Wednesday, April 22, 2009

How the RPF Model Explains October 19, 1987 (Black Monday)

U.S. and Global markets plunged on October 19, 1987 with the S&P 500 declining more than 20%. The cause of the decline has been much discussed with program trading often cited as the main culprit along with portfolio insurance (derivatives).

The application of the RPF Valuation Model to this period is very revealing. The chart below shows actual versus predicted S&P levels:



This second chart shows actual versus predicted PE Ratios, along with Treasury yields:



For more on underlying assumptions behind the calculations please see "The Risk Premium Factor: A New Model for Understanding the Volatile forces that Drive Stock Prices" (Wiley Finance) available on Amazon.  (http://amzn.to/jRHEAe )
Posted by Steve Hassett at 8:25 PM
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4 comments:

  1. Wow Steve, great stuff. Regarding your conjecture that interest rates reflect inflation, some feel the Fed contributed to the most recent bubble by keeping interest rates low while real inflation was occurring via excessive real-estate prices. I wonder if your model can be tweaked somehow to reflect actual inflation to "uncover" the recent bubble as you did with the 1987 data.

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  2. Actually that was Ken on the last post. My son hijacked my browser with his google acount.

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  3. The model uses actual inflation derived from TIPS (Treasury Inflation Protected Securities)after 2003.

    I agree that the decline in interest rates are a big driver of housing prices. If mortgage rates were 10% for 30 year fixed, you can afford to borrow about $115k per $1,000 of payments. At 6% the same $1,000 per month gets you $170k in borrowing. So on the same income, you can afford 47% more house.

    You might argue that this rise in home prices is not really inflationary since it does not increase the demand for more income.

    Regarding treasury controlling interest rates, in normal times, I don’t think they have much control over long-term rates, only short term rates. Today, they are buying notes themselves and that does drive down yields, but it has only been happening for the past few months.

    Thanks for reading!

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  4. That makes sense. Was just now reading about the Fed's recent note buying antics and whether it will work. Still I wonder about the use of TIPS as an inflation indicator. I would argue that home prices are inflationary as they seem to be reflected in regional salaries due to cost-of-living, which is largely influenced by housing costs.

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