1987 Déjà Vu And The Dragon King Trade

On a crisp October morning thirty-two years ago, a young Wall Street trader began his daily commute into the city.

It was a day that would begin like any other, but end quite differently.

The day was October 19th, 1987.

A day on Wall Street where fame and fortune were both made and lost in a single day.

Today, it’s simply known as “Black Monday.”

New York Times


And as that historic day unfolded that left the majority of Wall Street bloodied, battered, and broke…

Our young trader went on to acquire both fame and fortune, making between $70 and $80 million for his firm that day… including a single trade which turned a small $10,000 options bet into a one-day, $17 million windfall.1

That young trader was Nassim Taleb of “Black Swan” fame.

And Taleb wasn’t alone in acquiring fame and fortune that fateful day…

Paul Tudor Jones made over $200 million in what soon became known on Wall Street as “the greatest trade of all-time.”

And while Taleb and Jones were making their reputations and personal fortunes, some of Wall Street’s richest and most successful traders were losing theirs…

The Birth of the Black Swan Trade and The Swan Song for The Turtle Trader

Richard Dennis, the famed “Turtle Trader” and “Prince of the Pit” at the Chicago Board of Trade, who had turned a borrowed $1,600 into a personal $200 million fortune, lost a reported $50 million and blew up his hedge fund which closed its doors within a year.

Famed investor George Soros’ $2 billion Quantum fund lost $600 million, nearly a third of its value.

The 52 market making specialist firms on the floor of the New York Stock Exchange lost nearly a third of their capital.

And America’s new, emerging billionaire class saw a similar fate as well…

Crash's Biggest Losers

The Greatest Trade in History: How Paul Tudor Jones Predicted the Crash of 1987

In the summer of 1987, prior to the October crash, Paul Tudor Jones was profiled by Barron’s where he unveiled a bearish prediction for the U.S. stock market.

Jones thesis was based on a model his research director Peter Borish had developed.

The theory behind his model was rather simple…

“If the market is a reflection of people’s behavior and people behave similarly in similar circumstances, then the history of market prices may give us an indication of what may happen in the near future.”

You see, Borish believed that while markets change, human behavior rarely does.

In other words, Borish believed that it would not be earnings, interest rates, or any fundamentals within the market or the economy that triggered the next market drop…

But a dramatic shift in herd behavior…

One where a small group of investors heading towards the exit turns into a rather large herd all heading for a very small exit door at the same time.

The “madness of crowds” if you will.

What Borish discovered was that the chart of the bull market leading up to the 1929 crash had eerie similarities to the chart of current bull market that had started in 1982.

And when overlaying the two charts atop one another, this is what he saw…

Dow Industrials

As the bull market of 1987 began to mature, the correlation between the two charts grew to 92.2%.

This near perfect correlation led Paul Tudor Jones to issue his now famous prediction based not upon identifiable deteriorating market fundamentals…

But rather a sudden shift in market psychology.

“There will be some type of a decline, without any question in the next 10-20 months. And it will be earth shaking. It will be saber rattling. And it’ll have Wall Street in a tizzy.

And it will create headlines that will dwarf anything that’s happened up to this point in time.

You’re talking about something with incredible fireworks, with unbelievable and unprecedented volatility.”

Jones was soon proven right as the Black Monday crash of October 19th, 1987, became the greatest one-day drop in market history.

And now once again, thirty-two years after the Black Monday crash of 1987, yet another ominous chart alignment has appeared…

One where the S&P 500 charts of 1987 and 2019 are now in perfect alignment, just as the charts of 1929 and 1987 were prior to the “Black Monday” crash.

Now before you dismiss this chart and the possibility of another historic market correction being imminent, consider this…

Nobel Prize winning economist Robert Shiller on the day after the 1987 crash, sent out questionnaires to both institutional and individual investors asking them about their behavior during the ’87 crash.

Shiller received over 1,000 responses.

And the results showed the crash was not predicated on negative news stories, or deteriorating market fundamentals, but rather purely psychological phenomena…

Just as predicted by Peter Borish and Paul Tudor Jones.

