured oil onto a fire so that it got totally out of control.  I wrote a 13 or 14 page paper presenting my views which I sent to select clients and friends.  As it turned out I was correct.
I remember talking to our S&L analyst about a small S&L that had, prior to the crash, agreed to a $13 takeover by Great Western SB, one of the two large and dominant S&L's in California.  The stock was then trading at $5.50.  The analyst, Joe Jolson, said that in his opinion there was virtually no chance the deal would not close.  I thought he was correct and I made a (relative to my capital) a huge investment in the S&L and was richly rewarded when the deal closed.
There are many reasons I chose today to recount the above.  The point is not to prove I am a great trader or speculator, because if that was the case I would have bought OEX puts, not calls, when I left my office and made millions instead of losing most of my liquid net worth.
The main point is that at even given time there are always opportunities for the serious investor, trader, or speculator if only he or she is able to step back from the daily blather and try to gain some perspective on where we are at and what presents the best risk/reward at any given time.
A number of markets may be reaching very critical points.  I want to take a look at the longer term outlook.  Most of the time the long term seems easier to forecast.  Once we put the long term in perspective then perhaps I can gain some insight in to the intermediate and even short term.
There are only two conclusions I feel confident about to state they are almost bullet proof.  Everything else is more "iffy".
First, I am convinced that during the current decade we will see the price of gold price reach at least $3000 per ounce.  That would be a minimum target.  It could go much much higher.  $10,000 is not out of the question.  The reason I believe this to be the case is that it is clear the Fed and the US Government are committed to a course of guaranteed debasement of the currency.  The math is compelling. The US government will never be able to meet its obligations in terms of defense, entitlements, debt, and operating expenses from the revenue it generates.  Since it is out of the question to declare a "default" the only alternative is the debasement of the currency.
In the past I have written that we are not and will never be a basket case like Zimbabwe.  I still hold that conviction, but I am not nearly as certain as I once was.  Actually, we will never be a Zimbabwe, but we are clearly heading down the road of emulating the banana republics which have devalued their currencies using one means or another.
I keep coming back to complicating factors which differentiate the dollar from banana republic currencies.  First, the US currency is liquid and the world's reserve currency.   Second we have a military presence all over the world.  These factors create uncertainties which I cannot even begin to conceive of how to unravel.  I do believe that China is going to accumulate huge gold reserves in the coming years as they ease out of dollars and US debt instruments.  The gold market is relatively thin,  When an 800 pound gorilla like China moves in a thin market like this and has a large appetite to accumulate gold reserves the effects are quite profound.  This is incredibly bullish for the secular bull market.  How this will interplay with the relative strength or weakness of the dollar, I do not know.  But it is one of the reasons I am so bullish on gold and less certain about the relative strength of the dollar.
Even if the OMB uses very optimistic assumptions for revenues and interest rates there is no hope.  The US government structure is built on a gigantic Ponzi scheme.  There is no other way to do the math.  The Emperor has no clothes!
Given the above data and conclusions, the second thing about which I feel highly confident concerns the interest rates on 30 year bonds.  Bonds will see yields in the double digits again during this current decade.  If you have the ability to do so, I would advise my younger readers to buy a home and get a 30 year mortgage.  It is the best "synthetic short" available to those who buy my forecast.  It should be a home one intends to occupy for many years, because if rates skyrocket it will become difficult for new buyers to obtain financing.
Note that it may take years for the price of gold and the interest rates on the long bond to reach those levels.  Over the short to intermediate term anything is possible.
Until a couple of weeks ago I had turned short term  and intermediate term bearish on gold and the mining stocks.  I am now short term bullish on both but my conviction is shaky.  I want to see how they act in the coming weeks.  I am long GDXJ but I have one foot out the door.  As I have often noted I have no intent to sell my physical gold and silver.  If gold should correct towards $1100 or $1000 per ounce I might decide to put up to 50% of my liquid net worth in physical ownership of precious metals.  I will take it one step at a time.
Gold has been in a 10 year bull market.  Despite that fact, practically no one owns physical gold and investors have minimal exposure at best to the precious metals.  What is astounding is that gold corrected a mere 7% and sentiment became incredibly negative.  This has given me pause to reconsider my intermediate term bearishness.  I repeat, I will take it one step at a time.
I have been standing on the sidelines with respect to the long bond.  I missed a great trade in TBT.  I would not be surprised to see a bottom near term in the long bond as sentiment has gotten very bearish.  When I first got involved in the markets, in the 70's, long term bonds were dismissed as "guaranteed certificates of confiscation of wealth".  I believe we will see history repeat itself.
Today the long bond hit new lows for the move.  A very successful government auction on the 10-year resulted in a turn around and strong rally in the 30-year.  I remain agnostic.
I do find it scary that the Fed is buying bonds to the extent that the Fed know is the largest holder of US treasuries, having exceed the holdings of either China or Japan.  Ponzi Scheme anyone?
Long term I think almost all fiat currencies are headed towards their intrinsic value, which some say is zero.  I don't think they will go to zero, but they will likely lose 1/3 to 90% of their purchasing power this decade.  Almost everyone hates the dollar.  From everything I have read and concluded I think the dollar has a lot more going for it than the Yen and Euro, and for at least the intermediate term I will remain long the dollar versus those two currencies.
Of course, everyone wants to know where stocks are headed.  I have been incorrectly bearish.  Stocks were in a secular bear market from 1966 until 1982.  On a nominal basis losses of 40 to 60% were seen.  Adjusted for inflation it was a debacle, as in real terms investors lost 75 to 90% of their purchasing power.  That secular bear market lasted for 16 years.
Japan has been in a bear market since 1989, 21 years.  NASDAQ has been in a bear market for more than 10 years.  Midcaps have recently made an all time high.  The Dow and S&P are somewhere in the middle.  I am fairly agnostic about the stock market.  For 2011 I would say the odds  are now appear favorable for an up year.  But that is not a call I in which I have any confidence.
There is a very long cycle comparing the cost of an ounce of gold to the nominal price of the DOW.  Twice during the 20th century the price of the Dow equaled the price of one ounce of gold.  I believe that we are headed in that direction again.  In the past I thought they would likely cross at about 4000.  Now I am thinking it might happen at 10,000 or even higher.
For over 30 years I have been fascinated by the stock market.  I have studied a very wide variety of tools which, in the past, have proved useful in forecasting future stock price behavior.  Based on what I see today (Wednesday February 9, 2011) I cannot ever remember seeing a market which seems more set up for a substantial move down.  Tool after analytical tool is shouting "short this market, short this market".  Unless the market has changed its DNA, which I do not entirely rule out, the odds that the next 5 to 15% move will be down as opposed to up appears to me to be about 8 to 1.  But this market continues to defy odds, logic, and traditional tools of technical analysis.
If you are a serious market student you will understand why I made the above statement.  If you are not, it will make no sense to you anyway.
Soon Cisco will report earnings and everyone will know exactly what to do!
All the best,