This is a fascinating comparison between the 1987 market and where the market currently stands. Depending on the data we can draw many similarities between markets but there are some key points that are brought up in the post below. This is courtesy of FactSet…

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Last week, I detailed the various factors leading up to the stock market crash of October 19, 1987. As we approach the 30-year anniversary of Black Monday, are there signs that the bull market of 2017 could end in the same way? Let’s compare the financial, economic, and political factors now and then to paint a better picture.

The U.S. stock market is currently in the ninth year of a bull market. As of close September 13, the S&P 500 is up 11.6% since the beginning of 2017 and 269% since March 9, 2009, the beginning of the current bull market. Through its peak on October 5, 1987, the S&P 500 was up 35.5% year-to-date, capping off a five-year bull run, during which the index surged by 220% (starting August 12, 1982).

Inflation, Interest Rates, and Monetary Policy

One of the key factors leading to the 1987 crash was soaring inflation. However, the inflation situation in 2017 is vastly different from what the country was experiencing in 1987, when prices doubled over the course of a year. Today there are worries that inflation is too low; year-over-year monthly inflation has averaged 1.3% for the last five years.

Similar to 1987, the Fed is in tightening mode, having instituted three rate hikes in the last year. The difference today is that rate hikes are an effort to normalize monetary policy following the near-zero rates necessary after the last recession, rather than an attempt to combat soaring inflation. While higher interest rates have a mostly predictable impact on the economy, there is considerable uncertainty concerning the unwinding of the Federal Reserve’s $4.5 trillion balance sheet. In order to help the economy recover following the Great Recession, the Fed purchased bonds as part of its quantitative easing program (dubbed QE). QE had the same impact as lowering interest rates, but with the Fed funds rate close to zero, the central bank needed an additional monetary policy lever. Now that the process of raising interest rates has commenced, the Fed has dropped several not-so-subtle hints in recent months that it would begin the process of selling off its bond portfolio, likely this year. So the question is, what impact will this have on bond markets?

The answer is that no one really knows because such a massive bond sell-off has never occurred before. A cursory internet search will uncover articles that rank the impact anywhere between a yawn and absolute calamity. Former Fed chair Alan Greenspan has warned of a bond market bubble, so there are fears that unloading fixed income assets into the market could send bond prices crashing and yields soaring. The Fed has stressed that the unwinding process will be gradual, occurring over the course of several years, and be implemented largely by allowing maturing assets to simply run off. In the wake of Hurricanes Harvey and Irma, the odds of another Fed interest rate hike in 2017 have fallen, but it remains unclear whether the timing of the balance sheet unwinding has changed. There is also the risk that the European Central Bank and the Bank of Japan could begin unwinding their QE assets, which could compound the impact on global bond markets.

Soaring Earnings and Low Market Volatility

Similar to 1987, P/E ratios today are soaring. According to monthly data from Nobel Prize winning economist Robert Shiller, PhD, the S&P 500 P/E ratio rose from a low of 7:1 during the 1981-82 recession to a high of 18:1 right before the 1987 crash. Since bottoming out at 13:1 in early 2009, the Shiller P/E is now at 30:1. At this level, the P/E is just below the peak of 32:1 seen just before the market crash of 1929, but not quite as high as the 44:1 seen just before the dot-com bust of 2000-2002.

In addition to high P/E levels, many market observers today are concerned about ultra-low market volatility. The CBOE Volatility Index (VIX) is a popular measure of expected volatility for the S&P 500. Historically, the VIX average is 19.5, but so far this year, the index has averaged 11.5, having fallen below 10 occasionally over the last four months. Some analysts warn that low VIX levels are a sign of market complacency, and some research indicates that periods of extremely low volatility often precede market crashes.

Political Events, Then and Now

Similar to 30 years ago, we are seeing a weakening U.S. dollar, and its value remains a highly politicized issue.

In 1987, the value of the dollar was closely monitored by government officials, especially vis-à-vis the Japanese yen, as Japan accounted for roughly one-third of the total U.S. trade deficit. On October 14, 1987, after the release of worse-than-expected trade deficit figures, Treasury Secretary James Baker publicly suggested that the dollar needed to depreciate further; the Dow fell by 3.8% that day, beginning a four-day decline that ended with Black Monday. According to the Fed’s broad trade-weighted dollar index, as of October 1987, the dollar had weakened by 11.8% from its peak in March 1985 following the 1985 Plaza Accord.

In 2017, although the dollar remains strong by historical standards, we have seen a depreciation of about 9% since the beginning of the year. As noted in part one, a weaker dollar leads to higher inflation (which would actually be a desired outcome today), but the lag time of the price impact is difficult to predict. Today, the Chinese yuan is the focus of government attention, since nearly half of today’s merchandise trade deficit is with China. During the 2016 presidential campaign, then-candidate Donald Trump accused China of deliberately weakening its currency in order to boost exports. Shortly after taking office, Trump backed off from promises to label China a currency manipulator.

The dollar actually strengthened significantly following the U.S. presidential election, surging to a 14-year high on a trade-weighted basis by the end of 2017. The post-election surges in the dollar and the stock market reflected optimism for the implementation of fiscal stimulus under the new Trump administration. But as 2017 has progressed, the lack of movement on health care legislation, tax reform, and regulatory changes (on top of strong economic performance in Europe), has weighed on the dollar, but not so much on the stock market.

Ongoing legislative delays in Washington could continue to negatively impact the dollar and may at some point affect equities. In addition, a battle over the debt ceiling still looms. The U.S. avoided a September government shutdown with a deal this month that would extend U.S. borrowing authority through December 8 and provide $15 billion in relief funds for areas impacted by Hurricane Harvey. This means that discussions about the U.S. debt ceiling have been delayed by a couple of months, and there will be more uncertainty as we approach year-end.

There are two other areas of political risk, both revolving around U.S. international relations. Rising tensions with North Korea have resulted in higher market volatility in recent months, and the prospect of the U.S. pulling out of NAFTA is a negative for U.S. stocks.

As the analysis of 1987 showed, no single event can be blamed for the crash that occurred on October 19, 1987, rather a confluence of factors and events caused a rapid erosion in market confidence. The same can be said in 2017. No single factor indicates conclusively that a stock market correction is imminent, but the risks are out there and merit continued attention.