A friend sent me a note a while ago (I’ve been on the sidelines with covid for almost a week–better now, though) from Albert Edwards, a perma-bear, Europe-based strategist, opining it feels like 36 years ago in world stock markets today.
my memory of 1987
1987 was my ninth year in the stock market and my third as a portfolio manager, after six years as a securities analyst.
Black Monday, when stocks in the US fell by 22% in one day and closed on their lows, was October 19th, 1987. It’s hard to communicate how big a shock this was. I’d spent the morning at my son’s nursery school before heading to work, so I missed a lot of the excitement. One of my work colleagues, though, was so shaken by the day’s decline that he had a panic attack on his way home, was hospitalized for an extended period and was unable to touch a portfolio again. Retail investors fared particularly badly, because overwhelmed brokerage offices were unable to field more than a fraction of their clients’ panicked sell orders. There were enough instances of irate customers shooting (yes, with guns) their brokers–or if not their broker, at least someone in the office–that guards at the front door were common for months after.
Four things, plus a note, that I think are essential to understanding what happened in back then:
–prior to the crash, 10-year Treasuries had been trading for months at around a 9% yield (the benchmark back then in the US was the 30-year, which was trading at 10%), while stocks were trading at 20x eps, or a 5% earnings yield (an academic measure, but still a useful rule of thumb, that tries to equate stock/bond valuation levels). Just before the crash, the long Treasury, a less risky instrument than a stock, was producing guaranteed income that was almost double the implied “yield,” or return-as-a-share-of-company-earnings, that the holder of an S&P index fund would receive. This is a gigantic, and extremely unusual, valuation discrepancy. (Today, in contrast, the yield on long Treasuries is 4.8% and the earnings yield on the S&P 500 is about the same, implying both asset classes are in a similar valuation ballpark–the big flaw in the Edwards assessment.)
–the dollar was weakening against the yen and against European currencies, leading to fears that US interest rates might have to rise to keep foreign holders of Treasuries happy. That would be bad for any dollar-denominated investment
—dynamic hedging, something that’s a commonplace today, was in its infancy and being experimented with in the pension fund world. The idea, formulated and executed by academics (usually a bad sign), is to enhance a portfolio’s value by wrapping it in an actively-traded layer of derivatives whose deft trading will reduce overall losses and enhance gains (deft-trading academics???). The deeper problem was that apparently everyone had assumed there’d always be in infinite stream of dumb money willing to take the other side of the trades. On the Friday before Black Monday, however, buying in the derivatives market dried up to the point where the dynamic hedgers–all/mostly market neophytes– were unable to sell stock index futures at theory-determined prices. Over the weekend, they apparently decided that they were so far behind the curve they had to sell futures on Monday, even if the price were below what their theory required.
–in addition, early Monday morning before the open, at least one a major domestic pension fund (GM?) decided to sell a very large chunk of its stock holdings.
In the face of potentially massive selling in the cash market and in derivatives, buyers did what common sense would suggest. They disappeared, or became sellers themselves.
The result was chaos. Worst of all for retail investors, phone lines to brokers soon failed to function. Whether this was because they were overwhelmed or because brokers unplugged their phones is unclear.
—note: selling in the US quickly moved into the rest of the world. Many foreign markets at that time, especially less well-developed ones, had limits of, say, +/-5%, on how much a stock was allowed to rise or fall in a given day. The idea was that this would short-circuit any declines and give time for cooler heads to prevail. During the 1987 crash, this “protective” device had the opposite effect. After four days of limit down/no trade, a stock would end up being 20% lower and no one would have been able to sell a single share. This scared the wits out of people. Most affected exchanges quickly removed the limits and allowed prices to move down to the point where buyers emerged. There, order was quickly restored. For the few that didn’t, the ultimate declines were larger and the market disruption lasted longer.
As it turned out, the US stock market began to rally the following day. About six weeks later the indices returned to the lows, bounced off them and began to rise again–and the crisis was over.