Personal Recollections From The Crash Of 1987: "There Was No 'Smart Money' That Day!"

Tyler Durden's picture

Via LyonsSharePro.com,

The following guest post is a first-hand account of the events surrounding the Crash of 1987 by JLFMI President, John S. Lyons.

Personal Recollections of the Crash of 1987 on its 30th Anniversary

“There was no ‘smart money’ that day.”

What do the assassination of President John F Kennedy, the beginning of Desert Storm and 9/11 have in common? Provided you are old enough to recall JFK’s assassination, the answer probably is that you remember exactly where you were on the day of those events. If not that old, there is most likely another event that is so memorable that you recall where you were and what you were doing at that moment.

Being in the securities business for many, many years, the Crash of ’87 on October 19th of that year is right up there with JFK’s assassination and 9/11 as one of the mind-numbing catastrophes I’ve witnessed.

In retrospect only, it was fortunate that I had entered the brokerage business in 1969 and immediately weathered a 36% market decline into 1970. On the heels of that decline, I then endured one of the worst bear markets in modern history in 1973-74 when the Dow Jones Industrial Average lost almost 50% of its value. As a result, I was weaned on risk in my new profession. And I learned early on that if a career that centered around the stock market were to be endurable, I had to find a way to practice risk management.

As a result, I developed a risk model during the 1970’s as a means of guarding against such disastrous losses in the future. Fortunately, the model has been of very valuable assistance, protecting clients from every major decline since its inception in 1978. Its Sell Signals have occurred prior to insignificant declines as well, but its risk avoidance guidance supersedes those times. On September 25th of 1987, for example, our model issued a Sell Signal and I sold over half of my clients’ holdings. I was reminded just recently by an associate of mine at that time about how he passed by my office that day and was amazed at the pile of sell orders on my desk.

The Friday prior to the October 19th crash ended with the first triple digit decline in the history of the Dow Jones Industrial Average. In total, the market lost just over 10% that week. The apprehension of professionals in the business was palpable to say the least as we entered the weekend and yet there was no seemingly immediate cause for a significant decline. I have learned that such unexplained declines are the most insidious. On Saturday night, at dinner with friends at a restaurant in Chicago, I could not eat my food!

On Monday morning, the market opened and headed south immediately. There were no buyers – just panic. Program trading, a technique supposedly providing insurance for portfolios in which computers entered sell orders at certain predetermined levels below the market, simply propelled the decline. Markets were in complete disarray. There were no bids. No one to fill the mountain of orders that were coming from all over the world. Traders left the pits crying as the carnage grew. It seemed like the end of the world – their world at least. And there was nothing stock brokers could do except watch in horror. Paradoxically, on the way home that night, the outside world was acting like nothing happened. That was no comfort.

The DJIA closed down 508 points or 22.6% that Monday, October 19th. To provide some perspective, that decline today would be the equivalent of a 5,176 point loss. The Nasdaq would have fared worse were it not for the fact that it completely failed and effectively shut down. Bid prices were often higher than asked prices. When asked what smart money was doing that day, one leading money manager admitted that “there was no smart money”.

Though most of the eventual decline was over by the close on Tuesday, the gut wrenching market action continued for the rest of the week. And its wreckage would last for weeks and months. First Options, the company charged with settling trades on the Chicago Board Options Exchange couldn’t function for weeks and had to be bailed out by its parent, the Continental Bank. Significant corporate mergers that were almost completed were canceled or at least became questionable. My only major problem during the crash – and it was a big one – was that I was selling puts on some merger candidates that were all but assured prior to the crash.

For example, I had sold hundreds of puts at a quarter of a point with a strike price of 40 on a company that was trading at the 52-53 level. All the company’s stock had to do was to close over 40/share and the puts would be worthless and the trade profitable. Instead, the stock dropped to about 37 which made the intrinsic value of the put 3. Unbelievably, they were bid at 18 for more than a week despite having negligible trading in them. Unbelievably as well, I was issued no margin calls on the positions for over two weeks due to First Options being in chaos. Unfortunately I eventually had to take sizable losses in them. In some other cases that I knew about, no margin calls were ever issued for some substantial unsecured debits. I recall one investor who had a deficit in his account of almost $250,000 and was never called to cover that amount!

