Technology Investor 

Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

Previous Columns
8:30 AM EST, Thursday, October 11, 2007:
On October 19, 1987, the market fell 22.6%. In 1929 it fell 24% in two days. Thems huge falls. Gargantuan falls! Next week we will "celebrate" the 20th anniversary of the 1987 crash.

Reporters and analysts will try for two feats:

1. How and why did 1987 happen? That's called analysis.

2. Will a fall of that magnitude happen again? If so, when? That's called prediction.

Analysis: It happened because Wall Street's trading computers were programmed to sell when stock prices went down. The term is automated stop losses. (But it was called "portfolio insurance" in 1987.) The computers took over and sold everything. The more they sold, the faster the prices dropped. As humans watched the carnage, they panicked and sold also. And so the whole thing spiraled downwards for the day. The next day it spiked back 6%. And of course, since then it's exploded -- massively so. The time to buy was during the afternoon of October 19 -- if you had the cash. (See below.)

Prediction: Could a big drop happen again? Yes. Computers today are responsible for the bulk of today's trading -- even more so than in 1987. I believe they're programmed differently. They're more likely to buy when they see a big dip than sell. But I don't know. No one does. All those hedge fund computers are programmed secretly. You're more likely to find out Al Qaeda's next target than you are to find out how the quants have configured their computers. I know I've tried. The quants are the most secretive bunch I've ever met in 50 years of writing and reporting.

Could a big drop happen because people panic? YES. I panicked and recently sold Garmin at $86. The thing is now $111.54. I'm human -- stupid and panicky. I'm no different to anyone else, excepting of course, the readers of this column, who are super-smart (and respond positively to flattery).

Will a big drop happen next week? I don't think so. Though it is interesting to see that some of the stars are aligned with 1987. The dollar is falling. Our federal budget is in major deficit. P/Es are fairly high. The market has been on a tear. And we've recently had some down days.

I asked my friend Dan Good for his reminiscences on 1987. His email this morning:

I was in NY and had just finished a report on the breakup analysis and valuation of most of the Fortune 500 companies which showed valuations of large premiums to their pre-crash prices. When the market crashed, I couldn't believe the lower prices would hold because nothing fundamentally had changed with them or the economy so I bought virtually all of them. Two days later, when the market came back, I literally doubled my money and sold. I have very pleasant memories of the 1987 crash and recovery.

Who knows why it happened, but Wall Street was in panic over the insider trading scandals and problems with various countries were causing concerns.

Of course it could happen again. The herd mentality will always be with us.

If you want to read more, here's a list:

1. The 1987 Stock Market Crash.

2. The book called "A Demon of Our Own Design -- Markets, Hedge Funds, and the Perils of Financial Innovation" by Richard Bookstaber. Buy it at Amazon.

3. Lessons From the 1987 Crash by Robert J. Samuelson in the latest October 15 issue of Newsweek. Here's his piece in its entirety.

We used to think that financial panics were a thing of the past. Now we know that they are a clear and present economic danger.

The stockmarket crash of 1987 was horrifying even to Americans who weren't shareholders. On Oct. 19, the Dow Jones industrial average dropped 508 points, which was 22.6 percent and nearly twice the largest one-day decline during the 1929 crash. A comparable free fall today would be almost 3,200 points. Twenty years later, the crash of 1987 has changed the way we think. It's stripped us of the illusion that financial panics are a thing of the past: they remain a clear and present danger for the economy.
Story continues below ?advertisement

Let's be clear. A financial panic is not just a big price decline. Since World War II, there have been plenty of those. From early 1973 to late 1974, the stock market dropped roughly 50 percent (almost identical to the fall from early 2000 to late 2002). Nor is a panic simply the "popping" of a "bubble," though it might start that way. In a panic, fear takes control. Herd behavior swiftly triumphs. There's a stampede. People want cash—"liquidity," in finance lingo.

Americans thought they had immunized themselves against financial hysteria. Bank runs—depositors wanting their money—were the major form of panic, and Congress had dealt with them. In 1913, it created the Federal Reserve to lend to solvent banks. When that didn't prevent bank runs in the 1930s, Congress added deposit insurance so that a run on one bank would not cause a chain reaction. As for the stock market, the Securities and Exchange Commission, created in 1934, policed for the financial fraud that had often triggered panics. Finally, full-time portfolio managers for "institutional investors" (pensions, mutual funds, insurance companies) and investment houses dominated markets. Better informed, these professionals seemed less susceptible to herd behavior.

