Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
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.
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.)
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
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:
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.
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.
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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.
they had immunized themselves against financial hysteria. Bank runsdepositors
wanting their moneywere 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 earningsprofitsof $1 per share and a stock
price of $15, its P/E is 15.) Although stocks might go lower, few investors
expected a collapse.
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
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 contractsand
their declines drove stock prices down more. The two fed on each other.
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.
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 companiesGeneral
Motors, Ford, Citicorpannounced 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 upsetsthe 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.
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.
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 Ive 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 soldor 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.
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?
said he was looking for a book called "The Great Crash"
-- a book he had recently written.
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
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