One of the wonderful attributes of technical analysis is the ability to go back in history to view how prices performed and visually compare their traits with events that are happening today. The past performance of the financial market is never an indicator of future results, but we can learn from the past to avoid repeating mistakes. I think that the events that led up to the crash in October of 1987 strike a remarkable resemblance to events taking place today in commodities, bonds, the dollar, and stocks. If my analysis on the relationships among the financial markets in 1987 is correct, and it resembles our current situation, then it would be prudent to take steps to manage risk in a similar environment. Let's take a look at each of the major contributing factors to the 1987 crash and then compare these to the current markets.
A major factor in the late '80s was the manufacturing giant, Japan. Japan was able to use technology to automate their manufacturing and thus create a manufacturing superpower. Japan was importing all the natural resources it could so it would be able to churn out TVs, Walkmans, and computer equipment. Japanese cars were taking on more market share by the month. Japan's boom showed in their stock market's success. In 1987, the Tokyo Nikkei Average grew from 19k to over 26k in 6 months.
The S&P 500 grew from 180 in 1985 to almost 340 on the index in three years leading up to the October 1987 crash. Low commodity prices in 1985 and low interest rates fed the fire of economic expansion and stock growth. This began a wonderful trek in the stock market from 1985 up until late 1987. How did Japan's growth affect the rest of the markets? A trade imbalance widened, the dollar started falling, commodity prices rose, and interest rates started climbing.
A rising trade imbalance and low interest rates led to a falling dollar. The dollar fell from 160 on the dollar index to 90--perhaps for the same reasons our dollar is falling today: low interest rates and a large money supply in an attempt to stimulate export competition in favor of the US.
Commodity prices rose through 1987 as evidenced by the CRB index's push from 200 to 235 from March to mid-May. Commodity prices had bottomed in 1985 and didn't start to rise till 1987 based on a falling dollar and growing resource demand world-wide. Right behind the reversal in commodity prices was a reversal in bond prices.
Bond prices were rising through 1985 and leveled off in 1986. In 1987, bond prices began to fall, reaffirming the intermarket relationship between commodity prices and bond prices (as commodities rise, fear of inflation drives investors out of bonds). As bond prices fell, yields climbed higher than 10% by October. At 10%, investors generally have to reevaluate an income return of 10% in treasury bonds versus the inherent risk of investing in the stock market.
All of the events in 1987 (Japanese and US stock bubble, higher commodity prices, cheap bonds creating high interest rates, falling dollar) created the market crash in 1987. I would say the highest contributor had to have been a US government bond yield of 10%. How does the 1987 market crash resemble our current market today? You're probably already linking some of the traits I see in the market today: over-exuberance in the Chinese stock market, rising commodity prices, a falling dollar, and rising interest rates.
The Shanghai Stock Exchange Composite Index is up nearly 50% this year. China has begun to restrict capital this year through raising interest rates and margin requirements. The Chinese government is also allowing China's currency to float more versus the dollar. All told, if speculation doesn't calm down in the Chinese financial markets, it seems that their government will take the necessary steps to do it themselves. The Chinese market has weathered, yet again, another correction this year in May/June and we're not very far away on the current rally from May's highs. A double-top formation is still in the cards and could be dealt from the deck at any time.
Commodities have been rising based off of higher demand caused by global economic expansion and higher energy prices. Recently, the CRB index has remained fairly tame since the dollar has found significant support between 80 and 82 on the U.S. Dollar index. The Producer Price Index (PPI) was announced today, up 0.9% for May due to higher energy costs. Oil and gasoline continue to do well in the current environment and have outperformed the commodity index.
A Chinese market correction could pair back gains in energy thus far as investors anticipate demand destruction. Was there any demand destruction last year after the May 10th correction in the stock markets? No, but commodities sure fell on the speculation a correction would do just that.
On the other hand, it has been predicted by Evelyn Garriss of the Browning Newsletter -- a newsletter that covers climate, behavior, and commodities -- that the Atlantic will see 15 storms with two making landfall in the gulf oil producing areas. She believes that clear skies, warm waters, favorable winds, and thunderstorms drifting onto the Atlantic should bring about an active hurricane season. A strong hurricane season could disrupt supply and pressure natural gas, gasoline, and crude oil prices if a 2005 hurricane season repeats itself.
The dollar has found significant support near 80 on the dollar index but has recently cornered itself against a long-term bearish trend. It appears that rising interest rates have led to the recent strength in the dollar. It will take a few more days to iron out whether the dollar can push through the bearish trend and in doing so, bring further weakness to commodities.
All the buzz this week has been about falling bond prices. The higher rates caused by the fall in bond prices have helped shake stock investors a little and propped the dollar higher. Bond prices are oversold and a rally is a high probability from here. The head and shoulder pattern in the 30-year US treasury bond has resolved itself with a price target of 105 from the neckline at 110. Even with a yield over 5% in both the 30-year and the 10-year bond, we're in a period of relatively low interest rates. The problem, of course, is that the U.S. is a lot more susceptible to a housing market decline with a lot more double mortgages and a lot more adjustable rate mortgages today than in 1987.
The trend thus far this year has been an economic environment consisting of explosive growth in the Chinese stock market, rising commodity prices, falling dollar, and falling bond prices. Some of that looks to be reversing this month as the Chinese market has weathered a second significant correction. In addition, commodity prices (except for energy) have corrected and interest rates have made a break for higher ground. I feel that it's too soon to make any bearish or bullish predictions over stocks, commodities, or bonds. It does look however, that China's government is taking steps to apply the brakes to speculation in their stock market, and those steps could reverberate through commodity and stock prices.
Mark Twain said that history doesn't repeat itself, but it does rhyme. While today may not be repeating the '87 crash, this year is starting to rhyme like it.
Closing numbers:
Dow Jones Industrial Average--13553.73, up 71.38
S&P 500--1,522.97, up 7.30
NASDAQ--2599.41, up 17.10
Russell 2000--837.12, up 4.58