On Oct. 19, these comforting beliefs vaporized. General Electric fell from 50 to 41, Procter & Gamble from 84 to 61, IBM from 134 to 103 (all prices rounded to the nearest point). To be sure, stocks had seemed overvalued. Since recent lows in mid-1982, they had roughly tripled. The market's price-to-earnings ratio (P/E) was 22, up from 13 four years earlier. (The P/E is an indicator of stock value. If a company has earnings—profits—of $1 per share and a stock price of $15, its P/E is 15.) Although stocks might go lower, few investors expected a collapse.

What's fascinating is that "20 years later, we don't know much more about the causes of the crash than we did when it happened," writes Matthew Rees in The American magazine. In his recent memoir, former Fed chairman Alan Greenspan takes a similar view. Still, as Rees's retrospective makes clear, three lessons stand out.

First, financial markets change constantly, and, because what's unfamiliar is risky, they create new opportunities for miscalculation and mayhem. The unpleasant surprise in 1987 involved futures markets. Futures contracts (in effect, bets on some future price) on the Standard & Poor's index of 500 stocks were fairly new. As stock prices dropped, some investors sold S&P futures contracts—and their declines drove stock prices down more. The two fed on each other.

Second, financial markets depend on computerized systems to provide prices and complete trades, and their breakdown can compound turmoil. Without accurate prices, many investors freeze or panic. In October 1987, the New York Stock Exchange's order system was overwhelmed. Delays often exceeded an hour.

Third, professional money managers fall prey to greed, fear and crowd behavior as much as amateurs. The SEC's post-crash study found that two thirds of trading came from institutional investors and investment houses.

The crash of 1987 did have a happy ending. Early on Oct. 20, the Fed issued a one-sentence statement reaffirming its "readiness to serve as a source of liquidity to support the economic and financial system." Translation: it eased credit. Gerald Corrigan, head of the New York Fed, privately urged banks to maintain loans to brokers and securities dealers; that helped avert a fire sale of securities supported by credit. Around noon, many big companies—General Motors, Ford, Citicorp—announced buybacks of their stocks. That propped up prices. The panic subsided; the market stabilized. On Oct. 20, the Dow rose 102 points.

Since the 1987 crash, there's been a steady stream of financial upsets—the 1997-98 Asian financial crisis; the failure of the hedge fund Long-Term Capital Management in 1998; the popping of the stock bubble in 2000, and now the "subprime" mortgage debacle. None has turned into a full-fledged panic, and it's tempting to conclude that we've learned how to manage these problems.

Perhaps. But this may be wishful thinking. Global markets are more complex than ever. Financial innovations (again: "subprime" mortgages) constantly surprise, unpleasantly. Dependence on technology has deepened. Herd behavior endures. The real legacy of 1987 is: expect the unexpected.

Speaking at the American Bankers Association annual convention Comptroller of the Currency John C. Dugan made some interesting comments. “When a bank makes a loan that it plans to hold, the fundamental standard it uses to underwrite the loan is that most basic of credit standards that I’ve already talked about: the underwriting must be strong enough to create a reasonable expectation that the loan will be repaid,” the Comptroller said. “But when a bank makes a loan that it plans to sell, then the credit evaluation shifts in an important way: the underwriting must be strong enough to create a reasonable expectation that the loan can be sold—or put another way, the bank will underwrite to whatever standard the market will bear.” Those are pretty powerful statements on a several levels. First it is reminiscent of regulators finally realizing subprime underwriting standards were nearly nonexistent just over a year ago, too late to prevent the damage currently occurring. Second if you are an investor who took a loss on these investments, these quotes will fit nicely in your legal briefs when you sue the bank who securitized the product. Finally, it is the head of the OCC telling bankers, your underwriting standards are too weak, and to get your house in order. The reality of the situation is that by the time the regulators take any real action as usual it will be too late.

Published without comment. Read the caption on the T-shirt:

The true story of the Great Crash: John Kenneth Galbraith was a popular author. He tells the story of how he was browsing a bookshop at La Guardia Airport on his way back to Boston. The shop attendant asked what he was looking for, could she help?

He said he was looking for a book called "The Great Crash" -- a book he had recently written.

She replied, "Oh no sir. We wouldn't sell a book like that in an airport."

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
Go back.