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ANALYSIS
March 2, 2009
Sagging Index no longer reflects what’s going on in the market, some say, Replacements? Google it, to start.
March 2, 2009
Downward price spiral will actually boost the cost of capital for most companies. CFOS, take note.
March 2, 2009
The latest bailout at AIG could be a preview of how the president will deal with Wall Street.
March 2, 2009
No corporate defaults. Big debt offerings. Percolating CP issuance. Things may be looking up in the capital markets.
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October 8, 2007 12:01 AM ET
Twenty years after Black Monday—one of the largest stock market crashes in history—seasoned investors and economists say the industry has forgotten important lessons about the fickle nature of investing and market liquidity. In fact, the only lesson that seems to have stuck from the Oct. 19, 1987, market meltdown is that the Federal Reserve will bail out investors if things get really bad. Immediately after the crash, Alan Greenspan, freshly sworn in as Fed chairman in August 1987, said the Fed would provide “all necessary liquidity.” Some observers think his successor, Ben Bernanke, has continued the so-called Greenspan put. Fortunately, veteran investors and economists say today’s market is better equipped to avoid severe plunges. One of the main culprits in the crash was portfolio insurance, a program-trading strategy that caused pension funds to sell Standard & Poor’s 500 index futures when the market fell below a set level. The concept was that arbitrageurs would buy the underpriced futures, sell the underlying stocks that were trading at a higher price, and pocket the spread. On Oct. 19, however, the market for the individual shares had evaporated, causing stock prices to plunge below the level of the futures contracts and thus creating a downward spiral. Because arbitrageurs knew that at least $68 billion in futures contracts would be lined up for sale following a 100-point market drop the previous Friday, they stopped buying, Michael J. Clowes, contributing editor of Financial Week, wrote in his 2000 book, The Money Flood. The result: The Dow Jones industrial average plunged 508 points on Oct. 19, a whopping 22.6% loss. “The problem in ’87 was the assumption there would be enough liquidity in the market to replicate portfolio insurance options. That didn’t happen,” said Bill Gross, chief investment officer of Pimco. “That was the case on Aug. 14 [2007] as well. There was no liquidity. No one was buying anything.” Mr. Gross was referring to the day this summer when rumors swirled that Countrywide Financial was in liquidation mode and the market dropped 208 points in the midst of the subprime mortgage mess. “We didn’t believe [a lack of liquidity] would happen,” Mr. Gross said, referring both to the 1987 and 2007 debacles. “An investor can’t assume at any point there will be a semblance of liquidity.” “Liquidity often dries up when you need it most,” said Bruce Jacobs, principal of Jacobs Levy Equity Management. “In 1987, portfolio insurers suffered from the illusion that the futures market would offer unlimited liquidity.” Another lesson forgotten from 1987 is that it is dangerous for investors to put money into complicated instruments they don’t understand. “For a while, we learned transparency is good. But we soon forgot, such as in the hedge fund arena,” said William F. Sharpe, now an emeritus professor of finance at Stanford’s Graduate School of Business. “Portfolio insurance wasn’t transparent,” Mr. Sharpe explained. “Even the most informed investor underestimated how much was being run that way and trading from information-less mechanistic decisions. More information [about portfolio insurance in the market] might have mitigated the fall.” Today, many investors have even less information about the products in which they invest, said Roger G. Ibbotson, professor in the practice of finance at the Yale School of Management, and chairman and chief investment officer of Zebra Capital. “People thought portfolio insurance was hard to understand because it was a synthetic put. Today’s structured products are much harder to understand than those products,” he said. “The extraordinary downturn [of 1987] left an important lesson: Know what you are buying,” said David J. Dykstra, executive vice president of Northern Trust Global Advisors. This summer, as in 1987, “people bought securities they didn’t understand,” said Mr. Dykstra, who in 1987 was director of pension assets at United Airlines, now a subsidiary of UAL. Along with understanding their investments, investors should also know who else is investing in those instruments, added Jacobs Levy’s Mr. Jacobs. In 1987, investors made the mistake of not knowing the total amount invested in portfolio insurance, so they did not know how big the sell-off would be if stock prices fell. Many investors have repeated that mistake, he said. “The risk of a strategy may not seem all that great when you think you’re the only one doing it, but when every firm is offering portfolio insurance, or every highly leveraged multistrategy hedge fund is following a similar strategy, risk goes way up,” Mr. Jacobs said. “We saw this in 1987 and again today. I think that’s a habit that’s hard to break, because breaking it means forgoing short-term profits.” One lesson that investors do seem to remember from the 1987 crash is considered by many to be an unfortunate one: that the government will bail the financial markets out of tough situations. “The market has more of a touching faith in the Fed to solve all problems,” said Jeremy Grantham, chairman of the board for GMO. “It’s a moral hazard. If you look after them every time, they’ll take more and more risk.” But the good news may be that investors’ portfolios and the market itself are better protected against a severe crash. The depth of today’s derivatives market also makes a severe crash less likely, said Mark Rubinstein, a finance professor at the University of California at Berkeley’s Haas School of Business and a founding director of Leland O’Brien Rubinstein Associates, which created and licensed portfolio insurance as a method of downside protection. Laws have changed too, and now allow mutual funds to borrow money in emergencies so they do not have to sell stocks if there is a run of redemptions. “Back then, you had a lot of forced selling by mutual funds,” said Steven Leuthold, founder and chairman of the Leuthold Group, a Minneapolis-based institutional research provider. Mr. Leuthold said circuit breakers put in place on the New York Stock Exchange after the 1987 crash also should prevent a repeat. “At least under certain circumstances, you can call a time out and let people think about what they’re doing before they start trading again,” he said. But circuit breakers might not work, Mr. Sharpe said. “There are a lot more places to trade today,” so investors can find a way to circumvent restrictions. “I don’t think the controls are a good idea. It’s sort of like breaking the thermometer because you don’t like the results. “If consenting adults want to trade,” he said, “let them trade.” —Pensions & Investments
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