Edward Chancellor and I met soon after I read his prescient and literarily superb book, Devil Take the Hindmost: A History of Financial Speculation (2000). We have stayed in regular touch, including attending a Berkshire Hathaway annual meeting together. This morning he sent me the following column from Breakingviews which, with his permission, I am including as the first guest post to my blog.
Thirty years ago, on October 19 1987, the U.S. stock market experienced the largest single-day decline in its near-200 year history. Although the crash was traumatic to those who experienced it first hand, from an economic perspective it was a non-event. Its cause was largely technical. Program trading, which threw a huge volume of stocks onto a falling market, induced a panic. Since a number of currently popular investment strategies also involve automated stock sales in response to an initial fall in markets, another 1987-style crash cannot be ruled out.
What should really concern long-term investors, however, is a crash of the 1929 variety. That market panic was likewise triggered by information-less trading. But it took place in the midst of an extremely overvalued stock market, elevated corporate profits, excess leverage and highly unsettled international conditions. In other words, the type of conditions which obtain in today’s financial markets.
Until the late summer of 1987, American stocks were on a tear. Between the New Year and Labor Day, the Dow Jones Industrial Average climbed over 40 percent. Financial conditions were apparently benign – save for the fact that the Federal Reserve, under the charge of newly installed Chairman Alan Greenspan, appeared bent on raising interest rates, which induced a steep rise in Treasury yields. Geopolitical risks were also elevated. The Iranians had recently attacked a U.S.-flagged oil tanker in the Gulf, and President Ronald Reagan promised to retaliate.
Fundamental factors alone can’t explain why on the morning of Monday October 19, after heavy market declines earlier in the day across Asia and Europe, the New York Stock Exchange faced a tidal wave of selling. Big Board specialists were soon overwhelmed – trading in the S&P 500 Index was reduced to 25 stocks. At the Chicago Mercantile Exchange, stock futures fell to a steep discount to spot prices in New York. Arbitrageurs gave up trying to keep these markets aligned, and the CME ordered an early halt to trading.
By the end of the day, the S&P was down 20.5 percent while index futures fell nearly 29 percent. Turnover on the NYSE had exceeded 600 million shares – double the previous record – despite the fact that many sell orders were unexecuted as telephone calls to brokers and mutual funds went unanswered, and the exchange’s automated trading system broke down. Fears of further carnage were assuaged when the Fed announced before Tuesday’s open that it was providing liquidity “to support the economic and financial system.” Over the course of the day, the Fed opened the spigots, boosting bank reserves and pushing down its discount rate.
Most accounts of the ’87 Crash blame the tumult on the widespread use of portfolio insurance by institutional investors. Portfolio insurance promised to capture the upside of stock market exposure while limiting the downside, by automatically selling stocks as the market declined. On paper, this was an attractive proposition, but by October 1987 portfolio insurance covered roughly $100 billion worth of equities, equivalent to around 2-3 percent of the market’s total capitalization. On October 19, program sales, accounting for up to 40 percent of futures market volume, overwhelmed the market’s liquidity. Once the crash got under way, retail investors joined the rush to the exits.
Speaking at the Grant’s Conference in New York earlier this month, Frank Brosens, a former Goldman Sachs partner and founder of investment firm Taconic Capital, pointed to a number of current investment strategies which, like portfolio insurance, have the potential to unsettle the market by unleashing large-scale automated trades into a downturn.
For a start, insurers have been selling principal-protected variable annuity products, which are forced to reduce market exposure when volatility rises. Commodity trading advisors (CTAs) pursue momentum strategies which require selling stock futures when the market declines. Another hedge fund strategy, popularized by Ray Dalio of Bridgewater Associates, is known as risk parity. This involves leveraging a portfolio of government bonds, equities, and other assets based on their historic volatilities and correlations. If volatilities or correlations move abruptly, risk parity managers might have to decrease leverage and, possibly, also reduce their equity positions.
In addition, says Brosens, exchange traded funds which hold stocks on leverage must cut their exposure when the stock market declines. Most worrying of all are the ETFs which sell volatility futures: implicitly leveraged and roughly five times more volatile than the stock market. In the event of a large enough volatility spike such strategies will blow up. Brosens estimates these program trading strategies have in aggregate a total stock market exposure north of $1 trillion dollars – a somewhat larger share than portfolio insurance back in 1987.
Still the lesson that most have taken away from what happened three decades ago is that stock market crashes, however severe, aren’t a concern for long-term investors – especially when the Fed has their back. Yet it’s easy to overlook the fact that financial market conditions in October 1987 were more favourable than they are today.
Valuations are far more elevated. The U.S. market’s total capitalization stands at around 140 percent of GDP, roughly twice its level of October 1987. There’s also a lot more debt around. Thanks to an ongoing leveraged buyout boom at the time, U.S. corporate debt back in mid-1987 had climbed to 19 percent of GDP. Today, in the midst of another buyout boom, it exceeds 31 percent. All this debt makes companies even more vulnerable to a sudden rise in interest rates. Three decades ago, U.S. corporate profit margins were relatively depressed. Today, earnings at near all-time highs have potentially a lot further to fall. Finally, after another 30 years of financial globalization, the risks of cross-border contagion from an American stock market crash are far greater.
In fact, today’s financial conditions more closely resemble those prevailing in October 1929. The Great Crash was also exacerbated by program trading as brokers sold out clients who couldn’t make their margin calls. By coincidence, current NYSE margin loans are greater than ever before. After the 1987 crash, many anticipated the worst. The Anglo-French financier Sir James Goldsmith (who had exited the stock market earlier in the summer) compared his position to “winning a rubber of bridge in the card room of the Titanic.” Investors in today’s overvalued markets, crowded with a new generation of program traders, find themselves sitting at the same card table.