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4 Warning Signs Investors Shouldn’t Ignore

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A clear and undeniable warning sign of market madness to come presaged “Black Monday,” the calamitous, if now somewhat off-the-radar, crash of Oct. 19, 1987, when the Dow Jones industrial average plunged 22%. It was the largest single-day drop in Wall Street history. 

Alas, the powerful message of a terrifying four hours in the market nine months earlier was ignored — one of many danger signs that went unheeded, Diana B. Henriques, author of “A First-Class Catastrophe: The Road to Black Monday, The Worst Day in Wall Street History” (Henry Holt), told ThinkAdvisor in an interview.

Henriques, a multi-award-winning New York Times investigative reporter, is author of the bestseller “Wizard of Lies: Bernie Madoff and the Death of Trust,” which became an HBO film starring Robert De Niro. And she is a 2003 Pulitzer Prize finalist for team coverage of the Enron scandals’ aftermath.

Last month marked Black Monday’s 30th anniversary, the day the Dow plummeted 508 points, the equivalent of 5,000 points today.

Though by 1987, the market had gone through an epic change — “financial futures fundamentally changed the way the traditional stock market worked” — then morphed further by the time 2008 rolled around and is now even more dramatically different, Wall Street and Washington have failed to address the reality that the same four major risk factors continue to exist to this day, according to Henriques.

Black Monday’s “apocalyptic one-day crash was a long fuse that led into the future,” as Henriques frames it in the interview. She describes the shocking event that occurred months before Black Monday that signaled “something had thrown a monkey wrench into the market machinery.”

To wit, on Jan. 23, 1987, in the midst of a roaring bull market, the Dow suddenly plummeted 115 points, then ascended sharply; next, nosedived again until the closing bell — all in four hours’ time. The Dow’s 2% drop stunned and confounded everyone, Henriques says. Investors searched for an explanation but apparently found none:

 “I’ve been in the business for 18 years, and I have never seen anything like it before,” Morgan Stanley’s head of trading said at the time, according to Henriques’ book. “It’s berserk. It’s total confusion. No one knows what the heck is going on.”

Today, the situation is even more dangerous because the same main risk factors prevail as in 1987 and 2008; for example, the herd-like behavior of institutional investors: They now control not billions, but trillions of dollars. Moreover, the international too-big-to-fail banks are far bigger today.

Henriques stresses the critical need for the market to have sufficient resilience to withstand a sharp plunge without breaking. In 1929 and 2008, “the financial system fell apart. In 1987, it nearly did,” she says.

ThinkAdvisor recently interviewed Henriques, on the phone from her Hoboken, New Jersey, office. The journalist’s previous books include “Fidelity’s World: The Secret Life and Public Power of the Mutual Fund Giant.” In 2004, she won a George Polk Award for a series exposing financial services firms’ exploitation of military personnel. For “A First-Class Catastrophe,” she drew on more than 100 interviews with people who experienced the 1987 crisis firsthand. Here are highlights from our conversation:

THINKADVISOR:  Black Monday was Oct. 19, 1987; but you say that January 23, 1987, was “the most terrifying day the market has ever seen.” What happened on that day?

DIANA HENRIQUES: After two weeks of euphoric trading and setting new records, the market suddenly pivoted on a dime and plunged 115 points, soared back up and then soared back down to the closing bell, leaving everybody aghast.

What caused that?

Previously, such wild gyrations had occurred on “witching hour” days, when the novel new derivatives — stock index options and stock index futures contracts — expired and were rolled over. Those expirations [and resulting market plunges] were expected. But then the wild gyrations started happening unpredictably when nothing was expiring. On Jan. 23, it was clear that the machinery was breaking. Something bad had thrown a monkey wrench into it.

This was one warning of Black Monday, among others; but no one seemed to have taken note or realized their significance.

Absolutely there were warnings. But there was such a gap between the way people thought markets worked and the way they’d actually begun to work. Things had changed so fast that members of Congress, regulators and older bankers and Wall Street executives couldn’t quite get their brains around what was going on.

Wasn’t there anyone who had insight into it?

John Phelan [New York Stock Exchange chair-CEO] testified repeatedly that the trading strategies giving rise to these wild gyrations needed to be examined. He predicted long before Black Monday that the day would come when the strategies would turn a normal market downturn into [what he called] “a first-class catastrophe.”

Has the government’s or the industry’s thinking changed now that we’ve gone through the 1987 and 2008 crashes?

We made some gains after the flash crash of May 2010. That did awaken some regulators, and maybe some lawmakers, as to how imperative it was to upgrade the computer skills of our regulators. However, that hasn’t translated into budgets for highly skilled computer analysts to help us regulate a market that’s basically one giant server farm.

How so?

People who operate our markets using algorithmic-driven trading strategies are so far ahead of the people trying to regulate those markets that a meeting of the minds is going to be very difficult to achieve. We still have this romantic notion of a mom-and-pop market of the 1970s. It doesn’t work that way anymore. Those days are gone and aren’t coming back.

What’s a major difference between then and now?

Today’s market exists in cyberspace. The automation of every aspect of the marketplace creates a challenge to regulators that they just haven’t faced up to or addressed.

You say that despite the bitter experiences of 1987 and 2008, we still have a recipe for a market disaster today.

Yes. We’ve barely addressed anything that we learned on Black Monday or in 2008. The four major risk factors that blindsided us in 1987 and that returned to beat us over the head in 2008 are present today: too-big-to-fail investors, herd-like computer-driven investment strategies, unfamiliar derivatives untested in a market crisis, and a fragmented regulatory system where nobody can see the whole elephant. And the worst problems — the panic, the chaotic regulatory response — that emerged in 2008 exactly mirrored Black Monday.