When I say chaos, I mean chaos. Will it happen again? Although it is always claimed that we learn by our previous mistakes and take the appropriate steps to avoid the same problems in the future, history doesn’t bear that out. So called “reforms”, as well as proclamations such as that by Yale’s first Ph. D in economics, Irving Fisher, nine days before the stock market crash of 1929 that stock prices “reached what looks like a permanently high plateau”, are made with ultimately untimely confidence throughout history. Portfolio insurance during the ’87 crash was anything but insurance. Although it was embraced as risk management, it turned out to be risk fertilizer. Society in general always thinks that we have hit that new plateau in managing ourselves but unfortunately that is often quite the opposite. To me, the message is that we never should abandon employing some measure of risk management in investing and probably in most of our activities. So how is that accomplished?

Human Nature, The Stick in the Spokes of Risk Management

One of the phenomena that increasingly seems axiomatic is that human nature is the enemy of such risk management. The longer that one has gone without the need for caution, the more it is thought not to be needed when, in actuality, the more it is needed. This is due to a condition called perceptual recency, which simply stated means that one’s expectations of the future are the result of what one has experienced and is in their active memory. We are not good at anticipating junctures of change. That is understandable.

The following two charts show that we humans indeed clearly react to what has occurred in our memorable past. The higher we go and the longer we go higher, the more confidence we have that we will continue to go higher — and the less we feel the need for risk management. That eventually, and I repeat eventually, is injurious to one’s investing health. Note how the level of both household stock investment and consumer confidence continue to grow the higher the market goes.

 

So, as asked, how do we guard against the human natural tendency to dismiss the need for risk protection the higher the market goes — and to become more bearish, the lower it goes? Frankly the answer probably is that most investors, i.e., humans, cannot. I have spent a career practicing human nature avoidance in my job. Now I will admit that there will be times when the market does not need risk protection and there will be other times when there appears to be substantial risk afoot as quantified by our 40-year-old risk model but the market chooses to ignore it and continue to move higher. However, like wearing a seat belt, you cannot possibly choose to employ caution only shortly before an accident.

As stated above, declines that are the most hurtful typically begin with no seeming warning or at least before any provocation is identified. For example, on July 30, 1990, our model issued a Sell Signal and we sold 100% of our clients’ holdings. On August 2, Saddam Hussein marched into Kuwait and Operation Desert Shield began — as well as a substantial decline in the stock market. Similarly, the completion of selling 100% of our clients’ holdings on account of a Sell Signal on September 4, 2001 was obviously done without any known external provocation. The lesson regarding employment of risk management is that, no, you will not know when to sell by just “having that feeling” or even more remotely, by getting tipped off by the news in the morning paper. That said, many investors do believe that they will know when to protect their holdings.

Now of course, there will be legions of market experts, many with an investment product to sell, who will say it is foolishness to even try to “time the market” as they put it. I will admit it is difficult to find a good practitioner of avoiding risk. However, one must try. Failing to avoid a substantial market decline is a double whammy. It is well quantified that losing money has twice the negative emotional impact vs. the pleasing emotional impact derived from making money. That emotional jolt on the downside is what contributes to selling at the bottom (one whammy) and makes you divorce Wall Street until it is well into its next bull phase (a 2nd whammy).

So what was learned from the Crash of ’87? Not much in my opinion. For starters, the laws of human nature have yet to be repealed. Additionally, high frequency trading is today’s version of program trading. Only now, instead of transmitting an order through a stock broker, who sends it to a floor broker, who give it to a trader, who takes it to a specialist at the post where the stock in question is trading, high frequency computer generated orders are automatically entered at the behest of complex algorithms and are executed and reported back in milliseconds. Witness the May of 2010 “flash crash” where the market lost about 1000 points and then mostly recovered all within 15 minutes.

In summary, risk cannot be removed from the stock market. The Crash of ’87 affected everyone. Crashes will occur again. Wear a seat belt!

– John S. Lyons is President and Founder of J. Lyons Fund Management, Inc.

