Is This 1987 All Over Again? What’s Driving the Market Meltdown?

Financial markets are supposed to capture the wisdom of the crowd, but on Monday the crowd ran in all directions waving its hands in the air screaming. Japan’s stock market fell the most in 37 years with a 12% plunge that wiped out all its gains for the year, while in the U.S. the VIX index of implied stock volatility briefly had its biggest rise ever. Panic hit.

The selloff was triggered by Friday’s jobs data prompting a sudden switch in the economic narrative from soft landing to hard landing. Add to the mix a period of deflating hype about artificial intelligence and a Bank of Japan rate rise designed to strengthen the yen. News that Warren Buffett’s Berkshire Hathaway had sold half its Apple shares and boosted its cash pile added to the pain.

But the triggers couldn’t possibly justify the scale of the moves. When a new trigger arrived, in the form of better-than-expected data on the service sector, markets partially rebounded and the Vix fell sharply — again, far more than the data could justify.

The selloff—which at one point had chip maker Nvidia down 15%—was so big because investors had been all-in betting that things would work out well. Now things have calmed a bit, the question is whether the unwind of these bets, and the leverage behind them, is done. If it resumes, will the selloff feed back into higher savings and a weaker economy or, worse, hit the financial system?

The extreme examples of past effects from big market falls are 1987’s crash, 1998’s Long-Term Capital Management blowup and 2008’s global financial crisis. History is never perfect, but so far this looks more like a (much milder) version of 1987 than it does the other two.

In 1987, the stock market had its biggest one-day fall ever, with the S&P 500 down more than 20% on Black Monday in October. Investors had built up excessive leverage after a stunning 39% gain in the year to August’s high, and the crash led both to big margin calls and to badly designed automated trading that exacerbated the selling. But the Federal Reserve poured liquidity into the banks, brokers didn’t default and the market made back all its losses within two years. The economy was fine.

The good news was that 1987 was all about markets: They went up, they went back down, no one else was hurt. The S&P made 36% in the eight months to its August 1987 peak, similar to the 33% it rose in the eight months to the end of June this year. As in 1987, this year’s gains came in spite of tight monetary policy and higher bond yields. Just like today, in 1987 investors were on edge and ready to sell to lock in the unexpected profit. The losses are smaller so far, but lucrative trades have reversed , just as they did for the market as a whole in 1987.

In 1998, the situation was much worse, although stocks recovered more quickly. Highly levered hedge fund LTCM was crushed when Russia’s domestic debt default created a flight to safety. LTCM was big enough that it threatened to bring down Wall Street institutions. The Fed cut rates three times and pulled together a group of banks to rescue the firm and wind down its trades slowly. Stocks took just four months to recover, but the easy money helped stoke the dotcom bubble, which popped two years later and led to a mild recession—and gigantic losses for investors in tech stocks.

We don’t know yet if any hedge funds have been taken out by the big moves in markets, which have brought heavy losses for those engaged in the “ carry trade ” of borrowing cheaply in yen and buying higher-yielding currencies such as the Mexican peso or dollar. Large swings in Treasurys on Monday might also have hurt, given the large positions hedge funds hold. Traders are betting that the Fed will slash rates, with a super-sized cut of 0.5 percentage points priced into futures for the September meeting (and far more earlier in the day).

The really bad outcome would be a repeat of 2008, but it seems highly unlikely. True, some large U.S. banks failed last year, due to bad bets on government bonds. But banks are much less leveraged than they were, and the system is less exposed to a liquidity crisis, as private lenders have taken on much of the risk that used to sit in banks. Big losses are entirely possible, and private funds could hit trouble, but that would take time and wouldn’t create the same system-wide crisis.

The ideal would be that excess in the stock market unwinds as in 1987 without creating wider trouble, hopefully more gradually than in 1987. AI enthusiasm could deflate stock prices much more—even after falling 30% from its June high, Nvidia has still doubled in price this year. But the market is already much closer to normal, with Monday’s falls leaving the Nasdaq 100 index up only 6% this year, and the S&P 7%.

If panic continues to abate, the Fed cuts and nothing breaks in the financial system, we should count ourselves lucky. But it would be good if investors could remember the sinking feeling they had on Monday morning, and try to be a bit wiser and less speculative.

U.S. investors’ enthusiasm over Japanese stocks at this time last year turned out to be misplaced, but the market is again on the list of potential ways to diversify. Corporate shake-ups, hints of inflation after years of declining prices, and a trade battle could work in its favor.

