Market Memo: 30 years later, the 'Ghost of 1987' still haunts

10-16-2017

As we approach the 30-year anniversary of the still largest ever one-day stock market decline on Oct. 19, 1987, it may be worthy to reflect on lessons learned that day, along with whatever parallels there may or may not be to the present market condition. Here’s my cut, from one who was there….

“Get me someone who knows how to read a Quotron machine on the phone!”

Thirty years ago, I was a relatively young vice president with Prudential Investments, working on the staff of the company’s chief investment officer. At that time, the head of our institutional business was Bob Riley—completely old school and smart as a whip, but perhaps lacking a tad in the tact department. Out on the road on a business trip that day, early in the cell-phone era, Bob was unaware of what was happening. Finally, in mid-afternoon, he made a call from his limo, which was equipped with a then state-of-the-art version of a mobile phone—attached to the car’s antenna.


“Steve, just checking in. Anything happening?”

“Well, Mr. Riley, yes, I’d say something is happening.”

“What is it?”

“Well, I am sitting here glued to the Quotron machine, watching this drop. Pretty amazing. We’re down 300 points [on the Dow Jones Industrial Average]!”

“What?!? How many points did you say?”

“I said 300, but make it 350. No, correction, 400…”

“What? Are you nuts?  Get me someone on the line who can read a Quotron machine!”

Fortunately for my career, Bob eventually came to terms with what was happening, and the messenger wasn’t shot immediately. By day’s end, I’d calculated that we’d lost nearly $2 billion in paper value on our equity portfolio. Oops.

 


“There were more sellers than buyers!”

In listening to one of our senior portfolio managers explain our paper losses from Black Monday to our board later that month, the quote above stands out as the single best explanation for the dramatic decline.

Certainly, there were fundamental causes which could have provoked investors to sell, or not buy, equities. The market as measured by the S&P 500 had recently come through a 40%+ upsurge in the previous 12 months coming into October as the economy was bouncing out of a stagnant growth “recession” and earnings grew with it. Now growth, though still positive, was starting to slow. The specter of another bout of oil price flare-ups, which had sunk us in 1973 and again in 1981, was looming following the previous week’s dustup in the Persian Gulf, featuring Iranian missiles sinking an oil tanker. And policy uncertainty was rising, first at the Fed where a relatively unknown economic prognosticator from Wall Street, Alan Greenspan, had just taken over the reins from the great inflation fighter, Paul Volcker, and second at the Treasury, with its relatively inexperienced secretary, James Baker. Both had very recently stirred the pot. Greenspan had initiated his first rate hikes a few weeks earlier, and Baker had made comments on the Sunday news shows seeming to promote a weaker (inflation-inducing) dollar.

All of these inputs, by any reasonable calculation, affected the “fundamentals” of what stocks were worth, as both forward earnings streams would likely be lower and the discount rate for calculating the value of those streams would likely be higher. This kind of revaluation normally is digested gradually over time.

What caused the discontinuous drop of Oct. 19 was the presence in the market of a large number of very early “program traders” who had set up computer models which “dynamically” adjusted stock portfolios to insulate them, theoretically, from a large decline: so-called “portfolio insurance.” The problem was that these models all used the same simple, options-based algorithm that triggered sales to lighten equity exposure at the same time. This would have been fine if enough purely “fundamental,”—today we might say “active”—managers were ready to buy. But for the reasons noted above, they were hesitant to do so.


So with no obvious buyers, the algorithms went wild, with each new decline triggering more “protective” sell orders. Fundamental players like ourselves at Prudential who stepped in lightly early in the day were quickly punished by further declines, so we stepped aside. The program sells kept running, unabated. Hence the freefall. More sellers than buyers.

 

 

“They also serve who only stand and wait.”

Another key lesson for me from 1987 was the importance of understanding ahead of time what the market structure is and how it might react, or overreact, to market news. I along with everyone else initially was surprised by the move, and it took a long time to figure out what had caused it.

Two years later, equities had recovered all of their decline, and then some, as a Gulf war never materialized, the Fed stepped back from hikes following the sell-off and actually cut rates three times over the subsequent four months, and the economy and earnings continued to grind along. Fortunately, the seasoned managers around me had learned over time the importance of prudence and not overreacting to unexplained market moves. Left on my own, I might have panicked, but surrounded by these veterans, I didn’t. We held fast and were rewarded.

I’ve kept the quote from James Joyce, above, in my head ever since. It was frankly a guiding light for me during the worst days of the 2008 sell-off, when the market was gapping down as much as 5-10% within a day.

Sometimes when you don’t understand something, it’s because it doesn’t make sense. Just wait it out.

“Diversification pays.”

Another big lesson for me on that Oct. 19 was the power of diversification.

