Anatomy of a crash: lessons from Black Monday

On Friday 16 October 1987, Martin Zweig, an academic, newsletter writer and latterly fund manager, appeared in his regular slot on Wall Street Week, a prime-time US investment show.

Asked by host Louis Rukeyser what he made of the violent trading over the previous week, which had wiped more than 10 per cent off the value of the Dow, Mr Zweig said he expected worse to come. In his words: “I haven’t been looking for a bear market per se, I’ve been really in my own mind looking for a crash.”

When the markets reopened on Monday, the crash came and Mr Zweig’s reputation as a market seer was sealed. The Dow plummeted almost 23 per cent on the day and the events of 19 October 1987 became part of investment lore. As Mr Zweig predicted, the damage was short-lived and the market actually finished the year modestly above where it started, although well below its high.

Mr Zweig’s Super Model – a market-timing screen he developed for “the weekend investor” and explained in his classic book Winning on Wall Street – had given a ‘sell’ signal almost exactly a month before the crash. While Mr Zweig’s more detailed models had actually been less bearish than the Super Model, he had been positioning himself and the readers of his top-ranked newsletter, The Zweig Forecast, for tough times by reducing equity positions and buying short-dated put options (an option to sell an index at a pre-determined future date and price). He made out like a bandit on the high-risk puts, making a weighted total return of 2,075 per cent. That was more than enough to cover losses elsewhere and leave him up 9 per cent after the crash and ready to profit from the recovery.

How Zweig spotted market tops and bottoms

While Mr Zweig passed away in 2013, Winning on Wall Street, published shortly before the 1987 crash, left clear instructions on how others could go about trying to spot market tops and bottoms. The most clear-cut indicator Mr Zweig shared with investors was his Super Model, which at the end of last week issued its first ‘sell’ signal in over a decade.

Like all great screens, at its core the premise of the Super Model is clear and simple. It is based on two factors that have been shown to have a strong and enduring historical relationship with share price movements: ‘value’ and ‘momentum’.

In the case of ‘value’, the screen is not interested in absolute valuation measures as there is little evidence extreme valuations act as a trigger for market movements, although they can often influence the size of market movements when they finally occur. Rather, the model’s ‘value’ focus is on interest rate trends (Zweig’s Monetary Model). Stock valuations tend to be anchored to interest rates because, all other things being equal, if the interest being paid by bonds rises, the only way for equity returns to remain as attractive as they previously were in comparison with bonds is for valuations to fall.

Put prosaically by Mr Zweig, the Model tries to apply two key rules: “Don’t fight the Fed” and “The trend is your friend”.

This model awards the market a mark from zero (extremely bearish) to 10 (extremely bullish). While the model can be used as a graduated indicator of bullishness or bearishness depending on its score, Mr Zweig’s basic rule was that the model moves to a ‘sell’ when it hits three or less and will move back to a ‘buy’ only when it hits six or more. It will then stay at a ‘buy’ until the score once again drops to three or less.

The Super Model is not some kind of crystal ball. Rather it attempts to insulate investors from the influence of market ‘noise’ by quantifying signals from the indicators that Mr Zweig found to be the most reliable guides to future market performance based on extensive historical research. In doing this, the model attempts to give a systematic assessment of how probable it is to be a good or bad time to be in the market. The model does not always get it right, and neither did Mr Zweig expect it to. However, on a number of occasions it has made astute calls, as it did ahead of Black Monday.

The Super Model was an attempt by Mr Zweig to simplify his more complex market-timing systems to make them “understandable and workable for the non-professional reader”, following the dictum of Albert Einstein: “Don’t make things simple. Make them simpler.”

The system was first set out in the 1980s and is therefore somewhat dated, especially as it does not factor in the exceptional monetary policy that’s become commonplace since the credit crunch. However, the extensive historical research Mr Zweig undertook to find out what factors really drive markets means his advice has a timeless quality.

While Mr Zweig’s Model relates to the US market, the City usually follows Wall Street’s lead. This is rarely truer than when bear and bull markets are in full flight. So Mr Zweig’s tips about how to play the US market should be regarded as highly relevant to UK investors and not just broad lessons, even if country-specific events, such as Brexit, can still sometimes create noteworthy differences.

“Don't fight the Fed”

The most important factor in Mr Zweig’s Super Model is recent policy moves by the Federal Reserve. In his view: “The major direction of the market is dominated by monetary considerations, primarily Federal Reserve policy and the movement of interest rates.”

There are two chief reasons it pays to keep a close eye on interest rates. Firstly, as discussed above, the rates set by the Fed act as an anchor on which equity valuations are based. Second, rising interest rates reduce the corporate profits that equities are valued against. This happens because rising interest rates lift the cost of debt, which makes indebted companies become less profitable. Tighter credit conditions can also lead to financial distress at troubled companies and increased bankruptcies.

