The year 1987 is one that most stock market participants would probably rather forget. The stock market drop in the fall of that year shook the financial markets around the world and led to a lot of finger pointing as to what actually caused the global equity collapse. Many took the narrow view that various futures-related strategies, such as program trading and portfolio insurance, actually caused the selling panic. They reasoned that there didn't seem to be any economic or technical justification for the stock collapse. The fact that the equity collapse was global in scope, and not limited to the U.S. markets, would seem to argue against such a narrow view, however, since most overseas markets at the time weren't affected by program trading or portfolio insurance.
In Chapter 14 it will be argued that what is often blamed on program trading is in reality usually some manifestation of intermarket linkages at work. The more specific purpose in this chapter is to reexamine the market events leading up to the October 1987 collapse and to demonstrate that, while the stock market itself may have been taken by surprise, those observers who were monitoring activity in the commodity and bond markets were aware that the stock market advance during 1987 was on very shaky ground. In fact, the events of 1987 provide a textbook example of how the intermarket scenario works and make a compelling argument as to why stock market participants need to monitor the other three market sectors—the dollar, bonds, and commodities.
THE LOW-INFLATION ENVIRONMENT AND THE BULL MARKET IN STOCKS
I'll start the examination of the 1987 events by looking at the situation in the commodity
markets and the bond market. Two of the main supporting factors behind the bull
market in stocks that began in 1982 were falling commodity prices (lower inflation)
and falling interest rates (rising bond prices). Commodity prices (represented by the
Commodity Research Bureau Index) had been dropping since 1980. Long-term interest
rates topped out in 1981. Going into the 1980s, therefore, falling commodity prices
signaled that the inflationary spiral of the 1970s had ended. The subsequent drop
in commodity prices and interest rate yields provided a low inflation environment,
which fueled strong bull markets in bonds and stocks.
In later chapters many of these relationships will be examined in more depth. For now, I'll simply state the basic premise that generally the CRB Index moves in the same direction as interest rate yields and in the opposite direction of bond prices. Falling commodity prices are generally bullish for bonds. In turn, rising bond prices are generally bullish for stocks.
Figure 2.1 shows the inverse relationship between the CRB Index and Treasury
bonds from 1985 through the end of 1987. Going into 1986 bond prices were rising
and commodity prices were falling. In the spring of 1986 the commodity price level
began to level off and formed what later came to be seen as a "left shoulder" in a
major inverse "head and shoulders" bottom that was resolved by a bullish breakout in
the spring of 1987. Two specific events help explain that recovery in the CRB Index
FIGURE 2.1
THE INVERSE RELATIONSHIP BETWEEN BOND PRICES AND COMMODITIES CAN BE SEEN FROM
1985 THROUGH 1987. THE BOND MARKET COLLAPSE IN THE SPRING OF 1987 COINCIDED
WITH A BULLISH BREAKOUT IN COMMODITIES. THE BULLISH "HEAD AND SHOULDERS"
BOTTOM IN THE CRB INDEX WARNED THAT THE BULLISH "SYMMETRICAL TRIANGLE" IN
BONDS WAS SUSPECT.
Figure 2.1 shows that the actual top in bond prices in the spring of 1986 coin- -ided with the formation of the "left shoulder" in the CRB Index. (The bond market is particularly sensitive to trends in the oil market.) The following year saw sideways movement in both the bond market and the CRB Index, which eventually led to major trend reversals in both markets in 1987. What happened during the ensuing 12 months is a dramatic example not only of the strong inverse relationship between commodities and bonds but also of why it's so important to take intermarket comparisons into consideration.
The price pattern that the bond market formed throughout the second half of 1986 and early 1987 was viewed at the time as a bullish "symmetrical triangle." The pattern is clearly visible in Figure 2.1. Normally, this type of pattern with two converging trendlines is a continuation pattern, which means that the prior trend (in this case, the bullish trend) would probably resume. The consensus of technical opinion at that time was for a bullish resolution of the bond triangle.
On its own merits that bullish interpretation seemed fully justified if the technical trader had been looking only at the bond market. However, the trader who was also monitoring the CRB Index should have detected the formation of the potentially bullish "head and shoulders" bottoming pattern. Since the CRB Index and bond prices usually trend in opposite directions, something was clearly wrong. If the CRB index actually broke its 12-month "neckline" and started to rally sharply, it would b? hard to justify a simultaneous bullish breakout in bonds.
This, then, is an excellent example of two independent technical readings giving simultaneous bullish interpretations to two markets that seldom move in the same direction. At the very least the bond bull should have been warned that his bullish interpretation might be faulty.
Figure 2.1 shows that the bullish breakout by the CRB Index in April 1987 coincided with the bearish breakdown in bond prices. It became clear at that point that two major props under the bull market in stocks (rising bond prices and falling commodity prices) had been removed. Let's look at what happened between bonds and stocks.