October 19th, 2011
Twenty-four years ago today, I walked in the front door from work and my wife took one look at me and asked what the matter was. I made my favorite cocktail, a rusty nail, to steel my nerves to tell her that we’d just lost a good portion of our savings … in a single day.
To commemorate that day, I’m excerpting a chapter in my book, Run with the Herd, in which I describe each of the recent stock market crashes. The chapter sets the stage for describing the importance of and my approach to market timing.
The stock market crash of 1987 is perhaps more remarkable than the more recent Tech Bubble or Financial Crisis Crashes and singular even today because of the fact that it was and still is the largest one-day change in market history. The Dow Industrial Average lost 22.6% on October 19th 1987, or $500 billion dollars.
An extremely powerful bull market started five years earlier, in the summer of 1982, and continued into early 1987. That bull market had been fueled mostly by hostile takeovers, leveraged buyouts and “merger mania”, a philosophy of the time that companies could grow exponentially simply by purchasing other companies. Consequently, there was a scramble to raise capital to finance those buyouts. In “leveraged buyouts”, a company would sell junk bonds to the public thereby raising massive amounts of capital needed to finance their acquisition. IPOs were another commonplace revenue source.
The stock of “microcomputer” manufacturers, considered by many to be the top growth industry at the time, was another promising investment area. People viewed the personal computer as revolutionary, something that would not only change our way of life but also create outstanding profit opportunities. Investors were caught up in a contagious euphoria, animal spirits that made them believe, once again, that the market could continue to always move in only one direction – up.
The government began to take action. Seeing a growing inflationary concern, the Fed began raising short-term interest rates to temper the economy and, at the same time, cool the hot IPO-driven stock market. Coincidentally, since the SEC was unable to prevent shady IPOs and conglomerates from proliferating, it begun conducting numerous investigations of illegal insider trading in early 1987.
While the SEC could offer the proper information about the risk in these IPO’s to investors but it couldn’t cause them to change their behavior. Even though the SEC required companies to state explicitly that they had no revenue or profits and didn’t even have a fighting chance at getting any, investors still believed the potential was limitless. Ultimately, the barrage of SEC investigations began to rattle investors who decided by October to exit what they now believed to be a rigged game and move instead into the more stable environment offered by fixed income securities and, even in some cases, junk bonds.
At the same time, many institutional trading firms began increasing their dependence on program trading and to use futures contracts as insurance to protect against the potential of stock dips. But when the selling finally began, all stockholders seemed to want to dump their shares simultaneously and the market systems and procedures couldn’t handle the flood of orders. As the mass exodus began, the computer programs kicked in. The programs had created open stop loss orders and, as the influx of sellers began, the computers sent these stop loss sell orders to the NYSE computer system pushing prices down. The instantaneous transmission of so many sell orders overwhelmed the system and caused the whole market system to lag and leave investors at every level, whether institutional or individual, effectively blind. At the peak of the selling, there weren’t ANY buyers and some shares couldn’t be sold at all! (click on image to enlarge)
Herd-like panic set in and people started dumping stock in the dark without knowing or caring what their losses might ultimately be or whether their orders would execute fast enough to keep up with plummeting prices. The Dow plummeted 508.32 points (22.6%) and $500 billion vaporized. Markets in every country around the world collapsed in a similar fashion.
When they heard that a massive stock market crash was unfolding, individual investors scrambled, albeit unsuccessfully, to communicate with their brokers since each broker had hundreds or thousands of clients. Some investors lost thousands and millions instantly. Some unstable individuals who lost fortunes went to their broker’s office and started shooting and several brokers were killed despite the fact that they had no control over the market’s action. The majority of investors who were selling didn’t even know why they were selling except that they “saw everyone else selling”.
Remarkably, the markets recovered quickly from the worst one day stock market crash. Some modest refinements including “circuit breakers”, or the short circuiting of trading programs when markets slid by set amounts, were instituted. Unlike the stock market crash of 1929 from which recovery took years, this time the market regained its footing and quickly resumed its bull run. The post-crash recovery was reinforced by companies buying back their own stocks at then greatly discounted prices. Additionally, the Japanese Nikkei Index embarked on a massive bull market run contributing its own tremendous momentum to help carry the US stock market to new heights.
