Is 2013 Headed for a 1987 Crash?

Schaeffer's Investment Research
  AUG 07, 2013 4:00 PM

Although there are some similarities between these two years, there are also some major differences.

 


One common theme I keep hearing is that 2013 looks a lot like 1987 and is due for a 1987 style crash. Well, I don’t agree -- and here’s why.

First off, I do see some cracks and some more weakness (5% pullback or so) could definitely happen over the coming weeks. But I just don’t see the big crash so many are expecting playing out.

The main reason this year is like 1987 is because we are up "a lot." Well, that is true, but this isn’t as much of a match as most probably think.

As you can see below, as of August 5, this is one of the strongest years ever. Still, 1987 was up significantly more. In fact, the Dow (INDEXDJX:.DJI) was actually up nearly twice as much in 1987 as it was this year. Then, check out the returns for the rest of the year, after the big starts. Other than 1987, most are firmly higher.



The other big difference between 1987 and 2013 is what the masses are doing. You see, following the crowd can be a dangerous game and we have two drastically different "big" trades playing out.

Let’s turn back the clock to the period ahead of the 1987 crash. Back then, "portfolio insurance" or dynamic hedging was the rage, whereby players had concluded they did not need to hedge or buy puts in advance of a market decline – they would instead buy their protection when and if the market weakened and would add to that protection on further weakness. Of course, the net result of the dynamic hedging mentality was an exacerbation of market weakness as everyone scrambled for protection at the same time – in other words, it was the lack of a protection trade that was the precursor to the crash of 1987.

Plus there was a huge bubble in selling put premium, especially on the S&P 100 (INDEXSP:.INX). It was believed that put selling was a form of minting money, as the market would keep rising for years to come. Of course, these put sales (which were essentially bets that there would not be a crash) wiped out many traders in the October decline and exacerbated the crash.

Compare that with today’s "big trade" of buying volatility to hedge against potential market losses. Now, everyone is protected from a crash, thus lowering the odds of it actually happening. VIX (INDEXCBOE:VIX) call options and the action in the VXX have simply been phenomenal the past few years. Not surprisingly, we’ve been greeted with a low volatility world for going on over two years now.

This doesn’t look like it is about to change anytime soon, as just yesterday we saw over 1.1 million VIX call options trade – an all-time record!



That’s my take on the whole "2013 is just like 1987" debate.

This article by Ryan Detrick, CMT, was originally published on Schaeffer's Investment Research.

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