Bull!

by Maggie Mahar

  Other seasoned investors sensed that something was very wrong. The nineties had not yet begun, but already investors like Robert Picciotto, a San Antonio, Texas, businessman who had been buying stocks on and off for 20 years, believed that an increasingly volatile market was no longer driven by fundamentals. “I used to think, having looked at this thing in the sixties, that buying equities was a stake in the progress of the economy. If you believed the country would do well, you would do well. Now, it’s become a very jerky market driven by people interested in these things as pieces of paper—the financiers,” he complained, referring to the buyout frenzy. “How you do with a particular stock has little to do with how the company does.”7

  Harvard economist John Kenneth Galbraith also took note of what he saw as a “speculative buildup,” and The New York Times asked him to write an article on the subject. “Sadly,” Galbraith later reported, “when my treatise was completed, it was thought by the Times’ editors to be too alarming. I had made clear that the markets were in one of their classically euphoric moods and said that a crash was inevitable, while thoughtfully avoiding any prediction as to precisely when.” (After the Times turned him down, Galbraith found a home for the piece at The Atlantic Monthly).8

  This is not to say that there was no basis for the boom of the eighties. In the early stages, corporate restructuring was boosting the bottom line. As companies “downsized,” expenses were cut, along with breadwinners, and earnings per share rose—a persuasive argument that stocks were worth more. Simultaneously, inflation dwindled, and long-term interest rates were halved. Still, if mergers had eliminated redundant vice presidents, these marriages also had pushed corporate debt heavenward. In Washington, the budget deficit loomed large. And the millions of Americans who lost their jobs to plant closings and layoffs would not be buying a second car. There was reason to worry.

  Once again, Richard Russell sounded the alert. In August of 1987, he warned his readers that he was downshifting his forecast for the market from “bullish” to “neutral.” On Thursday, October 15, four days before Black Monday, Dow Theory sent a “Sell” signal. Russell told his subscribers to get out.9

  Russell was not alone. The small but hardy crew of money managers who had survived the seventies knew a peak when they saw one, and this time they were not inclined to let the bear toss them from the top. “In 1987, there weren’t many novices in the market—it was a market run by professionals and at the beginning of the year, a lot of us knew that it was radically overpriced,” said Steve Leuthold, who had been managing money since the mid-sixties. “But in the spring, the market broke out, and institutional investors were afraid of being held at the post. They jumped in—it was panic buying.”10

  Leuthold, who ran his own shop in Minnesota, stuck to his guns. When the October crash came, only 16 percent of his model portfolio was committed to equities.11 But many fund managers were afraid of missing a run-up and falling behind their peers. They preferred market risk to career risk.

  At Morgan Stanley, Byron Wien, the firm’s domestic market strategist, remained fully invested, though he was frankly uneasy: “A number of truly successful investors with long memories have already stepped aside, preferring to be too early rather than face the possibility of having their portfolios abused by a waterfall decline,” he candidly told Morgan Stanley’s clients in late March. “Others, like myself, are hanging on for the last eighths, confident (alas) that we understand the special forces influencing this bull move….”12

  The end did not come without warning. The market had been spooked for months. After spiraling to an all-time high of 2722.4 in August of ’87, the Dow began to falter, losing more than 13.5 percent of its value in late summer and early fall. Nevertheless, on Thursday, October 15, the Dow still stood at 2355.1. Then, the apocalypse. Friday, the Dow plunged 108 points. Yet on Wall Street, many soothsayers remained sanguine. The market, they said, was due for a correction. After five halcyon years, they had forgotten the word “rout.”