As the person in charge of running our portfolio optimization programs, some of the inputs on “negative asset correlation” that had us heavily weighted in bonds often seemed more theoretical than real to me. They became real on Oct. 19. At the end of the day, as I was calculating the extent of the mesmerizing damage to our stock portfolios noted above, I also took a look at what had happened in the bond market. Despite the dislocations, or maybe because of them, bonds were up more than 3%. While some of our credit exposed bond holdings were hard to value, I estimated that we’d made almost as much on bonds that day as we’d lost in stocks. This ultimately was another reason we didn’t panic at the bottom, and were able to enjoy fully the 45% rally in S&P stocks the next 12 months. Although in subsequent crises diversification didn’t always work out as well in the short term, I remained confident that it would in the longer term. And it almost always has.

“Be aware of the market structure.”

Another key lesson of 1987 was to always be aware of the market structure.

Although I knew of portfolio insurance, it had not occurred to me that it in itself was affecting the market structure and could under certain conditions undermine it. I’ve learned ever since to at least try to think through in advance the impact new market players out there might be having on the market structure that only a discontinuous event might unveil. In 2007 and 2008, it was the collateralized mortgage obligations and their levered impact on real estate security valuations and through them, the banks. Although we did not forecast the decline we eventually got when these structures came undone, we at least knew they were out there and could see the (temporary) outsized impact their unwinding was causing.

In today’s market, there are frankly a few new participants we are watching carefully. One of course is the massive positioning that has accrued in exchange-traded funds (ETFs), which themselves often depend on liquid derivatives markets to execute. Another is the billions in “risk parity” funds that trade on different algorithms but fundamentally depend on a semi-stable inverse correlation between stocks and bonds.

While we are in no way predicting the imminent or even longer-term blow-up of either of these players, we are thinking hard about how they might mechanically overreact in a dislocated market so that we are prepared as we best we can be to avoid doing something stupid. 


“The Fed matters.”

Yet another key takeaway of 1987 (there were many, obviously!) is that understanding the Fed and what it is likely to do, and how it is likely to react, is very important. Unlike nearly all other market participants, the Fed has the power to affect two key drivers of financial markets: sentiment and actual fundamentals. What it is doing and saying can drive the former, while where rates are and where they are going are inputs to the latter.

I’ve made a business ever since of trying to make sense of not only what the Fed plans next, but on how it might react to other realities. A key driver of our optimism on stocks in the dark spring of 2009, in fact, was the Fed. We felt that as bad as things were, it was likely to do “whatever it takes” to make them better, and could do so if it wanted. Our almost as long-standing “secular bull market” call rests as much on our view that we are in a “long cycle” that is keeping inflationary pressures at bay and the Fed’s monetary stance dovish.

“History never repeats, it rhymes.”

A final word of advice.

Every market has forces, factors and players that are similar to previous markets, and to that extent, somewhat predictable. But each market also has new and fresh inputs that distinguishes it from the last, and even the same players are themselves sometimes changed or transformed by market action. Human psychology is complex and evolutionary in nature.

I expect in the coming days a number of parallels to be drawn between the present market and 1987: a similar “stretched” market multiple, a Fed shifting toward a more hawkish policy stance along with a potentially new Fed chair, a rogue country out there shooting missiles in the air, and unknown new market participants such as the ETFs and the risk-parity funds. Some of this does rhyme with October 1987, and is worth keeping in mind. But too much is different for us to be terribly concerned about the ghost of 1987 just yet.

Although our market P/E multiple at 20 times 2017 earnings is similar to 1987’s, the discount rate in the form of the 10-year Treasury yield is significantly lower. On that basis, the valuation today is way cheaper. True, the Fed’s interest-rate policy is shifting toward less accommodation. But that shift has been extraordinarily well telegraphed compared to Alan Greenspan’s surprise 50 basis-point hike in early October 1987, the second in as many months, and today’s dovish, ever-so-slow forward path has been well communicated. (The Fed itself learned from the Volcker-Greenspan handoff and ever since has attempted to initiate directional policy changes under the outgoing chair instead of the incoming one.) Economic growth forecasts here and abroad are accelerating, and earnings for next year look pretty solid. And while North Korea could potentially do something very rash, we place the odds on that at near zero for reasons President Trump has explained to them.

One last point on the 1987 rhyme. As noted above, as tough as that one day was, the ensuing 24 months were terrific for stocks, as the market bounced to new highs on the back of what was still a solid economic and earnings backdrop. There’s that waiting thing again. And today the S&P is a full 2,119% (!) above the close on that frightful Oct. 19.

So, don’t get too worried if you see an old ghost rushing past you down the street. It’s probably just heading to an early Halloween Party. But if it does manage a “boo!”, hang in there. The future remains bright.