Lessons From a Crash

It was the year 1987 AD. Berlin wall still stood tall in all its sadistic glory. Developed world was using computers of 386 vintage as a force multiplier in many fields. Back in India a new car called Maruti had recently been launched to challenge the duopoly of Ambassador and Premier Padmini.This was also the period when a certain Diego Maradona was setting football grounds on fire with his brilliant individual skills.
For the US stock markets,1987 was turning out to be another spectacular year. By August the benchmark Dow Jones Industrial Average (DJIA) index had registered about 40% gains for the year. In fact the five year bull run since 1982 had catapulted the DJIA 3 x.US economy too was dashing ahead having registered five straight years of expansion.
The tragic developments that were to follow – particular in October – would leave more than a hole on market psyche. Many large financial institutions received a big jolt, some smaller ones faded into oblivion, a large number of investors lost sizeable amounts in the markets, and many a promising career was cut short after this event, dubbed as the black Monday.
Unfortunately the financial world moved on post the 1987 crash without taking the lessons properly. Not surprisingly some avoidable though extreme disruptions, with some similarity to that of 1987, have been hitting the markets with remarkable regularity. Lessons from 1987 could have cushioned the impact of events like ASEAN crisis (1997), the LTCM disaster (1997), Tech boom and bust (1997-2002) and global financial crisis (2007-2009) – if not prevented them altogether. For the 1987 disaster the culprit was the same, eternal one – unfettered greed that throws caution to the winds. However this was the first time when the folly of greed was riding the dragon of derivative instruments. The latter inflicted the main damage once lust for easy money had blindsided market participants.

The Learnings First

Why did the markets fall precipitously on 19th October, 1987 ? To say gravity, won’t be an oversimplification.The markets had risen too high too fast and hence they were ripe for a rout.
The lessons for market participants (especially equity investors), financial institutions and regulators were quite clear if one analyses the events of that fateful period of October’87 –
1. If some profit seems too good to be true then chances are quite high it is so. It is important for investors to steadfastly refuse invitations for free lunches in markets.
2. At any point in time, inability to justify a course correction for markets in future does not guarantee continued momentum, or even status quo. For example, if market frenzy takes a stock to price/earning multiple of 45x – say, substantially ahead of historical and peer group valuations – then the stock is best avoided even if one cannot pinpoint even a single reason for potential correction.
3. Even simple looking derivatives should be handled with care. People with less than perfect, understanding of and, experience in these instruments should treat derivatives as nothing but weapons of mass destruction
4. There is another and deeper issue with derivatives. Superficially the outcomes and methods look as simple as they seem compelling. Thus slowly people get sucked into the cauldron lured in by specter of easy profits. After some time the application of a particular derivative instrument becomes so widespread that contagion risks grow exponentially and uncontrollably. Now one seemingly innocuous mistake by an untrained hand is what it takes to bring down the entire edifice. Even people who understand and are experienced in these instruments find themselves helpless once the genie has been set free.
5. Quantitative models, even if they are mathematically rigorous and practically simple, are unable to capture emotions and hence can become irrelevant precisely when they are needed the most.
6. A quantitative strategy based on assumptions on correlation – among certain assets – derived from intricate data from past can often fall flat on its face when markets turn irrational. These correlations can in no time swing from a sizeable negative value to a meaningful positive one. An asset supposed to hedge another one may end up doubling the exposure in reality thus piling in the misery.

Anatomy of a stock market crash

On Monday, October 19th, 1987, DJIA nosedived by 22% – the biggest ever single day fall. The index remained extremely volatile for the week though it closed the week above Monday’s closing.

The solid trailing performance over preceding five years had layered a lot of froth over the markets and was also converting investors into reckless risk takers. On October 14th, and 16th the index had fallen by 4% each. Interestingly, news flow leading into the disaster was not too conspicuous even in hindsight. Some examples –
* Surprisingly high trade deficit
* 30 year bond yield rose above 10 percent level for the first time in two years
* US treasury secretary warned that the US might stop providing support for the dollar
* Legislation was coming up in the congress to tax greenmail

However, a chart showing an eerie similarity between 1987 and 1929 crash had been doing the rounds since early 1987 which had prompted some prescient (and/or lucky) traders to go short on the market.

