FRED GOODMAN'S KEY INDICATORS FOR INVESTMENT SUCCESS
Markets in Crisis: 1987
Tuesday, October 15, 2002
Fred Goodman
The Crash of 1987 and the subsequent recovery demonstrates the fine art of interpreting price/volume loops.

The stock market crash in October of 1987 has already acquired a mystique, a certain cachet that comes with time and which makes people speak of it in hushed tones. It is said that few people saw it coming and that it was over in just a few days.

It is used by the mutual fund hawkers as an example of why you should always buy and hold. "You see," they say, "there was no way to avoid it, and if you got out you would have missed the nineties."

Well, quite to the contrary, it was easy to see and there were definite signals both to get out and to get back in. The Dow Industrials had climbed from 1896 in December 1986, to just over 2700 by August 1987, a rally of over 40%. Before taking a vacation in Europe at that time, I sold almost everything I had. On the Thursday before black Monday, I sold the rest from a pay telephone in Paris. I was not as clever getting back in, unfortunately -- I waited until well into 1989.

Take a look at the rat's nest price/volume chart just below. The first thing to appreciate is that it took a very long time, almost a year and a half, for its effects to dissipate. Next, notice that it made a giant clockwise loop after it broke out of the bottom spiral and eventually crossed the upper part of the pattern. It is true that there was a one-day crash, but there was a 10% decline before that magic day, and the recovery took over a year --- it was not business as usual.

1987 -- The Big View

Now let's look at the market in the months before 508 point, one-day crash. The next chart reveals a pattern that moves from the upper left to the lower right, the bearish direction. That summer gave several warnings that all was not well.

1987 -- The Warning Through Friday, October 11th

Between August 14 and September 14 1987 there were two counterclockwise loops. Both were invalid, but they were followed by a nasty drop of over 5% in two weeks that ended with an invalid clockwise loop on very low volume. The pattern as a whole was again directed in the bearish direction from upper left to lower right. I think it is important to realize that not every loop will be just like the textbook. There will be failed loops on occasion, but when there are many of them in one direction or the other, give them the benefit of the doubt. Taken as a whole, there is no doubt that this is a bearish chart.

First Sign of Trouble Through Friday, October 11th

Here too, loops 1 and 2 are counterclockwise and number 3, though clockwise, closed to the downside and was invalidated by the remove one day rule. And certainly, the exit to the lower right was clearly bearish.

The Final Opportunity

The end of the decline was more classical than the beginning. After the bottom was reached at 1738.70 on October 19 (on a closing basis), there was a retreat on low volume. This is traditional after a decline, and what I expect to see now, in October 2002. Rallies that come just after a major decline and have a lot of volume behind them are usually short covering rallies and are usually quickly reversed. In 1987, it was not a short covering rally. Once the volume declined there were two tests of the 1738.70 bottom -- they are marked first test and second test and will be examined in detail below.

1987 -- Detail

The first test was a success, based on the fact that the market did not drop below 1738.70, but it was a failure based on the price/volume charts. It formed a counterclockwise loop, but it was invalidated by the "remove one day rule." The Dow then produced a counterclockwise pattern on still lower volume.

First Test

Here is the second test of the bottom. The market fell further than it did in the first test, but the bottom was not violated. The next chart shows this period with less clutter. It was the final bottom before the long tedious recovery that took a full year to complete.

Second Test

The chart begins at the blue circle. An invalid buy loop was completed following the successful test of the low. It is invalid because it disappears when the point is removed just under the arrow leading from "invalid buy loop." Next there was an invalid continuation buy loop, also because of the remove one day rule. These patterns were followed by no less than three 3-day clockwise loops, which of course are always invalid. Finally, there was a valid continuation buy loop and the market never came within 200 points of the bottom from then on. I think the important lesson to be learned from this analysis is that we cannot be too much of a stickler when it come to accepting bullish or bearish patterns. Even if they do not conform 100% to the textbook, if there are a large group of signals in one direction or the other, we must give them the benefit of the doubt, especially if there are other indicators pointing in the same direction.

Second Test Close Up

Fred Goodman, CFP, is a fee-only Certified Financial Planner based in Los Angeles. You can send him your questions and comments via email at Fred@MarketMonograph.com. The charts and commentary represent what Fred is thinking about the market and thinking of doing for his own account and for accounts he manages. There is no guarantee that you will profit from trading as discussed herein. You may lose money and Fred assumes no responsibility for what you do or do not do with this information.