The issue of interest rates and equity valuations feels highly pertinent at the moment given the high level of concern that valuations may be significantly overbaked. A popular justification for high valuations (the S&P 500’s current cyclically-adjusted price/earnings, or CAPE, ratio has only been exceeded during the dot-com boom and prior to the 1929 crash) is based on the argument that interest rates have found a lower long-term equilibrium level, which is currently coupled with benign economic conditions. This argument has held sway even as the Fed has started to ‘normalise’ monetary policy.

However, the market faces a major test of its faith in valuations when the Fed starts to unwind its quantitative easing (QE) programme. Many think QE has backstopped our current lengthy bull market. The process of winding down QE could start as soon as next month in the US. That said, the process is expected to be undertaken extremely gradually and the Fed’s level of conviction may prove weak if markets react badly, as was the case with the so-called ‘taper tantrum’ in 2013.

Mr Zweig’s Fed Indicator is the most important of three components to his Monetary Model (the exact rules for all the components of the Super Model are detailed in the box below). It focuses on the trend in changes to the discount rate set by the Fed, rather than the size of changes. He also used the reserve requirement in his model for the Fed indicator. The reserve requirement is a mechanism for controlling levels of lending by banks. However, this tool has not been used by the Fed for several decades. QE is not factored in to the Zweig model as it hadn’t been used at the time he was writing. However, given the way Mr Zweig viewed the reserve requirement, it seems fair to think he may have ascribed positive model points for ramp-ups in the QE programme and negative points for scaling back.

Mr Zweig was also interested in an interest rate very closely aligned with the discount rate. The so-called ‘prime rate’ used in his Prime Rate Model. The prime rate represents the interest charged to banks’ best customers. Part of Mr Zweig’s interest in this rate was based on its tendency to lag the discount rate. He said: “[A lagging rate] is exactly what an investor wants to keep his [or her] eye on, because changes in interest rates generally lead to changes in the stock market. An interest rate that moves a little behind other interest rates can often mark just that point when stocks finally begin to respond to the changes in rates.”

The final monetary indicator used in Zweig’s monetary model can be regarded in part as a sentiment indicator. Indeed, Mr Zweig did a lot of work monitoring market sentiment and kept check of about 30 different gauges, a number of which are detailed later in this article. However, the only nod to sentiment in the Super Model is the instalment debt indicator. That said, Mr Zweig states the importance of growth in instalment debt – loans with regular repayment terms, such as car loans – as being based on the relationship between demand for loans and the cost of loans (interest rates). However, when loan demand is high, and banks are willing to lend, this can also be an indicator of overoptimism. Again, Mr Zweig saw it as a bonus that this monthly data is reported with a delay of about one-and-a-half months.

“The trend is your friend”

Mr Zweig was a strong believer in paying close attention to market momentum. He felt investors should not worry about being slightly behind the market trend as there were far bigger risks from betting against it. In his words: “Big money is made in the stock market by being on the right side of the major moves. I don’t believe in swimming against the tide.”

There were a number of momentum trend indicators that Mr Zweig used, however, as far as the Super Model is concerned, he was interested in one simple indicator that he named the 4% Model. The Model is based on the movements of the Value Line index. This is an equally weighted index of about 1,675 US-listed stocks. The fact that the index is equally weighted (assigning equal significance to every share price movement regardless of company size) chimes with the importance Mr Zweig attached to the breadth of stock participation in market moves, which is evident from some of his other momentum indicators such as the advance/decline ratio.

The Model simply takes a 4 per cent rise in the index from recent lows to be positive and a 4 per cent fall from recent highs to be negative. The version of the Super Model that Mr Zweig outlined in Winning on Wall Street was based on the 4% Model using the Value Line’s weekly closes. He saw the plus side of using weekly rather than daily closes as “primarily its simplicity and the fact that you need not hover over a Quotron machine daily...  sometimes by examining too many trees, one loses sight of the forest – not a good idea”.

The right conditions for bull and bear markets

Mr Zweig’s study of stock market history underpinned a belief that at least one of three conditions needs to exist for there to be the danger of a bear market and that two conditions needed to exist for a market rising off its bear market lows to be the beginnings of a bull market.

