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November 01, 2005 1987 Redux |
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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.
Next, Dr. Jacobs describes how portfolio insurance sought to protect investors.
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,
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,"
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.
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,
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,
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,
Black Monday 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.
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.
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:
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.
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.
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,
As you look at this information, consider these recent words of Jeremy Grantham,
Sources:
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Doug Wakefield, Best Minds, Inc is a registered investment advisor that looks to the best minds in the world of finance and economics to seek a direction for our clients. To be a true advocate to our clients, we have found it necessary to go well beyond the norms in financial planning today. We are avid readers. In our study of the markets, we research general history, financial and economic history, fundamental and technical analysis, and mass and individual psychology. Copyright © 2005-2009 Best Minds Inc. Image rendition and html coding Copyright © 2000-2009 SafeHaven.com ADVERTISEMENTS
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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.
Consider
the growth of program trading. Alan Newman, editor of 
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