the stock market crash of 1987

The Wall Street Journal has an interesting article today on the birth of the ETF–and the index fund, for that matter.

Two factors stand out to me as being missing from the account, however:

–when the S&P 500 peaked in August 1987, it was trading at 20x earnings.  This compared very unfavorably with the then 10% yield on the long Treasury bond.  A 10% Treasury yield would imply a PE multiple on the S&P of 10x–meaning either that bonds were dirt cheap or that the stock market was wildly overvalued vs. the bond market.

–a new product, called at the time portfolio insurance, a form of dynamic hedging, had very recently been created and sold to institutional investors by entrepreneurs steeped in academic efficient markets theory.  Roughly speaking, the “insurance” consisted in the intention to stabilize equity portfolio values by overlaying a program of buying and selling futures against the physical stock.  Buy futures as/if the market rises; sell futures as/if the market falls.

One of the key assumptions of the insurers was that willing/eager counterparties for their futures transactions could be found at all times and at theoretically predictable prices.  On the Friday before Black Monday–itself a down day–the insurers’ model required them to sell a large number of futures contracts.  Few buyers were available, though.  Those who were willing to transact were bidding far below the theoretical contract value.  Whoops.

On Monday morning, the insurers, who appear to have had negligible actual market experience, capitulated and began selling futures contracts at whatever price they could get.  This put downward pressure both on futures and on the physical market.  At the same time, pension funds, noting the large gap between the price of futures and the (much higher) price of the underlying stocks, began to buy futures.  But to counterbalance the added risk to their portfolios, they sold correspondingly large amounts of stocks.  A mess.

Arguably, we would shrug off at least part of this today as just being crazy hedge funds or algorithmic traders.  Back in 1987, however, equity portfolio managers had never before seen derivatives exerting such a powerful influence on the physical market.  It was VERY scary.

conclusions for today

Stocks and bonds are nowhere near as out of whack with one another as they were back in 1987.  The nearest we have today to a comparable issue is what happens as worldwide excess liquidity is drained by central banks from money markets.

The trigger for the Black Monday collapse came from an area that was little understood, even by those involved in it–activity that had severe negative unexpected consequences.  The investors who did the best after the crash, I think, were those who understood the most quickly what had happened.

Collateral damage:  one of the most important results of Black Monday, I think, was the loss of confidence in traditional investment advisers working for the big brokerage houses that it created.  This was, I think, partly because of individuals’ market losses, but partly, too, to the generally horrible executions received when they sold stocks in the aftermath.  This was the start of a significant acceleration of the shift to discount brokers and to mutual fund products.

correction or bear market: where are we now?

correction vs. bear market

The financial media, in a deceptively over-precise way, has come to define a correction as a 10% fall in price of a given index during an ongoing bull market.  The same source defines a bear market as a fall of 20% or more.  There is some sense to making the distinction in this way, at least in that it’s unlikely that a market can fall by 20% and still be said to be retaining its fundamentally upward direction.  Other than that, I don’t find the 10%/20% distinction useful.

two worries:  price and earnings

To my mind, the key difference between the two–correction and bear market–is whether the favorable environment of expanding economies and resulting rising earnings per share which supports a bull market remains intact.

In a correction, stock prices have run ahead of the fundamentals and become too pricey.  We can no longer envision, say, achieving a 10% return from holding stocks for the coming 12 months.  Therefore, stocks have to fall to a level where buyers will anticipate a suitable return and reenter the market.  Buyers are concerned about price, not about earnings.

A bear market has very little to do with the 20% number.  What creates a bear market, simply put, is anticipation of recession, and the decline in corporate earnings that goes along with it.  Buyers don’t reenter the market after an initial fall, because they no longer believe that earnings will be rising.  They either continually withdraw funds from the  market or simply hold on to what they have and wait.  They look for some sign that the economic downturn the stock market has been forecasting has emerged—and reached its low point.  Historically, the turning point has been when the monetary authority begins to adopt a more accommodative stance.  Occasionally, it’s the legislature that acts.  Sometimes, it’s less action than investor perception that the assets of publicly traded companies are at bargain basement prices regardless of the near-term economic situation.

timeline

A correction runs its course in a matter of weeks;  a garden-variety bear market lasts nine to twelve months.

Where are we now?

For the mining industry–metals and oil–the picture has deteriorated dramatically over the past year.  This isn’t because the overall macro environment has weakened.  It’s because of overcapacity that the industry, in its typical shoot-yourself-in-the-foot fashion, has itself created.  This unfavorable situation will take a turn for the better only when substantial capacity is taken off the market.  Last time this happened for metals, in the early 1980s, the downturn lasted a decade.

Mining, and mining-dependent economies, apart, I don’t see any signs of actual GDP decline.  Yes, China may be growing at 5% instead of 7%.  Maybe it’s even 2%.  But it’s still growing.

So my vote is for correction.

One caveat:  as I’ve mentioned before, early September is the time when mutual funds in the US begin to sell to adjust the level of the yearend profit distribution they are required by law to make to shareholders.  Some of this selling may have been preempted by August’s market decline.  But until we see what the mutual fund situation is this year, I don’t think there’ll be much market desire to push prices higher.