Bear markets

Mr Zweig’s historic study of markets suggested at least one of three conditions needed to be present for a bear market to occur, which he defined as a market fall of at least 15 per cent. The only time he found all three factors present was in the 1929 crash. An extremely volatile period in the mid-1920s to mid-1930s is the only period Mr Zweig found that didn’t obey the rule. All the bear markets since he set out his idea have displayed at least one of these characteristics. Mr Zweig also noted that the presence of any of these conditions does not mean there definitely will be a bear market. The three conditions are:

1. Ultra high PE ratios. Mr Zweig observed “PEs in the upper teens or twenties generally reflect excessive speculation, gross overvaluations and poor future stock price performance.” This is the only one of Zweig’s three conditions that exists at the moment, and as it happens was the only one that existed in 1987. Some argue that due to a lower long-term average level of interest rates we have actually entered a “new normal” for equilibrium equity valuations that justifies the high PE. Mr Zweig said investors should not see high PEs as a danger if earnings have fallen heavily and are likely to rebound, which is often a case at the bottom of a bear market. Zweig’s exemption does not apply to the situation now.
2. Extreme deflation, which Mr Zweig said would be constituted by a 10 per cent decline in producer prices on a six-month average of annualised month-to-month changes. In this situation companies can’t charge higher prices and workers can’t command higher wages, leaving the economy in the mire.
3. An inverted yield curve (long-term bond yields lower than short-term bond yields). Mr Zweig measured the yield curve as the difference between six-month commercial paper and Moody’s Aaa corporate bond rates. More usually the yield curve is based on a comparison of the yield offered by different durations of government bonds (eg three-month, two-year and 10-year). When long-term rates are lower than short-term rates it is usually an indicator that the market thinks economic conditions will worsen in the future and thus require the Fed to loosen monetary policy in order to stimulate the economy. An inverted yield curve is also sometimes associated with excessive levels of inflation, which has resulted in the Fed aggressively hiking rates over the short term to get price rises down. Excessive inflation is generally considered bad for stocks.

Bull markets

Mr Zweig believed two ingredients needed to be in place for a bull market to take off. These are based on his belief that “if the tape can’t ignite, conditions aren’t right”.

1. An advance/decline ratio (see separate definition) of two-to-one over a 10-day period.
2. The Fed indicator (see separate definition) must have moved from zero or less to +3 or more, which will normally take at least two rate cuts.

Other indicators for investors' arsenals

While the advantage of the Super Model is that it gives clear 'buy' or 'sell' call that is relatively easy to calculate, Mr Zweig used a plethora of other indicators to judge sentiment and market movements. These are a selection of indicators he was particularly partial to and highlighted in Winning on Wall Street:

Put/call ratio

Early in his career Mr Zweig was very interested in the options market. While he decided that the extremely high risk of being totally wiped out by options trading meant it was not the potential road to riches he had hoped, he did invent an excellent sentiment indicator based on his studies of market behaviour. The idea is simply that the more people are using options to bet assets will go up in price, the more likely it is that markets will actually fall.

To make a judgement on misplaced bullishness, Mr Zweig looked at the volume of put options being bought (bets on price falls) against the volume of calls (bets on price rises). While there generally tend to be more calls traded than puts, reflecting the fact the market spends most of its time going up, Mr Zweig found that when the level of calls was very high compared with puts – leading to a low put/call ratio – investors were often ignoring risks.

Prior to the recent market ructions, the 10-day moving average for the put/call ratio was skirting around the bottom decile of its 10-year range, based on CBOE data. That suggests a fairly high level of optimism and complacency, which can be interpreted as being quite bearish.

Advisory sentiment

Another indicator Mr Zweig was very keen on was the survey of advisory sentiment conducted since 1963 by Investors Intelligence. As with the put/call ratio, he found this to be useful at extremes, and the same basic theory applies: extreme bullishness is dangerous and extreme bearishness can mark market bottoms.

The most recent weekly ‘bull-bear’ spread reported by Investors Intelligence stood at 40.5 per cent. This represented a fall on the reading of the previous two weeks, which was above 43 per cent. However, it also marked a fourth consecutive week above 40 per cent and can be interpreted as worryingly bullish. Investors Intelligence considers a spread above 30 per cent to show elevated risk and a spread above 40 per cent to call for stronger defensive measures.

Specifically – and rather scarily from the standpoint of this article – John Gray of Investors Intelligence has pointed to some distinct similarities between recent survey data and 1987. In the most recent weekly Advisory Sentiment report on 9 August, Mr Gray wrote:  “Overall, lofty bullish levels have held since late Nov-2016. Long-time investors recall similar data in 1987. History shows tops form slowly, often over many months, while bottoms can occur over a much shorter period of time.

“The bulls slipped back to 57.5 per cent from 60.0 per cent and 60.2 per cent in the prior two weeks. Those were again in the ‘danger zone’ that was last shown late Feb when the bulls hit a 30-year high at 63.1 per cent. Those are warning calls for defensive measures to protect profits. For a historical comparison, the bulls ended Jan-1987 at 64.6 per cent and then returned to 60.8 per cent that Aug after further market highs. Stocks crashed in Oct-87! The top signal from the advisor sentiment took nearly 10 months for its full effect.”