The Madness of Crowds

When respondents were asked: “Which of the following best describes your theory about the decline: A theory about investor psychology, or a theory about fundamentals such as profits or interest rates?”

67.5% of individual investors and 64% of institutional investors further validated Borish’s thesis, stating they believed the crash was about market psychology.

And when asked what major news stories they were reacting to during the day of the crash, the most popular stories were those about past price declines themselves, not fundamental news.

In fact, Shiller found that 35% of individual investors and 53.2% of institutional investors reported talking about the events of 1929 in the days leading up to the crash.

Here’s yet another observation that validates Peter Borish’s thesis…

A story told by the legendary Stanley Druckenmiller to Jack Schwagger in his 1988 book Market Wizards.

“That Friday after the close, I happened to speak to Soros. He said that he had a study done by Paul Tudor Jones that he wanted to show me. I went over to his office, and he pulled out this analysis that Paul had done about a month or two earlier.

The study demonstrated the historical tendency for the stock market to accelerate on the downside whenever an upward-sloping parabolic curve had been broken – as had recently occurred. The analysis also illustrated the extremely close correlation in the price action between the 1987 stock market and the 1929 stock market, with the implicit conclusion that we were now at the brink of a collapse.

I was sick to my stomach when I went home that evening. I realized that I had blown it and that the market was about to crash.”

Now, if you’re a member of that not-so-small group that dismisses stock charts and technical analysis as trying to read the future from tea leaves and chicken entrails…

Then consider this…

Because there’s one other key piece to the story behind Paul Tudor Jones’ confidence in his massive bet on the 1987 crash.

A part of the story that’s rarely been told and is now long forgotten.

It’s the one fundamental catalyst behind Jones’ confidence in putting on his crash trade…

U.S. Debt: The Ticking Time Bomb

In the 1987 documentary called Trader, which appeared on PBS, Jones explained his concerns about U.S. debt.

“The accumulation and then the repayment of debt basically drives every economic cycle that there is. And right now we’ve probably explored the envelope with regard to mortgaging our future earnings.

The next part of this cycle will be the repayment of what we’ve enjoyed now the last four, or five years.  We’re in the middle of the largest post-war business expansion cycle in history.”

Sounds familiar, doesn’t it…

Can you say 1987 déjà vu?

According to the Institute of International Finance, global debt hit $246 trillion in Q1, 2019, outpacing the rate of growth in the global economy as total debt/GDP rose to 320%.2

U.S. Debt has now reached $22 trillion.

And that number does not include the unfunded obligations to Social Security, Medicare, federal debt held by the public, plus federal employee and veteran benefits which now total $122 trillion.

Just days ago, President Trump signed a bipartisan budget bill which not only suspends the debt ceiling for two years…

It will increase spending by $320 billion while allowing the government to keep borrowing, even as the federal deficit approaches $1 trillion.

And according to the CRFB (Committee for a Responsible Federal Budget), the interest alone on our national debt will exceed the spending on Medicare by 2021, and national defense by 2024.3

Add in proposals like the Democrats’ “Medicare for All,” and you can add another $32 trillion over the next decade.4

Clearly, we are headed down a path that is unsustainable.

The Coming Paradigm Shift and The Dragon King Trade…

Ray Dalio, the founder of the world’s largest hedge fund (Bridgewater Associates), sees a coming “paradigm shift” in the markets.

Dalio says “investors are going to need to change their mindset about what will work after the longest bull market run in Wall Street history.”

A bull market run he sees about to come to an end.

So specifically, what will work in this new paradigm Dalio describes?

What will work is what I refer to as “The Dragon King” trade…

The “Dragon King” trade is a rather simple trade. It’s designed to provide maximum profits and protection during times of crisis, while taking on minimum risk.

So how does a “Dragon King” trade differ from Taleb’s “Black Swan” trade?

In his book “The Black Swan,” Taleb defines a “Black Swan” trade as this:

  • First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility.
  • Second, it carries an extreme impact.
  • Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.

Taleb’s “Black Swan” theory proposes that most major market events are unpredictable and extreme events are “fundamentally unknowable.”