Japanese stocks started 2024 off strong, but an unexpected interest-rate increase in August by the Bank of Japan triggered a sharp decline that the market has spent the rest of the year clawing back. Weakness in the yen has cut into returns in dollar terms. The iShares MSCI Japan ETF , which isn’t hedged, barely returned 7% last year, compared with 30% for the WisdomTree Japan Hedged Equity Fund .

The market is relatively cheap, trading at 15 times forward earnings, about where it was a decade ago, and events on the horizon could give it a boost. Masakazu Takeda, who runs the Hennessy Japan fund, expects earnings growth of mid-single digits—2% after inflation and an additional 2% to 3% as companies return more to shareholders through dividends and buybacks.

“We can easily get 10% plus returns if there’s no exogenous risks,” Takeda told Barron’s in December.

The first couple months of the year could be volatile as investors assess potential spoilers, such as whether the new Trump administration limits its tariff battle to China or goes wider, which would hurt Japan’s export-dependent market. The size of the wage increases labor unions secure in spring negotiations is another risk.

But beyond the headlines, fund managers and strategists see potential positive factors. First, 2024 will likely turn out to have been a record year for corporate earnings because some companies have benefited from rising prices and increasing demand, as well as better capital allocation.

In a note to clients, BofA strategist Masashi Akutsu said the market may again focus on a shift in corporate behavior that has begun to take place in recent years. For years, corporate culture has been resistant to change but recent developments—a battle over Seven & i Holdings that pits the founding family and investors against a bid from Canada’s Alimentation Couche-Tard , and Honda and Nissan ’s merger are examples—have been a wake-up call for Japanese companies to pursue overhauls. He expects a pickup in share buybacks as companies begin to think about shareholder returns more.

A record number of companies have also delisted, often through management buyouts, in another indication that corporate behavior is changing in favor of shareholders.

“Japan is attracting a lot of activist interest in a lot of different guises, says Donald Farquharson, head of the Japanese equities team for Baillie Gifford. “While shareholder proposals are usually unsuccessful, they do start in motion a process behind the scenes about the capital structure.”

For years, money-losing businesses were left alone in large corporations, but the recent spate of activism and focus on shareholder returns has pushed companies to jettison such divisions or take measures to improve them.

That isn‘t to say it is going to be an easy year. A more protectionist world could be problematic for sentiment.

But Japan’s approach could become a model for others in this new world. “Japan has spent the last 30 to 40 years investing in business overseas, with the automotive industry, for example, manufacturing a lot of the cars in the geographies it sells in,” Farquharson said. “That’s true of a lot of what Japan is selling overseas.”

Trade volatility that hits Japanese stocks broadly could offer opportunities. Concerns about tariffs could drag down companies such as Tokio Marine Holdings, which gets half its earnings by selling insurance in the U.S., but wouldn’t be affected by duties. Similarly, Shin-Etsu Chemicals , a silicon wafer behemoth that sells critical materials, including to the chip industry, is another potential winner, Takeda says.

If other companies follow the lead of Japanese exporters and set up shop in the markets they sell in, Japanese automation makers like Nidec and Keyence might benefit as a way to control costs in countries where wages are higher, Farquharson says.

And as Japanese workers get real wage growth and settle into living in an economy no longer in a deflationary rut, companies focused on domestic consumers such as Rakuten Group should benefit. The internet company offers retail and travel, both of which should benefit, but also is home to an online banking and investment platform.

Rakuten’s enterprise value—its market capitalization plus debt—is still less than its annual sales, in part because the company had been investing heavily in its mobile network. But that division is about to hit break even, Farquharson says.

A stock that stands to benefit from consumer spending and the waves or tourists the weak yen is attracting is Orix , a conglomerate whose businesses include an international airport serving Osaka. The company’s aircraft-leasing business also benefits from the production snags and supply-chain disruptions at Airbus and Boeing , Takeda says.

An added benefit: Its financial businesses stand to get a boost as the Bank of Japan slowly normalizes interest rates. The stock trades at about nine times earnings and about par for book value, while paying a 4% dividend yield.

Corrections & Amplifications: The past year is expected to turn out to have been a record one for corporate earnings in Japan. An earlier version of this article incorrectly gave the time frame as the 12 months through March. Separately, Masashi Akutsu is a strategist at BofA. An earlier version incorrectly identified his employer as UBS.

Is This 1987 All Over Again? What’s Driving the Market Meltdown?

Past routs offer lessons after Black Monday Morning