  Traders had a more visceral reaction to Friday’s plunge. At stock exchanges coast to coast, they found themselves on the front line of the debacle. In Chicago, at 2:45 P.M. central time, Steve Lapper, a 30-something trader on the CBOE (Chicago Board Options Exchange), realized that he could hear the time clock ticking in the trader’s pit. Up until that point, the day had been almost normal. True, the market had already slid 100 points, but in an orderly fashion. Then, in just five minutes, the Dow blew up, plunging from down 85 to down 130 points. The silence was abrupt. An eeriness settled over the crowd. “You felt like the plane was losing power—and taking a dive. All the food was on the ceiling,” Lapper said later.13

  On the San Francisco Exchange, Rick Ackerman began to feel a little queasy when the market had lost 100 points and some traders began clapping and applauding. Ackerman, 38, had been working the San Francisco Exchange for nine years, and he knew the black humor of the trading pits. He realized that market makers were just trying to keep their spirits up. But Ackerman also knew that some traders weren’t taking the slide too seriously. At the end of the day, he found himself sitting between two traders who each had lost a few hundred thousand dollars. Both had been having an extraordinary year and weren’t too upset. One of them said, “I bet I get back at least a third Monday—on S&P futures.” The bravado scared Ackerman. That evening, he called a friend on the East Coast. “This is it,” he said. “It’s over.”14

  But on the morning of Monday, October 19, Ackerman wasn’t yet terrified—just a little edgy. No one knew what was going to happen. “Some expected the market to be blasting up right out of the chute,” he said. “They had lost 20 or 30 percent of their capital the previous week, and they were raring to go.” What followed was chaos. Some traders couldn’t even keep track of their positions. At day’s end, the Dow had plunged 508 points, a stupefying 22.6 percent. In Chicago, Steve Lapper lost $1 million in that one day.

  On the way out, traders didn’t speak in the elevators. Friday, they had chatted, half exhilarated by the action. “But Monday,” Ackerman recalled, “people just sort of grunted.” As for Ackerman, he had lost about one-third of his capital. His two friends who had been looking forward to the buying opportunities on Monday weren’t so lucky. When the crash began they were both approaching two-million-dollar years—but by the end of trading on Monday, both were in the red. In the afternoon one of them turned to Ackerman: “Rick, what do I do? I’m out of the game.” He was an excellent trader, a dozen years Ackerman’s senior. Normally, he did not ask for his advice. “But this was a guy with kids and a mortgage,” Ackerman said later. “He just looked really sick.”

  A few swashbuckling skeptics had the nerve to short the market. Most were fairly young. Lapper estimated that some of the novices made enough to retire on. He knew one trader, a very smart, very nice guy, 29 years old, who had been short for a month or two. Probably he made millions. But the winners weren’t bragging. They looked sheepish. If someone asked, they said, “Yeah, I did okay.” Lapper saw only one trader with a giddy look. “He wasn’t mature enough to hide the gains on his face.”15

  In Boston, Fidelity, the nation’s preeminent mutual fund firm, was coping with its own chaos. The success of funds like Peter Lynch’s Magellan Fund—combined with aggressive marketing—had made Fidelity the crown prince of financial service firms. Long before the decade of online trading, Fidelity had made it easy to buy a stock: just dial 800. And while most mutual funds reported their results only once a day, after the market’s close, Fidelity offered hourly pricing of its funds—a feature that critics charged appealed merely to the gambling instincts of many of its clients.16

  On Black Monday that emphasis on instant gratification turned against the Boston firm. Across the nation, mutual fund investors were phoning in to sell—at least if they could get through on the phones. Fidelity’s lines were jammed. Meanwhile, fund managers were raising cash to meet the redemptions. Methodically, Peter Lynch began handing out the stocks in t
he Magellan Fund, in alphabetical order, to his traders. One received companies in the fund beginning with the letters A–D. Another got E–L. Their marching orders: Sell.17

  Forced sales might have been avoided if Fidelity’s fund managers had been able to keep some cash in reserve. But the unspoken rule at Fidelity was that funds must be fully invested at all times. Fidelity chairman Ned Johnson “could have…protect[ed] his investors from the full force of the coming crash,” Joseph Nocera observed in a A Piece of the Action, a book that traces the rise of the mutual fund industry during this period. “He could have let it be known, as the market began to tumble, that it would be all right for the fund managers to shelter some assets in cash. But Johnson did no such thing.”18