If you’re interested in the “all-access” version of our charts and research, we invite you to check out our new site, The Lyons Share. TLS is currently running a 30th anniversary 1987 Crash Commemoration SALE, offering a discount of 22.6%, or the equivalent of the Dow’s 1-day drop 30 years ago. The SALE ends October 22 so considering the discounted cost and a potentially treacherous market climate, there has never been a better time to reap the benefits of our risk-managed approach. Thanks for reading!

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Could never happen again...

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GUS100CORRINA's picture

Personal Recollections From The Crash Of 1987: "There Was No 'Smart Money' That Day!"

My response: I remember this day very, very well. My GE Stock price was cut in half and the executives were SOILING their underware.

I also believe that this was the event that triggered the formation of the PPT!.

GUS100CORRINA's picture

Personal Recollections From The Crash Of 1987: "There Was No 'Smart Money' That Day!"

My response: I was reflecting on the differences between the markets of 1987 and 2017. Below is a brief list of the differences that I have noticed.

1. With the advancement of internet technology, unlike 1987 where the internet was in its infancy, everyone today is their own broker. The interent has changed everything and is an enabler that could lead to a selling avalanche if things get out of control.

2. Leverage like Margin Debt is off the charts. This will add FUEL to the selling FIRE should a PANIC occur.

3. ETFs are now a predominant part of the financial system.

4. DERIVATIVE leverage is completely off of the charts measured in the 100s of TRILLIONS of dollars.

5. Corporate balance sheets are in the most leveraged position ever in the history of the American business cycle.

6. Valuation metrics of stocks are at historic highs.

7. Government debt is at historic highs and growing at over 2 times the CAGR of the GDP CAGR.

8. Interest rates are at historic lows.

9, Personal debt is at historic highs.

10. Central Banks own a large proportion of the markets with the BOJ the leader in this new paradigm.

What could possibly go wrong???? I am sure everyone has other items to add to the list as well.

Antifaschistische's picture

yah, that was before the Online Trading Academy taught all retail investors how to use stop loss sell orders to limit all their losses and "lock in" their profits if the market ever goes south.  Today, thanks to this great tool, no one will ever lose 20% in one day again.   LOL.  (yes, YES I am being sarcastic!!)  The advertisements on the radio are SOOOO annoying, but I do get a degree of satisfaction knowing that some people actually believe that BS.

mkkby's picture

Forget the stupid sell signals. This guy brags about the few that worked, but conveniently ignores the many many others that didn't. Guess that's how scum bags sell their newsletters.

Writer also didn't learn the lesson of thin markets. His short options were a huge risk because most options are thinly traded.

The only effective risk management is trade size. If your chips ain't on the table you can't lose them. Most people get greedy and put down all their chips plus more on margin. That feels good until the inevitable crash. There is always another crash.

EmeraldWI's picture

Couldn't most of those be reasons why they won't/haven't (will do anything to stop) let markets go down/function? 

hibou-Owl's picture

What goes wrong is when buyers stop buying.
Corporates have been the big support and pension funds after some return.
Technical analysisi is the best timing tool, as like 1987. NZSE went down nine days straight, and broke support trendline and I sold the Thursday before 87 correction. Some luck, and a bit of analysis.
I was hand updating graph paper charts from the newspapers as a student. I had 65 charts in a ringbinder, my parents thought I was nuts.
The CAC40 which I watch closely I think is a leading market and europe will be the trigger.

giovanni_f's picture

stock markets will be closed until further notice. You can neither buy nor sell, just hope that in the ensuing chaos stocks held in street name for you are not lost in the electronic jungle of your bank/broker and the DTCC.

Steelio's picture

I've heard estimates as high as 1500 Trillion for derivatives liabilities.

Nolde Huruska's picture

 

Ha! I was an officer on one of the ships involved in the contretemps reported on in column one. How's that for coincidence?

post turtle saver's picture

I remember where I was... in college, watching all my professors cancel classes for the day so they could go rework their portfolios...

this article is so fucking stupid, "there were no buyers hurr durr" there's ALWAYS a buyer and those who bought in the aftermath made out like bandits...

"you gotta know when to hold 'em... know when to fold 'em... know when to walk away and know when to run..."

Nomad Trader's picture

This is actually a very good article. "There were no buyers" is more a figure of speech to express that bid side liquidity evaporated. Sure there were probably buyers, but they were all 30% lower. It's pretty obvious that you've never seen a bear market. What's less obvious is how utterly bamboozled you're going to be when the next one comes around.

ceilidh_trail's picture

I was a buyer. This author was having dinner with the wrong people.

