by Robert J. Shiller
NY Times
19 October, 2017

Oct. 19, 1987, was one of the worst days in stock market history. Thirty years later, it would be comforting to believe it couldn’t happen again.

Yet that’s true only in the narrowest sense: Regulatory and technological change has made an exact repeat of that terrible day impossible. We are still at risk, however, because fundamentally, that market crash was a mass stampede set off through viral contagion.

That kind of panic can certainly happen again.

I base this sobering conclusion on my own research. (I won a Nobel Memorial Prize in Economic Sciences in 2013, partly for my work on the market impact of social psychology.) I sent out thousands of questionnaires to investors within four days of the 1987 crash, motivated by the belief that we will never understand such events unless we ask people for the reasons for their actions, and for the thoughts and emotions associated with them.

From this perspective, I believe a rough analogy for that 1987 market collapse can be found in another event — the panic of Aug. 28, 2016, at Los Angeles International Airport, when people believed erroneously that they were in grave danger. False reports of gunfire at the airport — in an era in which shootings in large crowds had already occurred — set some people running for the exits. Once the panic began, others ran, too.

That is essentially what I found to have happened 30 years ago in the stock market. By late in the afternoon of Oct. 19, the momentous nature of that day was already clear: The stock market had fallen more than 20 percent. It was the biggest one-day drop, in percentage terms, in the annals of the modern American market.

I realized at once that this was a once-in-a lifetime research opportunity. So I worked late that night and the next, designing a questionnaire that would reveal investors’ true thinking.

Those were the days before widespread use of the internet, so I relied on paper and ink and old-fashioned snail mail. Within four days, I had mailed out 3,250 questionnaires to a broad range of individual and institutional investors. The response rate was 33 percent, and the survey provided a wealth of information.

My findings focused on psychological data and differed sharply from those of the official explanations embodied in the report of the Brady Commission — the task force set up by President Ronald Reagan and chaired by Nicholas F. Brady, who would go on to become Treasury secretary.

The commission pinned the crash on causes like the high merchandise trade deficit of that era, and on a tax proposal that might have made some corporate takeovers less likely.

The report went on to say that the “initial decline ignited mechanical, price-insensitive selling by a number of institutions employing portfolio insurance strategies and a small number of mutual fund groups reacting to redemptions.”

Portfolio insurance, invented in the 1970s by Hayne Leland and Mark Rubinstein, two economists from the University of California, Berkeley, is a phrase we don’t hear much anymore, but it received a lot of the blame for Oct. 19, 1987.

Portfolio insurance was often described as a form of program trading: It would cause the automatic selling of stock futures when prices fell and, indirectly, set off the selling of stocks themselves. That would protect the seller but exacerbate the price decline.

The Brady Commission found that portfolio insurance accounted for substantial selling on Oct. 19, but the commission could not know how much of this selling would have happened in a different form if portfolio insurance had never been invented.

In fact, portfolio insurance was just a repackaged version of the age-old practice of selling when the market started to fall. With hindsight, it’s clear that it was neither a breakthrough discovery nor the main cause of the decline.

Ultimately, I believe we need to focus on the people who adopted the technology and who really drove prices down, not on the computers.

Portfolio insurance had a major role in another sense, though: A narrative spread before Oct. 19 that it was dangerous, and fear of portfolio insurance may have been more important than the program trading itself.

On Oct. 12, for instance, The Wall Street Journal said portfolio insurance could start a “huge slide in stock prices that feeds on itself” and could “put the market into a tailspin.” And on Saturday, Oct. 17, two days before the crash, The New York Times said portfolio insurance could push “slides into scary falls.” Such stories may have inclined many investors to think that other investors would sell if the market started to head down, encouraging a cascade.

In reality, my own survey showed, traditional stop-loss orders actually were reported to have been used by twice as many institutional investors as the more trendy portfolio insurance.

In that survey, I asked respondents to evaluate a list of news articles that appeared in the days before the market collapse, and to add articles that were on their minds on that day.

I asked how important these were to “you personally,” as opposed to “how others thought about them.” What is fascinating about their answers is what was missing from them: Nothing about market fundamentals stood out as a justification for widespread selling or for staying out of the market instead of buying on the dip. (Such purchases would have bolstered share prices.)

Furthermore, individual assessments of news articles bore little relation to whether people bought or sold stocks that day.

Instead, it appears that a powerful narrative of impending market decline was already embedded in many minds. Stock prices had dropped in the preceding week. And on the morning of Oct. 19, a graphic in The Wall Street Journal explicitly compared prices from 1922 through 1929 with those from 1980 through 1987.

