Thirty years ago yesterday I pushed my way into a crowded conference room at the New York Stock Exchange shortly after the day’s trading had ended.
The air was thick with the fear of journalists and stock exchange officials alike. The Dow Jones Industrial Average had plummeted 20 percent during the day, the record still for its largest one-day loss.
Only John Phelan, the NYSE’s chairman, seemed to summon a measure of calm. But he wasn’t reassuring: “I call it the nearest thing to a meltdown I’m ever likely to see.”
“Three more days like this and we’ll be down to zero!” shouted an American TV reporter.
“My advice is to buy at one,” Phelan replied, as I reported next morning as Wall Street correspondent for the Financial Times.
Phelan was right to assert fundamental value would underpin the market. Within 18 months, the market had fully recovered without significant damage to the economy along the way.
Many great market crashes had occurred before causing varying degrees of mayhem and damage. The ones since have been equally varied: the quadruple whammy in 1989 of the Asian Crisis, the Russian sovereign debt default, the failure of the Long Term Capital Management hedge fund and the collapse of the Japanese stock market, followed by the Dotcom bust in 2000; and the Global Financial Crisis in 2007-08, followed by the Eurozone sovereign debt crisis 2009-11.
While each crisis has its own triggers, many fall into three broad categories.
First are technical triggers. The 1987 US stock market crash was one of the purest examples. It was caused by the failure of regulations and market mechanisms to cope with new trading products and strategies.
The heart of the issue was the unstable relationship between share prices and new futures and options products. Periodically, future and options expiry dates would coincide to create a “triple-witching hour” on a Friday afternoon, which would unsettle the market.
As it happened, the Friday morning before the 1987 crash I was in Omaha, Nebraska, interviewing Warren Buffett for an FT profile. The corridors of Berkshire Hathaway’s reception were lined then, as today, with newspaper front pages of stock market disasters. As Buffett led me to his office, he regaled me with the stories.
Was he worried about the pricey market today? I asked. He didn’t have a care in the world, he replied. He only invested long term in companies with sound businesses.
By early afternoon, I was heading back to New York as a “triple-witching hour” was about to greatly spook the market, thereby triggering the precipitous collapse on the Monday.
Shares had had a spectacular run, rising 282 percent in just under six years. Yet, they were still priced at just under 20 times their 10-year earnings. But there were some economic concerns at the time.
However, that afternoon the futures and option strategies that supposedly provided “portfolio insurance” became weapons of wealth destruction. In the aftermath, regulatory and exchange changes made the markets more secure and stock prices recovered.
In New Zealand our 1987 crash shared some common characteristics with the US’s but these were supercharged, producing radically different outcomes. This was the “wild south” of markets, with grossly inadequate regulations and reckless trading behavior.
Moreover, economic liberalisation had created frenzied speculation by retail and professional investors alike. More than 200 companies, many of them with no or dubious value, were floated 1982-1987. By comparison, only 34 have floated in the past five years.
Our market had tumbled then recovered in August and September 1987. But the US crash in October pushed it over the cliff. By February 1988, our market had fallen 60 percent from its peak, the steepest fall in the world. Many high profile, flakey companies failed such as Equiticorp, Chase and Renouf along the way.
It took years to repair the economic damage; and only in the past decade or so have we finally achieved reasonable regulatory regimes and investment practices, and a range of solid companies capable of weathering storms.
Could global markets suffer another collapse caused by technical failures? Yes. Over the past decade, highly automated, ultra high volume and high speed trading has triggered a number of “flash crashes”.
The markets have quickly recovered after each. But a fair few market participants and regulators in the US and around the world worry about the risks of a disaster greater than 1987, particularly from trading vehicles untested in extreme markets. One example is Exchange Traded Funds, which now account for some US$4 trillion of assets.
Radical and risky innovation is a trigger for a second type of market crash. For example, the Dotcom bubble was driven by wildly unrealistic views about how the internet would develop and what type of companies would flourish in it.
At the height of the boom the NASDAQ market in the US, home to tech companies, was trading in more than 200 times earnings. Shares in a number of companies rose by more than 1,000 percent in 1999. Few survived after the market crashed in 2000.
It took a second generation of major tech companies to create hugely profitable business models, and reward investors accordingly. The big five are Alphabet (parent of Google), Apple, Facebook, Amazon and Microsoft. That group today has a market cap of some US$3 trillion. But with forecast earnings of some US$110 bn this year, their shares are trading on high multiples in expectation of unfettered growth for years to come.
A third type of crash trigger combines risky innovation with regulatory failure. For example, the US Federal Reserve relied on very slack monetary policy to keep the US economy on track after the Dotcom bust. This helped fuel the asset bubble, financial market innovation and deregulation, and imbalance of financial flows between countries that then triggered the Global Financial Crisis in 2007-08.
The invention of sub-prime mortgages in the US led to a vast, rapid proliferation of other forms of highly engineered, deeply toxic debt instruments and derivative products around the world.
The repercussions for the US and European economies were severe, particularly for the Mediterranean members of the Eurozone. Central banks resorted to unprecedented measures such as ultra-low or even negative interest rates, vast purchases of debt securities, and money creation to stabilize markets and economies.
These days the global economy is growing at a moderate pace and seems relatively unstressed. But with interest rates still so low, central banks are deprived of their main tool for tackling economic crises. Moreover the Fed and the European Central Bank are starting to unwind their massive balance sheets.
A policy miss-step by central banks in this uncharted territory was the number one market risk fund managers identified in a recent global survey by Bank of America Merrill Lynch.
A number of former central bankers have been thinking deeply about these challenges. For example, Ben Bernanke published this recent blog on how his former colleagues at the Fed could respond if the next economic crisis was price deflation.
Similarly, Mervyn King and Adair Turner, respectively Governor of the Bank of England and the UK’s chief financial regulator during the GFC, have written books about the radical changes needed in the very nature of financial systems.
With such massively complicated and unanswered questions swirling through the global economy, it’s no surprise the anniversary of a major stock market crash prompts investors to reduce all these to one issue: are equities over-priced?
The bulls say yes. We’re in a whole new world of low inflation, moderate economic growth, low interest rates and a reasonably benign international environment. Companies will thrive and deliver for shareholders.
The bears say no. We’re in a whole new world of radical shifts in technology, politics, economics and society; central banks, governments and economies are still burdened by baggage and unfinished business from the GFC; and the world is ever more intensely interconnected. Only the very best companies, young and old, will adapt and thrive.
But choosing which companies is a phenomenal challenge, even for an investor as gifted as Buffett.