The following is an excerpt from an industry research (white) paper that I am writing. I anticipate releasing it in November. Market internals continue to deteriorate, warning investors of the probable decline to come. In pondering the events that lead to the Crash of 1987, it occurred to me how timely this information is.
"Those who are cannot remember the past are condemned to repeat it." - George Santayana
The Crash of 1987
In focusing on history and patterns that led to substantial market declines, we would be remiss to exclude Dr. Bruce Jacobs. Dr. Jacobs is co-founder and principal of Jacobs Levy Equity Management, which is recognized as one of the world's leading institutional equity money management firms, and he is an expert on the events that led up to and occurred during the Crash of 1987.
In his wittily titled book, Capital Ideas and Market Realities, Dr. Jacobs details the account of an investment tool known as portfolio insurance and its contribution to the Crash '87. Much like indexing and program trading today, portfolio insurance promised a way to allow investors to participate in market rises and at the same time reduce the risk associated with market downturns. Dr. Jacobs describes the foundation upon which portfolio insurance was built.
"The portfolio insurance strategy was born from the tenets of market efficiency, drew milk from the ideas of traditional insurance, and was given substance by Black-Scholes option pricing theory."
Next, Dr. Jacobs describes how portfolio insurance sought to protect investors.
An actual put on an underling stock portfolio protects the portfolio from stock price declines below a certain level while leaving the portfolio open to stock price advances. Using computerized rules and program trading (again, like today), portfolio insurance aimed to replicate the behavior of a put option by selling short stock index futures. 1 (Emphasis mine)
Yet, there were differences. Unlike a put option, where loss is limited to the amount invested, a synthetic options replication system (like portfolio insurance) requires the use of futures contracts which do not have the same loss parameters. Each trade represents an obligation, and if trades keep moving against the investor, losses continue to mount and can exceed the original investment.
Additionally, like program trading and indexing today,
"Option replication requires trend-following behavior - selling as the market falls and buying as it rises. Thus, (in a classic fallacy of composition) when substantial numbers of investors are replicating options, their trading alone can exaggerate market trends." 2 (Parenthesis mine)
In the market environment of the early eighties, risk reduction with continued participation was as desirable as ever. The Dow had started 1965 at 874. Seventeen years later, at the end of 1981, it closed at 875. 3 Consider these comments from a 1979 Business Week article titled, "The Death of Equities,"
"The U.S. should regard the death of equities as a near-permanent condition. Even if the economic climate could be made right again for equity investment, it would take another massive promotional campaign to bring people back into the market. The range of investment opportunities is so much wider now than in the 1950s that it is unlikely that the experience of two decades ago, when the number of equity investors increased by 250% in 15 years, could be repeated. Nor is it likely that Wall Street would ever again launch such a promotional campaign."
In 1980, the Dow scratched its way back up to 950. The price of oil had been spiraling, and as a result, by 1980, oil or oil-related stocks accounted for nearly one-fifth the S&P 500. When they toppled, so did the index, falling 27 percent." 4
Doug Gillespie, of Gillespie Research, comments that, "In 1982, the mutual fund industry had seen net redemptions in eight of the last ten years." 5 Needless to say, this was not a time where individuals or institutions were excited about the markets. However, Wall Street introduced portfolio insurance, and as money began to pour in, the great bull market came snorting out of its pen.
"Portfolio insurance appealed to the self-preservation instincts of investment managers and fund officers 'who nearly lost their jobs maintaining static positions in the 1973-4 period.'" 6
The similarities between Long Term Capital Management (LTCM) and Leland O'Brien Rubinstein Associates (LOR) were uncanny. Fisher Black and Myron Scholes, who created the option pricing model that bears their names, were partners of LTCM and gave strong endorsement of their hedge fund. In much the same way Hayne Leland and Mark Rubinstein, from University of California, Berkeley, were at the helm of the discussion and implementation of portfolio insurance and were principals of the firm that bears their name. LOR, who with its licensees is conservatively estimated to have accounted for seventy-five percent of all insured portfolio assets, was the primary marketer and vendor of portfolio insurance. In both cases, the credibility of scholastic genius gave way to implicit trust that was largely unmerited.
Both LTCM and LOR (and program trading today) built their models on the premise of increasing returns and limiting risk, based on the assumption of efficient markets. In fact Leland and Rubinstein contended,
"Long term returns can actually be raised, with downside risks controlled, when insurance programs are applied to more aggressive active assets. Pension, endowments, and educational funds can actually enhance their expected returns by increasing their commitment to equities and other high return sectors, while fulfilling their fiduciary responsibilities by insuring this more aggressive portfolio." 7
Like LTCM, the flaws of LOR's posit were not apparent at first, and both experienced short-term success.