The declines that had already occurred in October 1987 looked a lot like those that had occurred just before the October 1929 stock market crash. That graphic in the leading financial paper, along with an article that accompanied it, raised the thought that today, yes, this very day could be the beginning of the end for the stock market. It was one factor that contributed to a shift in mass psychology. As I’ve said in a previous column, markets move when other investors believe they know what other investors are thinking.

In short, my survey indicated that Oct. 19, 1987, was a climax of disturbing narratives. It became a day of fast reactions amid a mood of extreme crisis in which it seemed that no one knew what was going on and that you had to trust your own gut feelings.

Given the state of communications then, it is amazing how quickly the panic spread. As my respondents told me on their questionnaires, most people learned of the market plunge through direct word of mouth.

I first heard that the market was plummeting while lecturing to my morning class at Yale. A student in the back of the room was listening to a miniature transistor radio with an earphone, and interrupted me to tell us all about the market.

Right after class, I walked to my broker’s office at Merrill Lynch in downtown New Haven, to assess the mood there. My broker appeared harassed and busy, and had time enough only to say, “Don’t worry!”

He was right for long-term investors: The market began rising later that week, and in retrospect, stock charts show that buy-and-hold investors did splendidly if they stuck to their strategies. But that’s easy to say now.

Like the 2016 airport stampede, the 1987 stock market fall was a panic caused by fear and based on rumors, not on real danger. In 1987, a powerful feedback loop from human to human — not computer to computer — set the market spinning.

Such feedback loops have been well documented in birds, mice, cats and rhesus monkeys. And in 2007 the neuroscientists Andreas Olsson, Katherine I. Nearing and Elizabeth A. Phelps described the neural mechanisms at work when fear spreads from human to human.

We will have panics but not an exact repeat of Oct. 19, 1997. In one way, the situation has probably gotten worse: Technology has made viral rumor transmission much easier. But there are regulations in place that were intended to forestall another one-day market collapse of such severity.

In response to the 1987 crash and the Brady Commission report, the New York Stock Exchange instituted Rule 80B, a “circuit breaker” that, in its current amended form, shuts down trading for the day if the Standard & Poor’s 500-stock index falls 20 percent from the previous close. That 20 percent threshold is interesting: Regulators settled on a percentage decline just a trifle less than the one that occurred in 1987. That choice may have been an unintentional homage to the power of narratives in that episode.

But 20 percent would still be a big drop. Many people believe that stock prices are already very high, and if the right kinds of human interactions build in a crescendo, we could have another monumental one-day decline. One-day market drops are not the greatest danger, of course. The bear market that started during the financial crisis in 2007 was a far more consequential downturn, and it took months to wend its way toward a market bottom in March 2009.

That should not be understood as a prediction that the market will have another great fall, however. It is simply an acknowledgment that such events involve the human psyche on a mass scale. We should not be surprised if they occur or even if, for a protracted period, the market remains remarkably calm. We are at risk, but with luck, another perfect storm — like the one that struck on Oct. 19, 1987 — might not happen in the next 30 years.

Robert J. Shiller is Sterling Professor of Economics at Yale.

by R. Christopher Whalen
October 16, 2017

The Hague | Almost as soon as it started, the excitement surrounding earnings for financials in Q3 2017 dissipated like air leaving a balloon. Results for the largest banks – including JPMorgan (NYSE:JPM), Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) – all universally disappointed, even based upon the admittedly modest expectations of the Sell Side analyst cohort.

Bank of America (NYSE:BAC), the best performing stock in the large cap group (up 60% in the past year), disappointed with a $100 million charge for legacy mortgage issues.  Despite strong loan growth, year-over-year BAC's net revenue is up about 5% but actually fell in the most recent period compared with Q2 '17.

As with many other sectors, in large-cap financials there was little excitement, no alpha -- just slightly higher loss rates on loan portfolios that are growing high single-digits YOY.  Yet equity valuations are up mid-double digits over the same period.

The explanation for this remarkable divergence between stock prices and the underlying performance of public companies lies with the Federal Open Market Committee.  Low interest rates and the extraordinary expansion of the Fed's balance sheet have driven asset prices up by several orders of magnitude above the level of economic growth.

Meanwhile across the largely vacant floor of the New York Stock Exchange, traders puzzled over the latest management changes at General Electric Co (NYSE:GE), the once iconic symbol of American industrial prowess.  Over the past year, GE's stock price has slumped by more than 20% even with the Fed's aggressive asset purchases and low rate policies.  Just imagine where GE would be trading without Janet Yellen.  

