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Chapter 1 Martellini Lessons From 1987 Crash

Chapter 1 Martellini Lessons From 1987 Crash - l Lessons...

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Unformatted text preview: l Lessons From Th31987Crash HE STOCK-MARKET CRASH OF 1987 WAS HOR- - rifying even to Americans who weren’t share— holders. On Oct. 19, the DowJones industrial av— erage dropped 508 points, which was 22.6 percent and nearly twice the largest one-day decline dur- ing the 1929 crash. A comparable free fall today would be almost 3,200 points. Twenty years later, the crash of 1987 has changed the my 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. 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 iden- tical to the fall from early 2000 to late 2002). Nor is a panic simply the “pop: ping” 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 immu- nized themselves against financial hyste- ria. 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 19305, Congress added deposit insurance so that a run on one bank would not cause a chain reac- tion. As for the stock market, the Securi— ties and Exchange Commission, created in 1934, policed for the financial fraud that had often triggered panics. Finally, full—time portfolio managers for “institu— tional investors” (pensions, mutual funds, insurance companies) and invest— ment 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 4-1, Procter 8c 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 compa- ny has earnings—profits—of $1 per share and a stock price of $15, its P/ E is 15.) Al- though 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 i 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, 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. three lessons stand out. First, financial markets change con— standy, and, because what’s unfamiliar is risky, they create new opportunities for miscalculation and mayhem. The un- pleasant surprise in 1987 involved futures markets. Futures contracts (in effect, bets on some fiiture price) on the Standard 8c Poor’s index of 500 stocks were fairly new. As stock prices dropped, some investors sold S&P futures contracts—and their de— clines 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 , g s i e g a E E E prices, many investors freeze or panic. In October 1987, the New York Stock Ex- change’s order system was overwhelmed. Delays ofien 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 trad— ing 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 reaflh'ming its “readiness to serve as a source of liquidity to support the economic and financial sys- tem.” Translation: it eased credit. Gerald Corrigan, head of the New York Fed, pri- vately 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 compa— nies —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 “sub- prime” 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 he wishfiil thinking. Global markets are more com- plex 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. amount 15. 2001 NEWSWEEK 45 ...
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