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.

stuff

I have no idea why the seasonal mutual fund-induced S&P 500 selloff hasn’t happened (so far, at least) this year.  Could be this is just an instance of the adage that the market tends to make the greatest fools out of the largest number of people–namely, me.   But even the best portfolio managers are wrong at least 40% of the time.  Not a profession for people who desperately need to be right about everything.

By the way, another curiosity about the annual mutual fund dividend is that holders strongly desire to have a dividend, even though this means paying income tax on it–but almost no one actually receives the payout.  Virtually everyone elects to have the dividend automatically reinvested in the fund.  In my experience, only holders of 2% -3% of shares actually take the money.  So there’s no need for the portfolio manager to raise cash.

This means the annual selloff is an occasion to do portfolio housecleaning plus optics for shareholders.

 

I heard an interesting radio interview of a prominent fixed income strategist the other day.  He said that the reason gradual money tightening by the Fed in the US has made no impact on the bond market is that central bankers in the EU and Japan are still creating new money like there’s no tomorrow.  That liquidity is offsetting what the US is doing so far to drain the punch bowl.  By next spring, however, both the EU and Japan will be at least no longer manufacturing new liquidity and may be joining the US in tapering down the excess money stimulus.  Once that’s occurring, we’ll see a bond bear market.  At the very least, I think, that would put a cap on stock market gains.  Until then, however…

 

September S&P 500 performance:

–I’ll post details for one month, the third quarter and year-to-date later in the week

–the biggest winners for September were:  Energy +9.8%, Finance +5.1%, IT +4.5%.  Losers:  Staples -1.1%, Real Estate -1.9%, Utilities -3.0%.  S&P 500 +1.9%.

ytd:  IT +24.4%; S&P +12.5%; Energy -8.6%.

Silicon Valley backlash?

I think we may be at a watershed moment in terms of the acceptability of the corporate behavior of tech/internet-related companies.

Up until now, it has been enough for investors that Silicon Valley produce increasing profits.  Institutionalized poor behavior on the part of the firms’ managements–whether that be violation of some employees’ civil rights or less-than-ethical treatment of customers or shareholders–has made little difference to their stocks’ performance.

Uber is perhaps the poster child for this phenomenon, which has also been, aptly, I think, characterized as “fratboy” behavior.  But now Uber appears to be losing its license to operate in London, which holds 5% of the worldwide active users of the taxi service, because of its not being a “fit and proper” operator.

The case of Facebook (FB) is just as interesting.  Founder Mark Zuckerberg announced plans last year to give a large amount of his stock in FB to a charitable trust that he and his wife would run.  In order to preserve his majority control of FB despite divesting a large chunk of his shares, he proposed that each A share, the ones with super voting power that insiders like him hold, be “split” into one A + two C shares, the ones with no voting rights.  Zuckerberg could then give away the C shares, representing about 2/3 of his wealth, without any decrease in his 53% voting control of FB.

The board of FB appointed one of its members, Marc Andreessen, a developer of the Mosaic and Netscape browsers, to represent third-party shareholders in this matter–to ensure that this restructuring would be fair to them.

Institutional investors sued.  During discovery, they found among other things, emails between Andreessen and Zuckerberg in which, far from defending third-party holders,  Andreessen appears to be coaching Zuckerberg on how to present his proposal to the board in the most favorable light for him.

Today, FB announced it’s dropping the restructuring plan.

 

If I’m correct about a fundamental change in investor sentiment, what does this mean for us as investors?

At the very least, I think it means that the business-is-what-you-can-get-away-with attitude (borrowing from Andy Warhol) of many tech companies will be penalized with a discount valuation.  It may also prevent some early stage firms from being able to list–preventing employees from cashing in on what they’ve built.  On tech/internet’s notorious anti-woman bias, I’m not sure.  After all, the investment business isn’t that far ahead of tech in eliminating this form of prejudice.

 

 

the Wall Street Journal’s new direction

The Wall Street Journal recently announced a reorganization intended to narrow its focus back toward politics and business, as well as to shift its orientation from print  to online.

As far as the stock market is concerned, the WSJ now seems to be trying to provide less news and more analysis.

But I’m finding the new analysis tack to be quite odd.  For example:

–two days ago, an article pointed out that shoppers are frequenting low-price retailers.  Yes, that’s true, but there was no acknowledgement that this trend has been going on for ten years

–yesterday’s paper pointed out that companies are preparing for higher short-term interest rates by tightening up their working capital management.  Potentially very interesting.  Unfortunately, the authors didn’t have much of a grasp of what working capital is, so the article’s usefulness was limited

–a third article, this one also from yesterday, contrasted the performance of value-oriented ETFs and their growth counterparts.  It also would have been a lot better if the author had a basic idea of what growth investing is   …and had refrained from using the disparaging term “momentum” for growth.

 

What could be going on?

–maybe it’s just August

–it could be a change in editors or in reporters

–it might also be sources.  To the degree that the Journal relies on interviews with professional Wall Street analysts, it could be that cutbacks on the sell side have diminished the available information.  Or it might be that the sell side is preparing for the day (coming soon, I think) where it will begin to charge cash instead of soft dollars for their research.  So brokers may have already begun to limit the information they will release for free.

If it’s not the first of these, we’ll all have to become a little more creative in how we access basic data.

At least there’s still the FT.

 

a rainy Friday in August in New York

August is the month when many senior portfolio managers are away from the office on vacation.  So big decisions on portfolio structure tend not to be made.

Friday is the day of the week when short-term traders’ thoughts turn to flattening their books so they won’t carry risk over the weekend.

It’s raining, which sparks thoughts in traders of sleeping in or leaving work early.

Add all that up, and the heavy betting should be that US stocks will likely move sideways in the morning and fade off toward the close.

That means this is a good day to stand on the sidelines and size up the tone of the market.

 

In pre-market trading, tech is up and bricks-and-mortar retailing (on the earnings miss by Foot Locker) is down.  …nothing new about this.  At some point there will doubtless be a fierce counter-trend rally.  But the negative earnings surprises are still provoking severe selloffs.  So I don’t think today is the day.

Pundits are speculating about the damaging effects on his political agenda of Mr. Trump’s apparent defense of neo-Nazis in Charlottesville.  …but the Trump trade has been MIA since January, with the US a laggard among world stock markets during Mr. Trump’s time in office so far.  Yes, there may be residual hope for corporate tax reform from the administration, which this latest demonstration of the president’s ineptness as a executive could arguably undermine.  My guess is, however, that he is already well understood.

Two questions for today:

–will the market perform more strongly than the season and the weather are suggesting? This would be evidence that there’s still an untapped reservoir of bullishness waiting for somewhat better prices to express itself.

–should we be buying in the afternoon if it’s weaker than I expect?  My answer is No.  I think there is a lot of untapped bullishness, but we’re in a slowly rising channel whose present ceiling is less than 2500 on the S&P 500.   That’s not enough upside for me.  I’m also content to wait for any incipient bearishness to play itself out further.

It will be interesting to see how today plays out.