30 Years Later: Can “Black Monday” Still Happen Today?

30 Years Later: Can “Black Monday” Still Happen Today?
Nov

20

2017

30 Years Later: Can “Black Monday” Still Happen Today?

You Bet it Can. How to Protect Yourself with a Cup of Coffee.

It’s October 19th, 1987. On the floor of the New York Stock Exchange, traders scurry about the floor, readying for the market’s 9:30 am open. Art Cashin, head of floor operations for PaineWebber turns to John Phelan, chairman of the Big Board.

“Morituri te salutant,” he mutters.

Translation: “We who are about to die salute you.”

On a dark Monday in 1987, stocks collapsed, losing close to a quarter of their value in one terrifying day of trading. This October marked the 30 th anniversary of “Black Monday.” With equity indexes once again cracking dizzying heights, media outlets from CNBC to the Wall Street Journal debated the pressing question that comes to mind when remembering this day of staggering loss: Can it happen again?

The October 16th edition of Barron’s provides us with an unsettling answer.

You bet it can.

As high net worth investors, our focus tends to fall on growing our assets and/or maximizing the income they generate for us and our families. With this focus on growth, we can sometimes forget that the vehicles we are using are not foolproof. This is especially easy to do when asset values are steadily increasing. Steady markets make us feel “safe.”


…the S&P was down 26% by year end 1987. During that same period, Coffee prices were up 10.6%, Soybeans were down 3.1%, Wheat was up 6.9% and Orange Juice was up by 20.1%.

There are those in the media and investment industry that try to reassure us that a 1987 like collapse cannot happen in this day and age. They make arguments about stop gap limits, ETFs, regulation and computer protections – things not in place in 1987. They make some good points.

However, the Barron’s piece, entitled “Computers in Control,” points out that the collapse was caused by a “quantitative tool” meant to protect against such a meltdown. Instead it morphed into a “poisonous feedback loop” of automated selling, crashing the entire market.

In short, a computer glitch.

Flash forward 30 years to 2017. Money managers, hedge funds, even some individual investors rely heavily on powerful computers to do their trading. These computers run quantitative, rules based systems known as algorithms to pick stocks, mitigate risk and place trades – often automatically and in some cases, even without the input of a human.

And manager reliance on these tools is growing – rapidly. In just the last decade, hedge fund assets managed via quantitative strategies has nearly doubled.

Barrons points out that these algorithms bear a disturbing resemblance to those blamed for Black Monday.


“The proliferation of computer-driven investing has created an illusion that risk can be measured and managed. But several anomalous episodes in recent years involving sudden, severe and seemingly inexplicable price swings suggest the next market selloff could be exacerbated by the fact that machines are at the controls.” -Barrons, October 2017

The piece goes on to cite several unsettling incidences that have occurred in recent years that could be a prelude to the next Big One.

Lets hope it doesn’t happen.

But if it does, you don’t want to be the one repeating Cashin’s impressive Latin.

Alternatives to the Rescue?

How do you counter this potential threat to your wealth? By distributing your asset base amongst different uncorrelated assets and strategies, of course. As we discussed in this newsletter last month – Diversification of both asset class and investment strategy is paramount. You should seek strategies that can potentially profit in a variety of circumstances – including bear markets, and potentially shrug off any goings on at the NYSE.

The High Net Worth Investor community has gradually been coming to terms with this new reality. The fact that Equities may not be the buy all end all asset class for life anymore has simply made them better investors. Financial Times reports that the assets managed by the 100 largest alternative investment managers rose to over $4 trillion dollars in 2016 – up over 10% from the previous year.

A recent Barron’s piece suggest that some asset managers are now comfortable recommending up to 50% of an investors assets be allocated to alternatives.*

*Barrons “Lets Look at the Alternatives” August 24, 2013.

All alternatives are not created equal, however. Marc Faber made a name for himself (and a fortune) as Wall Street’s “Dr. Doom” by shorting stocks in the months leading up to Black Monday.

Does that mean that you can gain protection by shorting stocks? Maybe. But that can be a complex, high maintenance, high risk procedure and its payoff over the long term is dubious.

Paper stock certificates are worth what those little numbers on the board say they are worth. They go up and down based on people’s emotions – or in the case of Black Monday, a computer program gone awry.

Frankly, I prefer something I can hold in my hand. Something that regardless of how people feel, will always have a value.

Holding Value as Stocks Collapsed

There is something instructive about the trader recollections featured in “Computers in Control.”

Cashin remembers that before his somber comment to Phelan on Black Monday, he “grabbed a COFFEE at the NYSE cafeteria.”

Abby Joseph Cohen, portfolio strategies at Drexel Brunham Lambert at the time, remembers that her and most of her peers stayed late at the office that night – until about midnight. She relays a story of going to the snack machine in the lobby for dinner – only to find that all of the candy bars, chips and other snacks were sold out. Candy bars, chips and snacks made from CORN, SOYBEAN OIL, SUGAR, COCOA and WHEAT.

Those traders still got in their cars and drove home that night in theirGASOLINE powered cars or took the subway powered by NATURAL GAS fired electric plants.

The point is, even in the worst of market meltdowns, people still need to eat, people still move about and we most certainly still need our coffee!

It was true in 1929, it was true in 1987 and it was true in 2008. It will still be true in the next market meltdown whether that be tomorrow or 2032. Unlike a piece of paper, a pound of sugar will always have a value. There will always be somebody who wants a bushel of wheat. The same cannot be said of a certificate of stock (at the low point of the 87′ crash, there were NO BIDS for many shares.)

If you think that’s a simplistic argument, consider that from it’s October highs, the S&P was down 26% by year end 1987. During that same period, Coffee prices were up 10.6%, soybeans were down 3.1%, Wheat was up 6.9% and orange juice was up by 20.1%.

Does that mean commodities move up when stocks move down? No. Does it mean that you should always be long commodities? No.

It does convincingly demonstrate that commodities cared little about stocks collapse because they are an asset class not onlyuncorrelated to equities but also somewhat uncorrelated to each other.

If memories of 1987 make you wonder if you’re overexposed to stocks, you’re already asking intelligent questions. If you’re considering alternatives, you may find commodities to be an intelligent answer.

None of us knows when the next 1987 meltdown will come along. But I can tell you that when it does, that snack machine will be sold out of corn chips and Snickers bars again.

Have a great month of option selling and a Happy Thanksgiving!

-James

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