Scuba Steve's picture

There was NO fukkin BID that day, nothin, notta, nothing ... I'm guessin thats when Sir Jacob and Sir Evelyn and their agents stepped in on Tuesday to lend liquidity.

rbianco3's picture

The newspaper also headlined, "US Ships Shell Iran Installation"

I did not know about this.

Knob Creek's picture

I think we actually took out a couple of their surface vessles and 2 drilling platforms then for an encore, we downed an Iranian passenger jet.

https://en.wikipedia.org/wiki/Operation_Praying_Mantis

https://en.wikipedia.org/wiki/Operation_Nimble_Archer

Moving and Grooving's picture

I'm always amazed when I watch that crusty old comedy 'Airplane!' at the van labeled 'Iran Air' with the blindfolded American hostages being led out by gun-toting Iranians.  That was released in 1980, 37 years ago. Some things just don't change.

 

 

ebworthen's picture

I would love a 30th anniversary crash.

The "market" 80% more of a casino now than it was then.

jmack's picture

   This is what you are missing.  the market cannot crash like that again, because of all the controls instituted to avoid it, such as the PPT, the limit down breakers etc.  

 

    So when the crash does happen, it will have to blow out those controls, and to do all that damage will be an epic, never before seen  crash that will strike at the Central Bank's solvency itself.   Until then, btfd.

Xena fobe's picture

Is it even possible to bypass the curcuit breakers? 

Maybe if overseas markets crash they would have to allow ours to follow suit?

Or a decline to just above the cut off could occur on consecutive trading days.  Barring PPT intervention. 

GunnerySgtHartman's picture

and to do all that damage will be an epic, never before seen  crash that will strike at the Central Bank's solvency itself

I can easily see that happening.  When this one comes, I don't think the PPT and the circuit breakers will be able to stop it.  Slow it, maybe - but stop it, no (short of closing the markets altogether).

BandGap's picture

It does mention that the Nasdaq was "saved" by closing. I think this would be a viable options should the implosion go into hyperdrive. They do it for runs on banks.

TuPhat's picture

But that does not stop the bank run, it only delays it.

scintillator9's picture

One has a lot of faith in software and systems designed by flawed people who operate and oversee flawed systems, software, and protocols.

Then again, some find my lack of faith disturbing.

Nomad Trader's picture

You might (though I doubt it) be right about the market "not being allowed" to crash like that again. But circuit breakers will only slow down a crash such that instead of a one day 20% move it would be a 3 day 20% move in smaller increments. I remember trading Asian futures in 2008. The circuit breakers acted more like magnets such that we'd say, "Hey Kospi is down 9%, let's smash it down to the -10% limit." We did the same thing to Parmalat stock right before it became the biggest bankruptcy in European history. If it was -8% we'd knock it down to -10%.  Then we'd get a 10 minute break, after which, we'd knock it down to -15%, and then to -20%. The point is that when the bear market comes the circuit breakers will not save you from being long and wrong.

Dukes's picture

Precisely. This is how it will happen. I recall trading wheat (or corn?) futures a few years ago and it would lock limit down at the open for a stretch of days. It was a bitch to get an order filled.

mkkby's picture

What if the fed, boj and snb bid? Factor that in. Your scenario is out dated.

reepotomac's picture

I bought 10 OEX puts on October 4 I believe, the day before the 90 point drop, for $2000. I sold them the day of the 90 point drop (the next day) and doubled my money. They expired the Friday before the crash at $40,000.

HRH Feant2's picture

I would love to subscribe. Too expensive. Sounds like good info if someone can repost? Thanks!

gamera9's picture

THis walk down memory lane Only reinforces that we will not see a crisis in Janet's lifetime

The Real Tony's picture

She said she won't see another crises, fact is she'll see many, many more in her lifetime not just one more.

Sudden Debt's picture

I'm doing nothing right now.

 

I'm hoarding cash right now in case of bank hollidays

and all the rest is secure

The Real Tony's picture

I'm leary of bank bail-ins I won't even store gold bars in banks anymore.