  In the end, Fidelity unloaded shares worth nearly $1 billion. So many mutual fund customers bailed out that, at the height of the panic, the firm activated a clause in its funds’ prospectuses that allowed it to delay making payments until seven days after redemption.19 Still, Fidelity Magellan was much better off than many funds because it held so many positions. As a result, it was able to sell a small portion of each stock, without moving the market. More concentrated funds found it much harder to unwind their positions.

  Tuesday was little better. In the morning, the Dow shot up 200 points, then spun into free fall. At one point, some Dow stocks could not be traded—there were no buyers. When the day finally ended, the Dow managed to close up 102 points, but investors were shell-shocked. Outside the New York Stock Exchange, a doomsday prophet exhorted the crowd, “People, I plead with you, start reading your Bible.” Across the street, a mobile van operated by the Seventh-Day Adventists offered free blood pressure tests.20 Wednesday, the Dow came up for air and grabbed another 186 points, but on Thursday it sank again, falling 77 points. Friday, the market closed flat. But traders were still dazed. All told, a trillion dollars had vanished into thin air.

  As for the individual investor, many bailed out. Those with money in mutual funds began phoning in their orders on Friday, and in the first half hour of trading on Black Monday, Fidelity, the largest mutual fund company in the United States, sold $500 million worth of stocks on the New York Stock Exchange—roughly 25 percent of the Big Board’s total volume in that period.21

  But in the two days following the crash, a giddy public began to rush back in, snapping up bargains. “Anytime the market gets the stuffing beaten out of it, there’s a knee-jerk reaction to buy. It’s as if Macy’s is having a sale—it’s unbelievable,” marveled Marty Zweig, manager of the Zweig Funds. “Those were the two biggest net-buying days ever,” Merrill Lynch’s Bob Farrell noted at the time. “Even my 25-year-old daughter in London—who doesn’t know anything about the market—called up and wanted to buy a stock.”22

  On Wall Street, the finger pointing began. What had caused the crash? “Program trading” (automatic trades based on signals from a computer program) was a favorite target. In particular, the critics blamed professionals who tried to cushion their portfolios against disaster with “portfolio insurance,” a form of computerized trading that involves selling futures contracts when the market begins to fall. As the market plunged, their “insurance” orders hammered futures prices, and share prices followed.

  If investors would just realize that “the crash was largely a technical problem, caused by computerized trading schemes, the worst can be avoided,” a story in The Wall Street Journal declared.23

  General Electric chairman Jack Welch also took an interest in damage control. “GE had recently bought NBC,” recalled Lawrence Grossman, then president of NBC News, “and early in the morning of Tuesday, October 20, I received an angry phone call…. Welch was phoning to complain about the way we were reporting the previous day’s sudden stock market plunge. He thought our pieces were undercutting the public’s confidence in the market, which would certainly not help the stock of NBC’s parent company. He felt no qualms about letting his news division know that he thought NBC’s reporters should refrain from using depressing terms like ‘Black Monday’ to describe what had happened to the stock market the day before.”24

  But whatever they were saying in New York, Minnesota money manager Steve Leuthold knew that neither computerized trading nor the media was creating the sell-off. “The market was overvalued—that triggered the program trading. Then mutual fund redemptions added to the pressure. But program trading didn’t cause it,” said Leuthold.25 In 1987 the traders were simply the handiest scapegoats.