How, specifically, do these risks manifest right now?

Two Wall Street institutions, Vanguard and BlackRock, manage $10 trillion! So the scale of the titan investors who so destabilized the markets in 1987 is exponentially bigger than it was then. The complex use of derivatives is worse today than in 1987 [S&P 500 futures then] or in 2008 [credit default swaps at that time]. The derivatives being introduced into the marketplace are eye-crossingly complex. Algorithmic trading strategies are a mystery to most regulators.

Why haven’t those risk factors been addressed in all these years?

The political will to wipe the board clean for a start fresh hasn’t been there. The opportunity in the aftermath of the 2008 crisis has been lost. Our regulatory structure has been virtually unchanged since 1974.

But the Dodd-Frank Act was passed.

That’s a dog’s dinner. There are some good things and some bad things and some things that are largely irrelevant to surviving the next crisis — and some things that will make it harder to survive it.

Is the use of market circuit breakers to stop trading of help in preventing another crash?

They’re one of the best-remembered changes after Black Monday, but they have dubious merit in the modern marketplace. Today there are 12 stock exchanges, 30 computer systems where you can trade stocks, the “dark pool,” which allows members-only trading. So circuit breakers would actually affect only small investors from being able to trade on Nasdaq or the Big Board. They’re not going to stop the giant institutions. And, by the way, who was it that panicked in 1987? The giant institutions.

That was probably a surprise.

In the lead-up to Black Monday, in July 1987, a senior executive from the Chicago Mercantile Exchange reassured members of Congress that they needn’t worry about all the new trading strategies and investment gizmos because everything was in the hands of professionals — big institutional investors who know what they’re doing and wouldn’t be running around with their hair on fire. In fact, it didn’t turn out that way.

If we have another financial meltdown, is there a calm voice to lead the country?

A panic is driven by emotion until someone steps forward and gives a reason to hope that grown-ups are in charge. You can put in little regulatory gimmicks, adopt circuit breakers, apply rules; but in the crunch, it’s going to come down to leadership.

Looking at the Washington environment now, that’s a question mark.

Who are possibilities? [This interview took place before Jerome Powell was appointed to succeed Janet Yellen as Federal Reserve chair.]

Janet Yellen would be an obvious one. Jay Clayton [Securities and Exchange Commission chair] is a securities lawyer, not a market leader, though maybe his voice would be affecting. Perhaps Treasury secretary [Steven] Mnuchin, but that’s harder to say.

What about Donald Trump?

I haven’t seen the president’s communication style, from the time he entered the campaign, exactly the recipe for calm command of the facts and an encouraging, stabilizing demeanor that I think would be important in the midst of a crisis. That doesn’t mean he wouldn’t rise to the occasion.

What would he need to bear in mind?

That every single utterance from the Oval Office would be a megaton bomb and also, that silence may be deadly. Flippancy may be incendiary. Ignorance may be terrifying. So during a financial crisis, what the White House says and how it says it will be crucial.

Was there anyone on Black Monday who was the calm voice from the cockpit?

Washington had a leadership deficit because President Reagan was distracted by his wife’s [Nancy] going through a health crisis. And everybody else in Washington regulatory circles was brand new in their jobs. But Alan Greenspan — new [Fed chair] — stepped up, and John Phelan, with his command of the facts, helped calm Wall Street.

What can be done now to prevent a financial disaster like the one in 2008?

It’s imperative to our economic health that we have a market that’s resilient enough to withstand a sharp plunge without breaking so that we can survive a fall without pieces falling off the machine.

What’s the best thing financial advisors can do should there be another crisis?

They play a critical role in guiding the middle-income, middle-market Main Street investors through the turbulence of an institutional panic. We’re the mice on the elephants’ dance floor: In a stampede, investors are going to need thoughtful, well-informed advisors who can keep them calm and safe through the turbulence like we saw in 1987 and 2008. The role of a knowledgeable investment advisor with a strong grasp of history will be a critical voice. Regulators need to get their [minds] around how to regulate the titans, but the rest of us are going to rely on good, sound advice from people we trust.

In 2008, many advisors were putting clients into CMOs [collateralized mortgage obligations] and CDOs [collateralized debt obligations] without knowing exactly what those products were.

Financial history shows that you probably shouldn’t invest a lot of money in something you don’t understand. In 1987, there were large pension funds and others who invested lots of money in strategies they poorly understood. The same thing happened in 2008. Investing in strategies or products you don’t understand, that haven’t been tested by time and haven’t come through a financial storm intact isn’t a good idea.

Will Trump’s intention to deregulate and to repeal Dodd-Frank help the situation?

It’s become political orthodoxy that we need financial deregulation. That’s nonsense. Financial deregulation has been the mantra of the federal government — both Republicans and Democrats — since 1980. It arises from this romantic notion that stock markets are rational and the only thing Uncle Sam can do is screw things up. But markets aren’t rational.

Why not?

Because investors aren’t rational. They do not always maximize their profits. They do panic. So the foundation of deregulation that markets are efficient and rational, and can regulate themselves is absolutely wrong. You can’t have a marketplace without rules, and you need to enforce them equitably. If some people have to comply with them and others don’t, you’ve got the law of the jungle. When you deregulate a marketplace, it quickly reverts to survival of the biggest.

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