Cash-to-assets

As well as advisers, Mr Zweig looked to another group of financial professionals to give a contrary steer to where the market may be headed. He monitored how much cash mutual funds were holding. In theory, the more bullish fund managers become, the less cash should be held. Mr Zweig associated very low cash holdings with bullish markets.

As of the end of June, the Investment Companies Institute (ICI) records cash as a percentage of assets at 3.3 per cent. The ratio is currently lower than it was at the start of the last bear market. However, the cash-to-asset ratio has been running at a very low level for several years. This may reflect the confidence investors have placed in QE to support the market, but could also reflect increased use of passive, index-tracking funds. Indeed, results from Bank of America Merrill Lynch’s most recent global fund manager survey found cash levels at 4.9 per cent, which is above the 10-year average of 4.5 per cent.

The ICI itself actually advises that the cash-to-assets ratio should not be considered an indicator of sentiment about the equity market, either currently or historically, as asset managers hold cash or cash equivalents for a broad variety of purposes, including as part of their overall investment strategy. The ICI particularly points to the increased use of derivatives as a way to protect portfolios as an alternative to moving into cash. The organisation also suggests the self-fulfilling aspects of the ratio (ie if asset values rise while cash levels remain unchanged the ratio will fall) can muddy interpretations.

In his book Trading Secrets, Investors Chronicle’s Simon Thompson suggests a variant on this indicator, based on the amount of money flowing into mutual funds and ETFs. Again, the view is that very strong inflows are a contrary indicator of where the market is actually headed and should therefore be a cause for concern. Based on ICI data, net flows (inflows minus outflows, both of which tend to dwarf the net figure) have been very strong in the first half of 2017. Indeed, long-term mutual fund and ETF net inflows of $329bn for the first six months of this year represent 1.7 times the total for the past two years combined ($85bn in 2016 and $108bn in 2015). However, when it comes to US equity funds specifically, there have actually been small net outflows in 2017, albeit at a noticeably lower rate than in 2016. That said, many global funds invest a significant amount of their assets in the US.

Advance/decline ratio

Mr Zweig felt the breadth of stock participation in market moves gave a very important indication of the strength of momentum. A key indicator he used for this was the advance/decline (A/D) ratio, which measures the ratio of the number of stocks rising to the number falling on any given day. In particular, Mr Zweig believed an extremely bullish indicator was a 10-day period over which the A/D ratio was two-to-one, which is one of the two conditions he thought needed to be present to call the start of a new bull market.

While Mr Zweig put most focus on the A/D ratio as a bullish indicator, in Trading Secrets Simon Thompson highlights how this can be used to identify market weakness, too. By adding daily A/D ratios to each other an ‘A/D line’ can be created. When this line diverges negatively from an index it can signal that market performance is built on weak foundations and suggests a correction may not be far off. At the moment the A/D line is tracking the S&P 500, suggesting little cause for concern despite all the talk we have of the market being over-reliant on so-called FAANGs (Facebook, Apple, Amazon, NetFlix and Google – more recently renamed Alphabet). It’s worth noting, based on other measures of stock participation, that Simon himself has recently outlined concerns about the divergence of performance of stocks in the S&P 500. Meanwhile, many commentators have got very hot under the collar about the emergence of the so-called Hindenburg Omen – another variant on this theme.

Will the market crash?

The sad news is, no matter how loud and confidently pundits scream about where the market is going, there is almost certainly no way to accurately predict its future course. What investors can do, though, is systematically look at economic and market trends that have historically been associated with tops and bottoms. If enough of these indicators tell the same story then there may be reason to pay attention.

Mr Zweig’s Super Model is an attempt to succinctly capture this approach, and yes, it is looking bearish. As examined in this article, there are also several other indicators favoured by Mr Zweig that give cause for concern. Indeed, in writing this article is has been a ghoulish surprise to find the sheer extent of the warnings being given by the indicators Mr Zweig attached significance to. That said, the Super Model has not always been on the money, but it has had some noteworthy successes including the famous 1987 Black Monday call.

The model’s recent ‘sell’ signal, coupled with the backdrop of tightening monetary policy in the US, high valuations and so many other toppy indicators, makes it easier to understand why bears have recently been springing out of the woodwork with great roars at even minor signs of market weakness. And while concern about the combination of complacency, overvaluation and bull market longevity may feel such a familiar trio of bogeymen that it’s tempting to ignore them, it’s worth remembering there were plenty of warnings about the build-up of debt in 2007 and groundless valuations in 1999 before markets came a cropper.

The Zweig Super Model suggests the growls of the bears are well founded and the market could be set for serious falls if selling takes hold. Keep your hard hat in reaching distance, but we also shouldn’t forget that interest rates remain very low and the Federal Reserve tends to be highly in tune with, and sensitive to, the market’s needs.