By Jeffrey Scharf
Last month marked the 30th anniversary of the worst day in Wall Street history. On Black Monday — Oct. 19, 1987 — the Dow Jones Industrial Average plunged 508 points or 22 percent. Volume was a record 604 million shares. The ticker tape that reported trades ran hours late. Telephone lines to some brokers were so busy it was impossible to place trades. For trades that were placed, it was impossible to get timely information as to whether the trade had been executed or at what price.
Numerous port-mortems were conducted to determine the causes of the sell-off. There were no obvious triggers – no war had broken out, no financial institution had collapsed overnight. Nor was economic trouble just around the corner as it was when the Dow ended a two-day plunge of 23 percent on Black Tuesday in 1929.
A primary culprit appeared to be the interaction between stock index futures and a new financial innovation known as “portfolio insurance.” Similar to oil futures or cattle futures, stock index futures enabled buyers and sellers to bet on direction of stock prices without buying or selling individual stocks.
Portfolio insurance was marketed as a “stop loss” in the event of a market decline. A pension plan with $100 million in stocks might put in an order to sell futures 10 percent below the current market level so that it would not lose more $10 million in a downturn. The confidence that losses were limited convinced investors to allocate more money to stocks than they otherwise would have. This drove prices up. Meanwhile, an ever-increasing number of orders to sell futures lurked below the surface.
Portfolio insurers assumed any decline would be gradual and markets would be liquid. The reality was far different. As the market dropped, more and more orders to sell futures were executed. Knowing that the futures were likely to keep cascading downward, buyers were scarce. A gap opened between the futures trading far below levels of the real market. Actual prices fell in order to catch up with futures prices.
Fast forward to 2017 and the financial innovation du jour is the exchange traded fund or ETF. An exchange traded fund is a mutual fund that can be bought and sold throughout the trading day. When an investor buys an S&P 500 stock index exchange traded fund, the exchange traded fund sponsor buys shares in the underlying stocks. When an exchange traded fund investor sells, the exchange traded fund sponsor sells.
Some observers fear a replay of 1987 where holders sell exchange traded funds en masse faster than exchange traded fund sponsors can sell shares. If nobody steps up to buy exchange traded funds, prices will keep falling. Stock prices will then fall to catch up with the exchange traded funds. As prices spiral downward, a generalized selling panic will ensue.
While a panic can happen at any time, portfolio insurance is nearly unheard of today. In addition, the market has built-in circuit breakers which provide for trading timeouts when the S&P 500 Index falls 7 percent, 13 percent and 20 percent in a single session.
Someday another selling panic will come along. But those anticipating an exact replay of 1987 are as likely to be off base as those who expected an exact replay of 1929.
Jeffrey R. Scharf is a private investor and newsletter writer. Contact him at firstname.lastname@example.org. To view previous Everybody’s Business columns, visit santacruzsentinel.com/topic/Jeffrey Scharf.