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For the majority though the developments came as an avalanche from which some took a long time to recover.

The Mindset and The Protagonists

While psychological seeds for this disaster were sowed by widespread greed for easy money, by poor memory of market trends prior to 1982, and by an uncontrollable urge not to be left behind peers, there were three sets of protagonists in the mayhem around the black Monday. The three protagonists had one thing in common – they all were based on sophisticated strategies that seemed simple, elegant and practical. The three protagonists were –
1.       Risk arbitrageurs: Risk arbitrage (arb) desks at various financial institutions were thriving on betting on who would take over whom in the takeover boom of those days.The weapons for takeovers were high yield bonds which provided capital for a raider to make a run on the target company.
2.       Portfolio insurance buyers: Portfolio insurance is effectively a dynamic hedging strategy designed to prevent a stock portfolio dipping below a predetermined floor. As the portfolio value rises hedges are reduced. Hedge is increased as portfolio value declines and as that latter slips below the floor the portfolio is fully hedged. Thus the instrument looked like a remarkably simple way to enjoy best of both the worlds – participate in the upside if portfolio is moving up and limit your downside if the markets are tripping. The strategy was based on the now famous Black-Scholes equation for option pricing.
3. Cash – future arbitrageurs

The snowball …..

On October 14th, the Street realized that there was a bill in the congress that intended to tax greenmail. This would dim the prospects for many takeover in the works. As a result risk arb firms started a broad liquidation which in turn weakened the markets.
The drop in the market was felt by portfolio insurance hedgers who were forced into their own programmed selling which continued through 16th October, Friday.

…..Gathers Momentum….

Over the weekend – after running their models on Friday closing prices – many more portfolio insurers got ready to make adjustments to their positions to increase their hedges by liquidating stocks. It still seemed business as usual at portfolio insurance desks as models appeared to be in control and nothing had gone beyond the script.
However mutual fund clients of these portfolio insurers were panicking and giving sell orders. Redemptions on Friday and on weekend meant that a commensurate amount of their equity positions had to be sold.
On Monday, 19th October even before the markets opened portfolio insurers had sold S&P futures worth 500 m, about 30% of public volumes. Futures prices dropped precipitously – and stock markets had not even opened.
Now, as the chasm grew between cash and future prices, cash- futures arb teams waded in to gain from this widening gap. With market yet to open on Monday – 19th October, cash price was being assumed at Friday closing and as futures had dipped pre-market there was a seemingly big opportunity for cash – future arbs. However risk of gap down opening of stock markets that had somehow been overlooked, was to play out soon- and, painfully.
Here in futures market the cash – futures arb traders were the other side of portfolio insurance hedgers .These traders in turn were depending on stock market for their other side of the trade. Effectively the cash-futures arb traders were taking the market impact from the futures and transmitting it back to individual stocks on NYSE. In this normal link up between cash and futures markets the weak link was the difference between the time frames to transact in the stock markets, and in future markets. The latter was much more quicker. Further, liquidity in cash market was much lesser than in futures market. This proved to be calamitous that day for traders who had been lured in by the siren song of cash versus futures arbitrage.

…..Finally turning into an avalanche

Finally when the cash market opened it was at a breath taking discount to Friday closing. Due to this gap down opening of stocks, sell orders started building up and potential buyers, even the long term players, panicked effectively closing a liquidity tap that could have provided succor to markets. Thus stock prices started falling sharply prompting portfolio insurers to throw more sell orders into the futures markets. Dipping futures, in turn, pulled down the stock prices too.
The cascade in stock prices wreaked havoc on cash – futures arbitrage traders ( gap down opening of stocks turned their arbitrage opportunity on its head), who started limping to the sidelines thus depriving the markets of another source of liquidity. Meanwhile the portfolio insurers continued their selling spree even as liquidity was drying up. The result was that the DJIA saw the worst ever single day decline of 22%.

Shrug off  – the post script

The disaster with its genesis in unbridled greed, herd mentality, inability to raise even basic questions, and unrestricted application of derivative instruments by untrained hands – should not have come as a surprise. What was remarkable was the resilience post the disaster. The index retraced the losses in less than 18 months in a sense paving the way for the next disaster in mid -nineties.

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