The comments of notables of the day are instructive for putting the confusion and crash into some context. The statements are important also because they offer some insight into what different people in similar positions might have said after each of the later market crashes. While each situation is different, people never learn and their responses are always the same. Many of the comments resonate as we are hopefully exiting from the effects of Financial Crisis Crash, the 2010 Flash Crash and the 2011 Deficit and Budget Congressional Debates:
- “Technically, the crash of 1987 bears an uncanny resemblance to the crash of 1929. The shape and extent of the decline and even the day-to-day movements of stock prices track very closely.” – George Soros in “The Alchemy of Finance”
- The market crash of 1987 caught most economists, scholars, and investment professionals by surprise. Nowhere in the classical, equilibrium-based view of the market so long considered inviolate was there anything that would predict or even describe the events of 1987.” – Robert Hagstrom in “Investing, the Last Liberal Art”
- The President [Ronald Reagan] has watched today with concern the continued drop in the stock market….consultations confirm our view that the underlying economy remains sound. We are in the longest peacetime expansion in history. Employment is at the highest level ever. Manufacturing output is up. The trade deficit, when adjusted for changes in currencies, is steadily improving. And, as the chairman of the Federal Reserve has recently stated, there is no evidence of a resurgence of inflation in the United States.” – White House Statement released on October 19, 1987
- I have never experienced anything like this, so it is difficult to have clear vision. I don’t understand it in terms of the fundamentals of the economy” – Robert Allen, president of AT&T, October 20, 1987
- “The borrowing has to stop. The market slide was a shot right between the eyes that had better wake us all up to simple fact that we can’t keep romping forever on borrowed money.” – Lee Iacocca, Chrysler Corp Chairman, October 20, 1987“
- The market is sending an unequivocal message to the President and the Congress to stop the political games and agree on a Federal deficit-reduction plan.” – Representative Dan Rostenkowski, Democrat, October 20, 1987
- “It’s the nearest thing to a meltdown that I ever want to see. We were fortunate this occurred when the American economy is very stong.” – John J. Phelan, Chairman of the NYSE, October 20, 1987
- “They should bar buying and selling by programming. They can’t stop the selling once it gets going, it’s just computers selling to computers. It became a gamble, not an investment anymore. All those guys with 65 credit cards and Porsches who think they are all geniuses at 25 – now see what’s happened.” – Alexander Kopelman, 80 year old Florida man, October 20, 1987
- “I told my clients that it was a sucker’s market (two days after the crash). A week ago, I would have taken a gamble on anything that looked promising when I was dealing for my own account or for some of my family members. I had been spoiled by the bull market, I never knew anything else. But I became a cynic and a skeptic in a hurry.” – A broker, October 23, 1987
- “I will tell you that, prior to the opening of the market, Mr. Phelan (Chairman of the NYSE) and I had a conversation where he advised me that there was an inordinate number – “unbelievable” I think was his word – of sell orders coming into their market. That was like an hour before their opening on Monday. So we saw it coming, but who knows who pushed the button to make it happen. I think that button was pushed a million times by a million people.” – Leo Melamed, chairman of the Chicago Mercantile Exchange, October 28, 1987
- “Brokers hurling themselves from high windows. Men selling apples on street corners. Silent, shuffling breadlines and shouting crowds outside banks. Even for many of us who did not endure the Great Crash, images of the Depression still flicker across the years. Is that why so many people panicked?” – Susan Toth, author, October 25, 1987
- “Investors had expectations before the 1987 crash that something like a 1929 crash was a possibility, and comparisons with 1929 were an integral part of the phenomenon. It would be wrong to think that the crash could be understood without reference to the expectations engendered by this historical comparison. In a sense many people were playing out an event again that they knew well.” – Economist Robert Shiller
- “So improbable is such an event that it would not be anticipated to occur even if the stock market were to last for 20 billion years, the upper end of the currently estimated duration of the universe. Indeed, such an event should not occur even if the stock market were to enjoy a rebirth for 20 billion years in each of 20 billion big bangs.” – Mark Rubinstein, economist in “Comments on the 1987 Stock Market Crash: Eleven Years Later”
- “Those who thought Black Monday on 1987 was the most frightening day of their lives are forgetting those first few hours of Terrible Tuesday, when the market as we know it simply ceased to exist…. In fact, the dirty little secret of that Tuesday morning is that the screens simply weren’t functioning. It was like the Wild West out there. Anything you tried to buy simply went up ahead of you until you caught it and then it would come down so fast that you could lose hundreds of thousands of dollars in mere seconds. I retreated to the sidelines rather than endure that kind of punishment.” – James J. Cramer, founder of theStreet.com and CNBC personality