Black Monday 1.0: October 19, 1987
I was there at 10 Hanover Square, New York City, in the headquarters of Kidder, Peabody & Co. I was visiting the research and trading departments, which I did on a semi regular basis, to maintain relationships with the analysts and traders that serviced my institutional accounts in the Kansas City region.
It was surreal. The market was in the process of dropping 500 points in one trading day (from 2200 on the Dow to 1700 — almost a 23% decline in one trading day). This was after the Dow had already shaved off 500 points over the previous two months (from a 2700 top — 18.5%). I saw a lot of staffers walking around, dazed and confused, with that “thousand yard stare.” It truly felt like the end of the world as we knew it. The biggest problem for most was that we could not get our arms around what caused the severity of the decline. There was really no strong evidence as to what could be going on to cause this incredible panic, but we all assumed whatever it was it had to be very bad — WRONG.
The cause was not fundamental. It was bad Market Mechanics!
It was something the geniuses at the New York Stock Exchange and the Securities and Exchange Commission had not thought of when they lifted the “uptick rule” to facilitate the then latest rage, computerized program trading and the new investment tool called “portfolio insurance.” “Broadly, the models (portfolio insurance) would suggest that the investor decrease the (portfolio) weight on stocks during falling markets, thereby reducing exposure to the falling market, while during rising markets the models would suggest an increased weight on stocks.” (Fed Governor, Mark Carlson 2006) Buy higher, then higher … sell low, then lower … you get the picture. This exaggerated the existing trend and with no “uptick rule” the effects could be and were disastrous. Viola! You have the ingredients for the 1987 meltdown. It was not about the fundamentals. It was all about stupidity and bad market mechanics. This is very instructive. If you know the set-up is right for bad market mechanics to do do their wonders on price, you have a tremendous advantage.
The current “set up” just may be perfect!
“Black Monday 2.0: The Next Machine-Driven Meltdown” (you need a subscription to read) is not my own title. It belongs to this week’s edition of Barron’s Magazine. It is the title of their front page story. And, if my premise, Bad News Sells, is correct this headline should gather a lot of eyeballs. What is important here is that my blog usually takes Barron’s to task for their negative, sometimes sensational bad news stories. This week I applaud them. Their article provides investors with a valuable heads-up on a real issue that could negatively impact market mechanics and stock prices. It warns about the potential dangers of the proliferation of ETF investing and high-speed algorithmic-based computerized trading. Being fore-armed with the facts could make a potentially scary market decline a lot easier to for you to stomach.
What else could help you withstand this potential crack in the market?
First and foremost, learn from history! Learn from the bad-market-mechanics experience of 1987. Secondly, know it can happen again. Mark Twain said, “History doesn’t repeat itself but it often rhymes.” We could see a rhyme on the 1987 experience in the current market. Be comfortable with the stocks that you own (know what you own and why you own it) and the invested position (stocks vs. bonds vs.cash) that you are in. Be comfortable! This will keep you from doing something really harmful to your portfolio in a market panic. And, it may fortify you to take advantage of the many opportunities that would be created in this type of market (in the 13 years after the 1987 bottom the DOW more than quintupled).
Remember, Bad News Sells but sometimes that is good thing!
What’s your take?
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