While “Dragon King” theory proposes the exact opposite…

That most extreme events are actually knowable and to an extent, predictable…

While often being mispriced because they are ignored by the market.

And it’s this “mispricing of risk” that runaway bull markets often provide, which gives leverage to the “Dragon King” trade.

There are main two elements to our “Dragon King” trade.

The first, is the use of long-dated, deep out of the money put options on the broad market.

Option contracts that can be bought for pennies, which provide extreme leverage to major market volatility or crashes.

Think of it as “cheap insurance.”

Insurance that is often underpriced by uber-bullish, sentiment driven bull markets.

In simple terms…

It’s a trade in which you always hold a smallish (1% or less) portfolio position in long-dated, deep out of the money put options on the broad market.

This is the type of trade in which Nassim Taleb made millions for First Boston during the crash of 1987, and again during the “flash crash” of August 24th, 2015, where he made over $1 billion in a single week for Universa (the hedge fund he was working with as a consultant).

And that brings us to the second part of our Dragon King Trade…

Another form of “insurance” which has withstood the test of time for nearly 4,000 years…

Of course, I’m talking about gold.

And I’m not the only one…

Billionaire Ray Dalio, who is now warning of a coming “paradigm shift,” has famously said of gold…

“If you don’t own gold, you know neither history nor economics.”

And there’s Paul Tudor Jones, the man who executed “the greatest trade in the world,” into the face of the 1987 crash.

What’s Tudor Jones recommending today?

“If I had to pick my favorite trade for the next 12 or 24 months, it’d probably be gold,” he recently told Bloomberg News. “I think if it goes through $1,400 an ounce, it goes to $1,700…quickly. It has everything going for it in a world where rates in the US are conceivably going to zero.”

Even the “Bond King,” Jeff Gundlach of Double Line Capital, has jumped aboard the gold train…

“I am certainly long gold,” Gundlach said in an investor webcast on June 13th, adding his trade is based on the expectation that the dollar will finish the year lower.

And for those who can only shake their head in disbelief given the current state of politics in America, there’s this from billionaire Kyle Bass with perhaps the sagest advice of all:

“Buying gold is just buying a put option against the idiocy of the political cycle. It’s just that simple.”

And last, but not least… there’s Stan Druckenmiller, the guru to Wall Street’s gurus. The man who averaged over a 30% return for three decades on Wall Street. A trading legend who never had a single down year and only five losing quarters over that same thirty-year time span.

In June, Druckenmiller warned investors… “Get out of the stock market and buy gold.”

Back at The Whiskey Bar…

Here at the Whiskey bar we aren’t recommending you run for the exits and dump all your stocks in favor of gold.

Although, like a fine Kentucky bourbon fireside on a wintry night, we do love the warmth and peacefulness that gold provides…

But always in reasonable doses.

Also, taking some money off the table and raising some cash here is not a bad idea…

Maybe take a look at some of those far-outside the money put options. That type of “Dragon King” trade showed the ability to turn $10,000 into $17 million. Opportunities only come around so often.

And remember, the IEI (3-7 year U.S. Treasury ETF) did gain nearly 20% during the same time frame in which the S&P 500 lost over 50% during the 2008 financial collapse.

To be clear…

We are not predicting an imminent market collapse.

Nor are we trying to give “one size fits all” market advice, or advising specific trades.

That’s not our mission here at Whiskey & Gunpowder.

Our mission is to bring you outside of the box, often contrarian, and hopefully profitable ideas you can act upon as you determine your personal situation best warrants.

Let us know how we did…

We’re anxious to hear your feedback.

You can reach us at WhiskeyAndGunpowderFeedback@StPaulResearch.com.

Be safe out there…


Marty Robinson
For Whiskey & Gunpowder

1 Taleb Explains How He Made Millions On Black Monday As Others Crashed
2 Global Debt Hits $246 Trillion, 320% Of GDP, As Developing Debt Hits All Time High
3 US could spend more on servicing debt than defense by 2024: study
4 How Much Will Medicare for All Cost?

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