44_shooter's picture

A very wise old guy - self made guy - on my block, gave us that advice a long time ago - always have at least $10k in cash around - just in case.

We have lived like that for quite sometime.

Made a lot of sense to us at the time - sure makes a lot of sense these days..

44_shooter's picture

A very wise old guy - self made guy - on my block, gave us that advice a long time ago - always have at least $10k in cash around - just in case.

We have lived like that for quite sometime.

Made a lot of sense to us at the time - sure makes a lot of sense these days..

HRH Feant2's picture

100 pounds of silver bullion and coins (maples and kangaroos) and $1000 dollars in twenties. I have that, on hand.

I had to paint my house this summer. Paid $3k cash. Have to restock my cash supply. $10K cash on hand, not in the bank, actual cash, is smart.

I am shooting for $5K cash on hand. I don't want to liquidate any PMs.

GunnerySgtHartman's picture

Same here.  I'm drawing down my bank accounts to a level that only has 4-6 weeks' worth of cash in them,  The rest of my cash and all of my PMs are in a safe location.

DoctOZ's picture

Always keep cash.  But if you have only been hoarding cash for the past over 15,000 point run up in the Dow you have lost a lot of money. 

TheMexican's picture

It will happen again. And yes the market does not alway go up. It can be range bound for decades. Or go into a slow decline for years on end. This low volatility is a new one, it has its own type of pain.

illuminatus's picture

"There Was No 'Smart Money' That Day!"

Neither were there totally captured and controlled markets. It really is different this time. The markets will crash when they are told to crash.

Ben A Drill's picture

‘87 ....... didn’t Japan cause that? How fast did the market recover. If I remember correctly it was super fast.

mr bear's picture

Most of the blame back then was placed on so-called "program trading," AKA the computers. After the dust settled, the "circuit breakers" were put in place.

EmeraldWI's picture

Japan was resisting buying debt at our Treasury auctions. Markets took a few years to recover--super fast if you didn't need to eat or just lived off love for Ronald Reagan. America's standard of living had been declining for the masses and has never recovered. 

mr bear's picture

I guess my IRA was up to about $40,000 back then.

About three weeks before the fateful day, I observed that the Dow had run up by 60+ points two days in a row. 60 whole points! I was spooked and thought this was unsustainable, so I dumped it all into money markets.

On the afternoon of the crash, I called my IRA guy (I think I was with Franklin at the time) and shoved it all back into the S&P at that day's closing price. It was as though I had cashed in on a 30% short sale.

After about three days of patting myself on the back for being a genius, I realized I'd actually gotten the biggest lucky break an investor could get in one lifetime. So I went 100% SP500 index and never sold again until 2013 -- 26 years later and four years into retirement.

Half my goods now are 25% S&P and 25% MM, the other 50% in some really neat 6.5-7.5% corporates and utilities. Yes, I took the hit in 2008-2009, fearful of selling at the bottom, but made most of it back before going to a more conservative retirement portfolio. So let me take this opportunity to thank former Fed Chair Bernanke for his repeated assurances in 2008 that the subprime crisis was "well-insulated from the general markets." That was the last time I took a Fed spokesman's word at face value.

wisehiney's picture

Long treasury bonds were smart money that day.

TLT

The Real Tony's picture

I certainly remember the plunge in the gold shares starting around 1:00pm that day. They were up about 10 percent up until around 1:00pm then plunged about 40 percent from 1:00pm to the 4 o'clock close. Gold prices were up and held firm that day. I remember 1984 the entire year as the market fell was blamed on deficits.

The Real Tony's picture

I could say I caused the '87 crash but no one would believe me. I bought Dow Chemical at 10:20 am that morning. Sold at the open on Tuesday and bought Gillette Corporation upon the sale of Dow Chemical. I also can take credit for Hillary losing the election as I bought HVI.TO about one week before the election last November. It was to the tune of half a million dollars, I sold at the open after being down a fortune at 2:00am that early morning. I thought Hillary would win by a bigger landslide than Ronald Reagan did.

Savvy's picture

I was a starving student living on brown rice and oranges. I can honestly say I never even noticed.

London..unfortunately's picture

Oranges?! You had money for oranges?! You were lucky...

https://www.youtube.com/watch?v=VKHFZBUTA4k