  A close look at the numbers suggested that individual investors contributed to the stampede for the exits. Institutions that use computers to program their trades do most of their buying and selling in “block trades” of 10,000 shares or more, and on October 19, block trading accounted for only about “half of the share volume and 60% of the dollar volume of transactions,” Peter Bernstein, a financial consultant to institutional investors, observed in his 1992 book, Capital Ideas. “This was only two percentage points above the average for the preceding fifty days, and almost identical to the average for the last fifty trading days of 1986,” suggesting that the admittedly savage selling pressure from the institutions was but “a part, and not an unusually large part of Black Monday’s sell-off,” Bernstein observed. Meanwhile, the volume of transactions below 10,000 shares ballooned on Black Monday, winding up “nearly triple the average daily number in 1986 and well above the previous high.” Few, if any, of these smaller transactions would have been triggered by programmed trading; the bulk represented trades by smaller investors.26

  As for portfolio insurance, while it contributed to the speed of the market’s fall, there was little reason to suspect that it caused the crash. What is certain is that it played a role in the market’s parabolic climb: as prices levitated, those who used the strategy remained complacent: “After all,” they said, “if the market collapses, we have portfolio insurance to protect almost all of our gains.”27

  Nevertheless, those true believers who subscribed to the theory that stock markets are efficient had to try to find some external explanation for the crash. According to their theory, the stock market does a nearly perfect job of pricing in all available information about a given stock—in other words, investors weigh the information available to them judiciously and act rationally on it. Of course, the theory’s followers acknowledge that individual investors may make errors, but if misguided investors offer to sell a stock for less than it is worth, investors who have paid better attention to the available information will rush in to buy it, quickly bidding up the price. Conversely, if the inattentive offer to pay more than a stock is worth, sellers rush in to meet their orders, and as supply increases, the price falls.

  Under the efficient market theory, then, only a sudden turn in the news—an event that has not been priced into the market—could explain such a precipitous plunge. But in the days before Black Monday, there had been no abrupt change in the information available to shareholders: no declaration of war, no oil embargo, no terrorist attack. Then again, “There was no rational case for things being so far up [before the crash]—only romantic reasons,” Bernstein noted at the time.28

  All of this confirmed what heretics, such as Yale economist Robert Shiller, had always believed. To Shiller, Black Monday merely served as further proof that the efficient market hypothesis was “the most remarkable error in the history of economic theory. This is just another nail in its coffin,” added Shiller, who would become better known in 2000 after he published his best-selling critique of the nineties bubble, Irrational Exuberance.29

  Why, then, did the market fall in 1987? To say “the computers did it” is too easy—or not easy enough. Gravity is the simplest answer: the market fell because it had climbed too high, too fast.

  Markets, after all, are only as rational as we are. Often, they overshoot—and the result is a boom that leads to a bust as prices revert to a mean. In 1987, stocks were overvalued. Many investors knew it, and once prices began to slide, they headed for the exits. What se
emed an irrational sell-off was, in fact, a perfectly reasonable response: when risk becomes too steep, the market has a nervous breakdown.

  The crash was not caused by some external event. Booms and busts are built into the system. As noted earlier, without cycles there would be no progress. But not all downturns signal the beginning of a cataclysmic bear market. Sometimes, if prices have not strayed too far off course, the market is able to wring out the excess and move forward within a matter of months. On other occasions, it takes years for the market to retrench and build a solid foundation for a new bull market.

  In October of 1987, many believed that Black Monday signaled the beginning of just such a long, bleak bear market. But when Steve Leuthold looked at fundamental measures of the market’s value, comparing share prices to earnings and “book value” (the value of a company’s assets, minus liabilities such as debt), he was not convinced.

  “It’s not one of those big bear markets, like 1929–32, or even 1973–74,” the Minnesota money manager declared a week after the crash. “It’s perhaps more akin to the bear markets that we saw back in the sixties, especially 1962,” he added, referring to the blowup that cost Edwin Levy, a greenhorn who had just come to Wall Street, everything except his slightly used Mercedes SL. That crash signaled that the bull was getting giddy, but the long bull market of 1954–66 was far from over. Indeed, it would be 11 years before the crash of 1973–74 brought it to a decisive, disastrous end.