Yet, as John Breazeale, in a statement resonant of Yogi Berra, comments, "If your trading strategy is fundamentally flawed, eventually you'll lose a lot of money." 8 Breazeale ought to know. He has been managing money since the early '70s and currently manages a long-short portfolio.
In a fallacy of composition similar to LTCM, as other players entered the market and employed similar program trading models, portfolio insurance (dynamic hedging today) actually exacerbated the volatility in markets - the very thing it was designed to protect against. 9 As the markets rose, so did the amount of money in portfolio protection products. In 1986,
"The November issue of Institutional Investor had indicated that '76.5 percent of investors that selected insurance did so primarily to protect the gains...made since the onset of the bull market in 1982." 10
As investors began to buy, the markets moved higher. As the markets climbed, the portfolio insurance models assumed that the markets were safer and the "black boxes" took increased exposure to the markets.
However, as Gilbert and Sullivan note in the H.M.S. Pinafore,
Things are seldom what they seem, skim-milk masquerades as cream;
Black sheep dwell in every fold; all that glitters is not gold.
By the close of trading the Friday prior to Black Monday, from its August 1987 peak, the Dow had lost 17.5 percent. Somehow this little piece of history is overlooked. Yet, the recurrence of this "decline-before-the-decline" pattern can be seen in other crashes as well.
"Portfolio insurers sold futures equivalent to $530 million, $965 million, and $2.1 billion in stocks on the Wednesday, Thursday, and Friday preceding the crash (SEC 1988: 2.6, 3.9). The market fell 10 percent in this same period. A typical portfolio insurance strategy would have called for the sale of 20 percent of the equities in response to a 10 percent decline." 11
In what could be interpreted as a false sense of security, the total equities sold that week were only about a third of that volume. This muted selling created a huge overhang of selling pressure that would wreak havoc on the markets the next week.
On Monday morning, the fallacy of composition that Dr. Jacobs had debated with his colleagues was now to take place. No more marketing. No more debating, just the hard cold reality of the markets.
"From 9:30-9:40 a.m., program selling constituted 61 percent of NYSE volume. Between 11:40 a.m. and 2:00 p.m., portfolio insurers sold about $1.3 billion in futures, representing about 41 percent of public futures volume (Brady Comm. 1988:36). In addition, portfolio insurers sold approximately $900 million in NYSE stocks. In stocks and futures combined, portfolio insurers had contributed over $3.7 billion in selling pressure by early afternoon.
From 1:10 - 1:20 p.m., program selling constituted 63.4 percent of NYSE volume and over 60 percent in two intervals from 1:30 to 2:00 p.m. In the last hour and a half of trading, insurer sold $660 million in futures. The DJIA sank almost 300 points in the last hour and a quarter of trading." 12
Again, this was a loss of more than 13 percent in this last hour and a half.
Lessons from 1987
Dr. Jacob's work on the intricacies of the patterns and probable causes of the 1987 crash makes a few points painfully clear:
Markets are given to the irrational herding instincts of the masses, and are therefore inefficient. The extremes of the black pessimism of the early eighties and the manic behavior that led to Black Monday lend evidence to this truth.
Fallacies of composition eventually lead to liquidity crises, where everyone wants to sell. As well, program trading and indexing foster trend following behaviors, which often lead to fallacies of composition.
There are patterns that are evident before market crashes. This is true of 1929, 2000, and events leading up to Black Monday in 1987. Managers who study history and who are given to independent research can often identify these patterns and, in anticipation of decline, exit the markets ahead of other investors.
Applying the Lessons of 1987 to 2005
The following three issues point to the manic behavior of the masses. Exchange Traded Funds (ETFs) 13 and program trading certainly promote trend following behavior. And, the exponential growth of ETFs, program trading, and the US Credit derivatives market is nothing short of a mania. Combine this with the bullish sentiment of the masses, and we have a formula for trouble.
Since their introduction to the marketplace in 1993, ETFs have experienced phenomenal growth, both in terms of the number of ETFs and the amount of dollars invested in them. The benefit of this tool is that investors can buy or sell an entire index or sector in an instant rather than making multiple transactions. Unlike index funds, ETFs have the flexibility of stocks, allowing investors the ability to trade ETFs at their current market value throughout the trading day. They can also be sold short. Unlike a stock however, they have one major advantage for short sellers. They are not subject to the SEC tick-rule requirement, so investors can short them at will.