To be fair, though, much of GE’s reputation in the second half of the 20th Century came about because of financial machinations more than the rewards of industry.  A well-placed reader of The IRA summarizes the rise and fall of the company built by Thomas Edison:

“For years under Welch, GE made its money from GE Capital and kept the industrial business looking good by moving costs outside the US via all kinds of financial engineering.  Immelt kept on keeping on. That didn't change until it had to with the financial crisis.  No matter what, untangling that kind of financial engineering spaghetti is for sure and has been a decade long process.  No manager survives presiding over that.  Jeffrey Immelt is gone.”

Those transactions intended to move costs overseas also sought to move tax liability as well, one reason that claims in Washington about “overtaxed” US corporations are so absurd.  Readers will recall our earlier discussion of the decision by the US Supreme Court in January not to hear an appeal by Dow Chemical over a fraudulent offshore tax transaction.

The IRS also caught GE playing the same game.  Indeed, US corporations have avoided literally tens of trillions of dollars in taxes over the past few decades using deceptive offshore financial transactions.  Of note, the Supreme Court’s decision not to hear the appeal by Dow Chemical leaves offending US corporations no defense against future IRS tax claims.

Like other examples of American industrial might such as IBM (NYSE:IBM), GE under its new leader John Flannery seems intent upon turning the company into a provider of software.  Another reader posits that “they’re going to spend a decade selling the family silver to maintain a dividend and never make the conversion they would like and never get the multiple they want.  GE is dead money at a 4% yield, which given some investors objectives – retirees and the like -- might not be such a bad thing.”

The question raised by several observers is whether the departure of Immelt signals an even more aggressive “value creation” effort at GE that could lead to the eventual break-up of the company.  Like General Motors (NYSE:GM), GE has been undergoing a decades long process of rationalizing its operations to fit into a post-war (that is, WWII) economy where global competition is the standard and the US government cannot guarantee profits or market share or employment for US workers.

GE's decision this past June to sell the Edison-era lighting segment illustrates the gradual process of liquidation of the old industrial business.  Henry Ford observed that Edison was America’s greatest inventor and worst businessman, an observation confirmed by the fact that Edison’s personal business fortunes declined after selling GE.  In fact, the great inventor died a pauper.  And of the dozen or so firms that were first included in the Dow Jones Industrial Average over a century ago, GE is the only name from that group that remains today.

But the pressure on corporate executives to repurchase shares or sell business lines to satisfy the inflated return expectations of institutional investors is not just about good business management.  The expectations of investors also reflect relative returns and asset prices, which are a function of the decisions made in Washington by the FOMC.  Fed Chair Janet Yellen may think that the US economy is doing just fine, but in fact the financial sector has never been so grotesquely distorted as it is today.

Let’s wind the clock back two decades to December 1996.  The Labor Department had just reported a “blowout” jobs report. Then-Federal Reserve chairman Alan Greenspan had just completed a decade in office. He made a now famous speech at American Enterprise Institute wherein Greenspan asked if "irrational exuberance" had begun to play a role in the increase of certain asset prices.  He said:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”

In the wake of the 2008 financial crisis, the FOMC abandoned its focus on the productive sector and essentially substituted exuberant monetary policy for the irrational behavior of investors in the roaring 2000s.  In place of banks and other intermediaries pushing up assets prices, we instead have seen almost a decade of “quantitative easing” by the FOMC doing much the same thing.  And all of this in the name of boosting the real economy?

The Federal Reserve System, joined by the Bank of Japan and the European Central Bank, artificially increased assets prices in a coordinated effort not to promote growth, but avoid debt deflation.  Unfortunately, without an increase in income to match the artificial rise in assets prices, the logical and unavoidable result of the end of QE is that asset prices must fall and excessive debt must be reduced.

Stocks, commercial real estate and many other asset classes have been vastly inflated by the actions of global central banks.  Assuming that these central bankers actually understand the implications of their actions, which are nicely summarized by Greenspan’s remarks some 20 years ago, then the obvious conclusion is that there is no way to “normalize” monetary policy without seeing a significant, secular decline in asset prices.   The image below illustrates the most recent meeting of the FOMC.

The lesson for investors is that much of the picture presented today in prices for various assets classes is an illusion foisted upon us all by reckless central bankers.  Yellen and her colleagues seem to think that they can spin straw into gold by manipulating markets and asset prices.  As Chairman Greenspan noted, however, “evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”

While you may think less of Chairman Greenspan for his role in causing the 2008 financial crisis, the fact remains that he understands markets far better than the current cast of characters on the FOMC.  Yellen and her colleagues pray to different gods in the pantheon of monetary mechanics.  As investors ponder the future given the actions of the FOMC under Yellen, the expectation should be that normalization, if and when it occurs, implies lower returns and higher volatility in equal proportion to the extraordinary returns and record low volatility of the recent past.