September 8, 2012

How could Paul Tudor Jones predict the Black Monday 1987 crash?

Ask someone who was interested in the stock market in the 1980s to mention a day they will always remember, and the person will answer the Black Monday of October 19 1987. What happened on that day was that the Dow Jones fell with 22.61 percent. It was a bad day for all investors - but not for all traders. One trader who actually predicted the crash was Paul Tudor Jones. We are here going to explain exactly how he did it - and how you may do it yourself in the future.

To be able to understand the events of the Black Monday, we need to understand what happened in the markets the days before the crash. The Dow Jones moved from 777 in year 1982 to 1700 in year 1986 - that's 119 percent in 4 years. From that point and to August 1987, the Dow Jones moved up to 2700 in nine months. So the market had moved up very fast in a very short time, so the valuations were too high. These types of rapid movements are called parabolic curves, as seen in the image below.

Parabolic curve. Source: Chartpattern

If we draw a similar curve on the chart from the events around October 1987, we will find the following:

Dow Jones 1982-1988. Source: Yahoo Finance

Here's a more detailed chart:

Dow Jones 1983-1988. Source: Yahoo Finance

We can clearly see from the charts how the move before the crash of 1987 was parabolic, and how the crash began when the last "base 4" trend-line was crossed. The stock market has an historical tendency to accelerate downward whenever an upward sloping parabolic curve has been broken. This is a similar chart to the chart Paul Tudor Jones had before the crash. The same thing had happened in a similar crash in 1929, and Paul Tudor Jones had compared the chart from 1929 with the chart from 1987. He didn't know exactly when the crash would begin, but he had a plan drawn up to use when the crash finally happened.

We are not exactly sure what kind of plan Paul Tudor Jones had, but we know how Paul Tudor Jones finds the tops and the bottoms of the market. He has a very strong view of the long-run direction of the market and a very short-term horizon for pain. To find the bottom of a market, you need to test the bottom several times, sell if you haven't found the bottom, and buy again several times until you have found the bottom. You will end up with several small losses - and a big profit when you have finally found the bottom. That big profit is now hopefully larger compared with the small losses. Back in 1987, Paul Tudor Jones probably sold short several times as the market moved up - trying to make money when the market eventually would crash. He accumulated several small losses, but when the market crashed, he made a large profit. His fund's return after October 1987 had ended was 62 percent, and the fund's return after 1987 had ended was 200 percent.

It's also possible to see from the chart that it was a good idea to buy when the price had reached the "base 2" trend-line. Of course, the price could have continued to the "base 1" trend-line, but it can be something to have in the back of your head as a rule-of-thumb, to be ready to buy when the price is close to one of the lower bases.

One other funny thing from the crash was that after the crash, the stock market was at the same levels as one year before. The companies were doing just fine, and it was probably a buying opportunity of a lifetime. The famous investor Peter Lynch was on a holiday in Ireland at the time of the crash and had to fly home to New York. He later said:
"The decline was kinda scary and you'd tell yourself, "Will this infect the basic consumer? Will this drop make people stop buying cars, stop buying houses, stop buying appliances, stop going to restaurants?" And you worried about that."