The Storm Before the Stock Market Crash

A hundred-year October storm. One million people left without electricity. The Stock Exchange remains closed, but on the next trading day, sell orders flood the New York Stock Exchange, and the Dow (INDEX: ^DJI) drops 23% -- still the largest daily percentage decline. Could it happen again?

Technically speaking, the Great Storm of 1987, which ravaged Southern England on Oct. 16, 1987 -- the Friday that preceded Black Monday -- was not a hurricane, because it did not originate in the tropics. Nevertheless, hurricane-force winds were recorded in multiple locations. In fact, the Great Storm is thought to be the most severe windstorm to have hit the U.K. since 1703.

Here's the timeline of events.

Friday, Oct. 16
At 9 p.m. GMT on Friday evening, BBC News gives this account of the storm impact: "The power failures and the fact that so few City [London's financial district] workers made it to work meant that there almost no deals struck on either the Stock Exchange or the money markets. Most dealers took the opportunity to take an early and a long lunch."

If that conveys a degree of complacency, it is probably overstated: London traders cannot ignore what is going on in the U.S. market once it opens, as the S&P 500 (INDEX: ^GSPC) falls 5.2% for the day. Investors are clearly becoming edgy, and this shows up in equity option prices: The S&P 100 Volatility Index, a precursor to the VIX Index (INDEX: ^VIX) that tracks investors' expectations of future volatility in the S&P 100, jumps 31% to close above 36.

Monday, Oct. 19
U.K. share investors get their first opportunity to trade shares after Wall Street's poor performance on Friday, and they send the FTSE All Share Index (INDEX: ^FTSE) down 11.4%. The selling wave intensifies once it hits U.S. shores, and the S&P 500 declines 20.5% -- its largest-ever one-day decline. Volatility explodes: The OEX Volatility Index more than quadruples, closing higher than 150.

Could it happen again?
The likelihood that the market will experience even a 4% pullback tomorrow -- let alone a repeat of 1987 -- is very low. But "very low" does not equate to zero, and there are several factors that increase the risk that Hurricane Sandy and the market's two-day closing could be the catalysts for an unexpected stock market decline.

Persistent low volatility in stock prices -- both observed and implied -- of the sort we have witnessed during the second half of this year is not indicative of stability when it is coupled with persistent distortion in the pricing of risk assets (hello, Dr. Bernanke!). Consider that since the beginning of July, the S&P 500 has lost more than 1% on only four trading days (two of which have occurred within the last six sessions).

Current valuations don't offer protection against a significant price decline, either. If you assess the S&P 500 on the basis of trailing earnings or cyclically adjusted earnings (the 10-year average of inflation-adjusted earnings), stock prices were either similar to or lower than today's prices on the eve of the Crash of '87:

Source: Robert Shiller, author's calculations. TTM = trailing-12-month.

Would it matter?
Ask yourself: If the market were to drop 5% tomorrow, how would you react? What if the decline were 10%? Would you feel like selling stocks or would you be tempted to add to your holdings? For many investors, the natural reaction is to sell and thereby put an end to the discomfort of watching prices fall. However, what is natural may not always be rational -- or profitable. Investors who bought shares on Black Monday with an equity-appropriate holding period in mind ended up doing very well. Over the following five-year period, for example, the S&P 500 returned 13% annually -- and that's before factoring in dividends. That terrific performance is perhaps not all that surprising if one considers that stocks were not expensive even before their Black Monday haircut (see the table above).

Price vs. value
Which brings me to my final point: If you're an investor (not a trader) with an investor's timeframe, you cannot allow price movements alone to guide your investment decisions. Instead, you need a separate, stable yardstick against which to compare the prices on offer in the stock market. That yardstick is value. If you're confident the stocks you own are fairly valued (or even undervalued), that gives you the confidence to hold onto them even as you watch their prices go down. Better yet, you can add to your position or look for other bargains. That's exactly the mindset one of our top analysts adopted to zero in on a sector that has become a hunting ground for value and identify "The Stocks Only the Smartest Investors Are Buying."

The article The Storm Before the Stock Market Crash originally appeared on Fool.com.

Alex Dumortier, CFA has no positions in the stocks mentioned above; you can follow him @longrunreturns. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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