Jim Bianco, president of Bianco Research LLC, stated recently, "The majority of trading is no longer investors buying a stock based on a company's fundamentals, it's program traders buying groups of stocks and making macro plays." Since the beginning of 2000, ETFs have grown from $36 billion to over $260 billion today. With an annual growth rate of over 29 percent for the past five years, 14 ETFs possible effects must be considered.
Consider the growth of program trading. Alan Newman, editor of Crosscurrents newsletter, notes that the week ending September 16th 2005, program trading accounted for 6.61 billion shares of the 9.33 billion total shares traded on the NYSE. That means program trading comprised 70.9 percent of total shares traded, the third largest percentage of program trading ever recorded. 15 He states, "And if that was not enough, it was reported that brokerage firms executed an additional 4.2 billion shares of program trading away from the NYSE." 16 Clearly, program trading has reached epic proportions.
As we turn our focus to credit derivatives, keep in mind that credit derivatives are only one area of the derivatives markets. Still, since their inception in 1997, they have been one of the fastest growing areas of the derivates markets. At the end of 1997, their notional amount stood at $55 billion. At the end of 2004, that number had grown to $2,347 billion, or $2.3 trillion. Amazingly, at the end of the second quarter of 2005, the notional amount had grown to $4,105 billion, or $4.1 trillion. That means credit derivatives have grown at an annualized rate of 150 percent in the first six months of this year. And, this is just the notional amount. 17
All of the above points to the masses acting in a largely similar fashion. Combine this with wildly bullish sentiment, which is a contrary indicator, and we begin to see how a 1987 style meltdown could occur.
With the myriad of economic and financial problems our country now faces, most people are unconcerned if not overly optimistic. According to Investors Intelligence, bullish sentiment on the stock market has now had 158 straight weeks with more bulls than bears. In the 42 years that this has been tracked, this is the longest streak of bulls outnumbering bears. It is currently even 6 weeks longer than the 152 weeks that bulls outnumbered bears as we experienced the Crash of 2000. 18 Keep in mind, this is a contrary indicator. That means that when there are more bulls than bears, markets historically have declined.
This Wednesday, the Dallas Morning News ran an article in their business section titled, "The New Math of Stock Returns." Trying to bring investors expectations back down to reality, the article stated, "More financial experts are pointing to evidence that 10% a year isn't a reasonable assumption anymore." The article quoted from a source I find very helpful in studying historical stock market trends. Ed Easterling, president of Crestmont Research, quipped,
"From 2005, guess the length of time that is needed to assure [a 10 percent] long-term average? The answer - probably never." 19
As you look at this information, consider these recent words of Jeremy Grantham,
"The commercial or political imperative to deliver relentlessly bullish opinion is extreme, even when insiders may actually feel more bearish. To make matters worse, it seems that most of us are hard wired to be gullible; to believe that authorities know what they are doing, and that a large consensus view should probably be adopted." 20
- Capital Ideas and Market Realities (1999) Bruce I. Jacobs, Page 4.
- Ibid, p. 4.
- Unexpected Returns (2005) Ed Easterling, Page 34.
- Bull (2003) Maggie Maher, Page 46.
- Interview with Doug Gillespie, Gillespie Research, October 21, 2005.
- Capital Ideas and Market Realities (1999) Bruce I. Jacobs, Page 45.
- Ibid, p. 40.
- Interview with John Breazeale, President of Delray Financial, August 31, 2005
- Capital Ideas and Market Realities, p. 5.
- Ibid, p. 42.
- Ibid, p. 148.
- Ibid, pp. 152-153.
- Chart- http://www.tradertech.com/blackman_article2.asp
- Samex Capital's Stock Market Crosscurrents (October 17, 2005),
Alan Newman, page 1,
To subscribe to his research, visit www.cross-currents.net.
- Ibid, p. 2.
- Ibid, p. 1.
- Source of data- http://www.occ.gov/ftp/deriv/dq205.pdf, page 7
- Elliot Wave Financial Forecast, November 2005, page 4 To learn about their services, visit www.elliotwave.com
- Dallas Morning News (Wednesday October 26, 2005), The New Math of Stock Returns, Will Deener, page D1
- GMO Special Topic, Letters to the Investment Committee V, The Bullish Bias in the Investment Industry, October 2005, Jeremy Grantham, page 3. www gmo.com