We face a bigger threat than 1987
After the 1987 crash, many expected the worst, says Edward Chancellor. Investors would be wise to be on their guard in case it happens again.
Thirty years ago, on 19 October 1987, the US stockmarket experienced the largest single-day decline in its history. While 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: a panic induced by program trading, which threw a huge volume of sell orders for stocks into a falling market.
Until the late summer of 1987, American stocks were on a tear. Between the New Year and Labor Day (the first Monday in September), the Dow Jones Industrial Average climbed by more than 40%. 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 elevated. Iran had recently attacked a US-flagged oil tanker in the Gulf, and President Ronald Reagan promised to retaliate.
Fundamental factors alone can't explain why on the morning of 19 October, after heavy market declines across Asia and Europe, the New York Stock Exchange faced a tidal wave of selling. NYSE specialists were overwhelmed trading in the S&P 500 index was reduced to 25 stocks. At the Chicago Mercantile Exchange (CME), 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% while index futures fell nearly 29%. 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 only assuaged when the Fed announced before Tuesday's opening that it was providing liquidity "to support the economic and financial system".
Most accounts of the 1987 crash blame the tumult on the widespread use of portfolio insurance by institutional investors. This promised to limit losses by automatically selling stocks as the market declined, which seemed attractive on paper. By October 1987, portfolio insurance covered roughly $100bn-worth of equities, equivalent to around 2%-3% of the market's total capitalisation.
On 19 October, program sales, accounting for up to 40% of futures market volume, overwhelmed the market's liquidity. Since a number of currently popular strategies also involve automated stock sales in response to an initial fall in markets, another 1987-style crash cannot be ruled out (see below).
The lesson that most have taken away from what happened three decades ago is that crashes, however severe, aren't a concern for long-term investors especially when the Fed has their back. But it's easy to overlook the fact that conditions in October 1987 were more favourable than they are today. Today's conditions more closely resemble the Great Crash that began on 24 October 1929.
That panic took place in the midst of an extremely overvalued stockmarket, elevated corporate profits, excess leverage and an unsettled international situation just like today. It was also exacerbated by a form of program trading, as brokers sold out clients who couldn't make their margin calls. Current NYSE margin loans are greater than ever before.
After the 1987 crash, many expected the worst. The financier James Goldsmith, who had exited the market earlier in the summer, compared his position to "winning a rubber of bridge in the card room of the Titanic". Investors today are sitting at the same card table.
A version of this article was first published on Breakingviews.
Markets then and now
The US market's total capitalisation stands at around 140% of GDP today, roughly twice its level of October 1987. There's also a lot more debt around. Thanks to a leveraged buyout boom, US corporate debt back in mid-1987 had climbed to 19% of GDP. Today, in the midst of another buyout boom, it exceeds 31%. This makes firms even more vulnerable to a sudden rise in interest rates.
Three decades ago, US corporate profit margins were relatively depressed. Today, earnings are at near all-time highs and have potentially a lot further to fall. Finally, after decades of financial globalisation, the risks of cross-border contagion from a US market crash are far greater.
The strategies that could spark the next panic
Speaking at the Grant's Conference in New York earlier this month, Frank Brosens, co-founder of investment firm Taconic Capital, pointed to a number of current strategies that have the potential to unleash large-scale automated trades into a downturn.
Insurers have been selling principal-protected variable annuity products, which are forced to reduce market exposure when volatility rises. Commodity trading advisers pursue momentum strategies that require selling stock futures when the market declines. Risk parity, another hedge-fund strategy, 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 cut leverage and reduce their equity positions.
Exchange traded funds (ETFs) that hold stocks on leverage must cut exposure when the market declines. Most worrying of all are the ETFs which sell volatility futures: implicitly leveraged and roughly five times more volatile than the market. In a large volatility spike, such strategies will blow up.Brosens estimates these strategies have a market exposure north of $1trn a larger share than portfolio insurance back in 1987.