We reviewed Black Monday 1987 in a post last year [Link]. It had lots of responses, but the question remains, “What caused it?” That day not only did stock prices tumble, but the market ceased to function. The antiquated system at the New York Stock Exchange could not handle the selling volume. 600 million shares traded, more than 3 times the normal volume.
REASONS
Afterward, market analysts put forth several reasons for the meltdown. All contributed to the panic. In no order, they were:
High Stock Prices - The price-earnings ratio for the S&P 500 was almost 50% above its historic norm.
Falling Dollar – The government announced a U.S. trade deficit larger than expected. Foreign exchange traders sold dollars because they feared it would fall. This had little to do with domestic economics, but some investors thought it did.
Inflation - Investors worried that the 1970s inflation could be returning. [In the 1970s, inflation grew at 9% a year for a decade, cutting the dollar’s purchasing power by 52%.]
Tax increases - Congress introduced a bill that would reduce the tax benefits associated with financing mergers and leveraged buyouts.
Rising Interest Rates - Foreign investors pulled back from U.S. investments, spiking interest rates.
Lack of market information – That day, stock price quotes were unreliable. Some stocks did not even trade. Herd behavior seized the market. A survey right after the crash showed that many reacted to the falling prices, not specific news. They sold only because “everybody else was selling.”
Margin Calls and Broker Liquidity – Investors who bought stocks on margin (with money borrowed from their broker) might not be able to repay it when the broker made a ‘margin call.’ These bad loans could force the brokerage into insolvency. Liquidity concerns threatened the entire financial system. [Some poorly capitalized brokerage firms did fail.]
ACADEMIA GONE WILD?
Added to these ‘usual suspects’ was another thing that was icing on the cake, ‘Portfolio Insurance.’
To be clear, there is no such thing as actual insurance against stock market losses. Only a fool would write a policy to cover that potential loss.
Mark Edward Rubinstein, at the University of California, Berkeley and fellow finance professor Hayne E. Leland, aided by adjunct professor John O'Brien, developed portfolio hedging strategies in 1976. They were academic pioneers in finance.
In 1979, Leland realized that he could apply their research to hedge a portfolio. Thus, ‘portfolio insurance.’ The three teachers co-founded LOR Associates in 1980 to provide portfolio protection strategies. LOR's asset base reached $50 billion by mid-1987 (the equivalent of over $700 billion when adjusted to the current S&P 500). Fortune magazine co-named the three partners "1987 Businessmen of the Year."[i]
Portfolio Insurance strategists tried to minimize market risk by selling stocks[ii] as the market fell. Sales were based on algorithms. If the price of securities fell by a predetermined amount, the algorithm said sell 3%. Another fall, another 3% sale. The formulas were supposed to erase losses and enhance gains. Portfolio insurance may have led to overconfidence with users taking outsized risks. They then were forced to sell when the market turned down.
But everyone could not sell at the same time. Academics had believed that herd behavior was no threat, that the ‘market was efficient,’ - that it could absorb whatever volume of orders was placed. The ‘efficient market’ is an academic concept that clearly does not take account of human panic. When asked what happened, academics simply said, “The efficient market wasn’t efficient that day.”
In theory there is no difference between theory and practice, while in practice there is.
Portfolio insurance did not start the crash, but a government report concluded that such insurance was roughly 15% of total selling that day. So, many other institutions were also selling stocks.
THE SAGE OF OMAHA EXPLAINS
In the Berkshire Hathaway 1987 Annual Report, Warren Buffett explained, in his usual simplistic way, the fuzzy thinking of those who embraced portfolio insurance - how ridiculous the concept was for any long-term investor:
Mr. Market experienced a sudden, massive seizure. We have "professional" investors, who manage billions of dollars, to thank for most of this turmoil. Instead of focusing on what businesses will do, they focused on what they expected other money managers to do.
They embraced portfolio insurance," in 1986-1987. The strategy is simply an exotically labeled version of the small speculator's stop-loss order. The strategy dictated that ever-increasing portions of a stock portfolio, be sold as prices decline. The strategy says nothing else matters: A downtick of a given magnitude automatically produces a huge sell order. According to a government report, $60 - $90 billion of equities were poised on this hair trigger. [2.5 billion shares of stock]
If you have thought that investment advisors were hired to invest, you may be bewildered by this technique. After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price? Or would you sell your house to whatever bidder was available at 9:31 on some morning merely because at 9:30 a similar house sold for less than it would have brought on the previous day?
Moves like that, however, are what portfolio insurance tells a pension fund or university endowment to make when it owns a portion of Ford or General Electric. The less these companies are being valued at, says this approach, the more vigorously they should be sold. As a "logical" corollary, the approach commands the institutions to repurchase these companies - I'm not making this up - once their prices have rebounded significantly. Considering that huge sums are controlled by managers following such Alice-in-Wonderland practices, is it any surprise that markets sometimes behave in aberrational fashion?
[i] LOR later developed a method of market trading with a new product that eventually became the first exchange traded fund (ETF). Unlike Portfolio Insurance, the ETF has been a success, offering investors a mutual fund with significant tax advantages.
[ii] For simplicity, this post refers only to stocks to illustrate the point. A more complex product, stock index futures, also played a major part in the selling that day.
Great recap!