A Crash Course in History

What the market has done over the past week duplicates what happened in the one-day 1987 crash, when the Dow Jones industrial average plunged a record 23%. The week of October 6 through 10, Standard & Poor's 500-stock index plummeted 18%. Could past be prologue?

Through October 10, the S&P fell 42% from its record high exactly 12 months earlier. Since 1926, the average bear market has seen a plunge of just 38%. But what's really remarkable this time is how fast much of the damage has occurred. The S&P closed October 3 at a 24% loss from its peak. That was awful. But what followed was much worse. Since then, the S&P has lost almost as much as it lost over the entire previous year.

In 1987, the Dow peaked on August 25 at 2,722. Like other investors, I watched my investments fall in the weeks that followed. But the Dow was still at 2,508 on Tuesday, October 13 -- a loss of just 8% -- when the slide began in earnest. The Dow plunged 95 points on Wednesday, which was almost 4%. Thursday, it fell another 58 points, and Friday it lost 108 points.

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The big drop came Monday, October 19. It was a 508-point crash caused mainly by leveraged derivatives-portfolio insurance-which, ironically, had promised to insulate big investors from the risk of a sharply falling market. As Wall Street fell, portfolio insurance triggered selling in stock futures in Chicago, setting up a feedback loop. By the end of the day, many Wall Street firms weren't even answering their phones.

In other words, the 1987 crash was, like the current crash, caused by financial instruments. The exotic mortgage securities billed as low-risk by Wall Street's rocket scientists are far more complex, but ultimately they had the same kind of nonsensical thinking behind them: They ostensibly offered a way to leverage up to great returns with no risk.

On October 20, 1987, the financial markets nearly collapsed. Stocks simply didn't open for trading when the market did. No one was willing to buy. Ultimately, however, the market rallied, and October 19 turned out to mark the bottom of that bear market. There wasn't even a recession. In one and a half years, the market reached a new high -- and kept rising for another ten years. (The more broadly based Standard & Poor's 500-stock index hit its bear-market bottom on December 4.)

No way we're going to get off that easy this time. Housing prices still have to fall more to attract buyers; there's still a tremendous inventory of unsold homes. What's more, it's not clear that the government's Herculean efforts to resuscitate the credit markets will succeed. In this crisis, the credit markets are far more important than the stock market. And once the credit markets revive, there's the question of how deep and how long the recession will be.

At the same time, given the depth of panic in the stock markets, I think we may well be near the bottom. Of course, I can't be sure. Indeed, I thought it was time to buy several weeks ago. But the wisest hands I know among fund managers are all finding terrific bargains among the highest-quality stocks.

Ken Heebner, one of the savviest fund managers, thinks that hedge-fund selling is behind a lot of the recent selloff. That makes sense. With their lines of credit frozen, these highly leveraged funds have had little choice but to dump stocks.

Will this decline go on another six months? Another year? It's possible, of course -- and probable, if government rescue efforts fail to gain traction.

But I have little doubt that buying stocks when panic is so widespread will look like a wise move in a couple of years or less. For those who own stocks, it's way too late to sell. For those who can afford to invest more in stocks, I think this a time to do just that-as was October 19, 1987.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.