Still, the historical similarities are eerie. By 1986 and 1987, stock prices had made a strong recovery from the stagflation and the extended, painful bear market of the 1970s to 1982. Both the U.S. bull market and the economy had been rising for almost five years, and were starting to look long in the tooth, while inflation and interest rates had been declining, and price-earnings ratios had been rising.
In addition, there was talk of trouble brewing in the American savings-and-loan industry, just as today there is fear of the subprime-mortgage market. Back then, a wild, speculative bubble was building in Japan, very similar to what is going on in China today. The Japanese market was selling at close to 70 times earnings and every mama-san was trading stocks. There was much talk of the shrinking supply of stocks as buybacks and private equity were reducing the number of shares outstanding, and much chatter about the flood of liquidity that was lifting stocks. Sound familiar?
By 1986 and early 1987, many investors, still scarred by memories of the bear market, were suffering from severe acrophobia. Respected economists and market gurus were warning that stocks were getting expensive, that inflation and interest rates would soon be rising, and that unsound and speculative financial practices were rampant. They railed against programmed trading, options, the newfangled hedge funds and something called portfolio insurance. They were right to fret, but they were too early, which in investing can be the same as being wrong. In other words, the general dyspeptic mood then was similar to today’s.
Portfolio insurance was particularly dangerous because it was really just automatic selling (to cap losses) disguised as a sophisticated strategy. Portfolio insurance meant that a decline in the market would feed on itself because selling would beget lower prices, which in turn would beget more selling. In 1987, when interest rates began to rise, out of a clear blue sky American stocks began to fall. On Oct. 14 and 15, the Dow Jones industrial average fell 3.8 percent and 2.4 percent, respectively, and then on Friday, Oct. 16, as portfolio insurance kicked in, it dropped a further 4.6 percent. The following Monday the full blast hit, and the decline cascaded into an epic crash, with the Dow falling 22.6 percent in one day.
Today many hedge funds automatically sell into declines to make sure that they don’t have to report major “drawdowns,” which is just a fancy word for losses. Their fund-of-funds clients abhor draw-downs, as hedge funds are not supposed to lose money in down markets. Also, banks and others have created “structured products” that sell a portfolio of hedge funds, with virtually guaranteed 6 to 8 percent returns. If a customer wants a higher return, the bank will lend him money so he can leverage his investment. The dangerous similarity to portfolio insurance is that if a price decline begins to gather momentum, the underlying positions have to be liquidated because of the guarantees. In other words, shares will be indiscriminately sold into a decline regardless of value.
In early April 1986, the market suddenly dropped 7 percent, with extremes of selling very similar to what happened on Feb. 27 of this year. The perma-bears beat on their chests and screamed that the party was over. The frightened bulls dumped stocks. There were two more similar episodes in the next five weeks, and each time investors reacted by quickly reducing their long positions. On each occasion, stocks rallied a few days later. Gradually the bears capitulated, and the mass of investors began to realize that it didn’t pay to panic and sell into the declines because you subsequently had to buy back at higher prices.
Beginning in mid-May 1987, the U.S. and most other world stock markets took off, with the Dow Jones industrial average climbing from just over 2200 in late May to well over 2700 (a gain of more than 20 percent) by August. Big-capitalization blue-chip stocks led this surge. This pattern is very similar to what is currently happening. Each scare is followed by a surge to new highs. Gradually the bearishness is beaten out of the sellers. Big-capitalization stocks are on the rise. We could be headed for another blowoff and then a bust. My guess, though, is that in terms of time, we are in the spring of 1987. There could be a spike ahead. But then watch out.
