90 is depicted inFigure 9.4.It is widely believed that there was a bubble in U.S. technologyand dot.com stocks (many of which were traded on Nasdaq) duringthe late 1990s and early 2000. The Nasdaq Composite Index closed at751.96 on December 30, 1994 and closed at 1,005.89 on July 17,1995. The Nasdaq Composite Index closed at 1291.03 on December31, 1996, 1570.35 on December 31, 1997, and at 2,192.69 on December 31, 1998. The index continued to increase during 1999 and closedat 3,028.51 on November 3 and at 4,041.16 on December 29. Thedot.com bubble peaked on March 10, 2000 when the Nasdaq Composite Index hit an intraday high of 5132.52 and closed at 5048.62.Like the deflation of the Japanese bubble, an extended period ofvolatility and decline in Nasdaq stock prices followed. The rise andsubsequent decline of the Nasdaq Composite Index is depicted inFigure 9.5.There was no universal euphoria over technology stocks prior toMarch 10, 2000. Many market participants were wary that a bubble intechnology stock prices existed. Indeed, concern by policymakers andothers that there was a potential bubble in U.S. stock prices wasexpressed far earlier at substantially lower levels of stock prices. Aswas noted in Chapter 3, “Talk Isn’t Cheap,” Fed Chairman AlanGreenspan made his famous “irrational exuberance” speech inDecember 1996 when the Nasdaq Composite Index stood at almost1300 even and the Dow Jones Industrial Average at 6437.10.21
276
40000.0039000.00
12/29/89date.open 38913.12date.high 38957.44date.low 38827.71date.close 38915.87
38000.0037000.0036000.0012/29/89
35000.0034000.0033000.0032000.0031000.0030000.0029000.00
27000.0010/2/89
11/2/89
12/2/89
1/2/90
Daily trading range of the Nikkei 225 index from October 1, 1989 to April 15, 1990.
FIGURE 9.4
The Japanese stock market peaks.
2/2/90
3/2/90
4/2/90
TRADING CATALYSTS
28000.00
CHAPTER 9 • BUBBLES, CRASHES, CORNERS, AND MARKET CRISES
5200.003/10/00
3/10/00date.open 5060.34date.high 5132.52date.low 5039.35date.close 5048.62
5000.004800.004600.004400.004200.004000.003800.003600.003400.003200.003000.002800.002600.002400.008/2/99
9/2/99
10/2/99
11/2/99
12/2/99
1/2/00
2/2/00
3/2/00
4/2/00
5/2/00
The behavior of the Nasdaq Composite Index during 1999 and 2000.
Nasdaq peaks on March 10, 2000.
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FIGURE 9.5
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The perceived bubble in dot.com stocks traded on the Nasdaq inthe U.S. pales in comparison with the performance of technologystocks traded on the Neuer Markt in Germany. The Neuer Markt wasintroduced in 1997 as part of the Deutsche Börse. The Neuer Markt’sNemax all-share index closed at 506.48 on the first day of trading in1997. It soared to a peak of over 8,000 in early 2000 and fell almost95% by September 2002. This is a far greater percentage rise anddecline than occurred on Nasdaq over the same 5 1/2-year timeperiod. The Neuer Markt was subsequently closed by its parentDeutsche Börse.22Financial panics and market crises may encompass many of thepreceding events such as market crashes, corners, or squeezes. However, market crises merit their own examination. Market crises areperiods where markets fail to function normally due to a lack of confidence or liquidity. Market crises may be driven by fundamental economic factors or factors internal to the market. They may be localizedor general. Market crises may be relatively short-lived as occurred onThursday, March 27, 1980—in response to the sharp decline in silverprices when the corner was effectively broken—or last for a protracted period of time as occurred with the Asian Financial Crisis of1997 and 1998. Extreme examples of market crises are financial panics. The Federal Reserve System was established, in part, to eliminatefinancial panics.23Many financial market crises are often attributed to an externalevent. For instance, the devaluation of the Mexican peso in December 1994 by the newly elected government of President ErnestoZedillo triggered a crisis in Mexican financial markets that quicklyspread to the financial markets of other emerging market countries.Similarly, the apparent trigger for the Asian Financial Crisis of 1997and 1998 was the decision by the Thai government to devalue theThai baht on July 2, 1997. Given that market crises often have a plausible external factor that precipitates them, the question naturallyarises as to whether market crises should be considered internal or
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external trading catalysts. One argument for classifying market crisesas internal trading catalysts is that much of the initial impact of market crises on financial and commodity prices stems from marketdynamics. Indeed, in some cases, the external factor that is perceivedto have triggered the market crisis is often the result of an internalfactor, such as a speculative attack on a currency. This does not meanthat devaluations are always the result of speculative attacks by currency traders. Devaluations are often the result of the pursuit offlawed economic policies by governments. However, speculativeattacks on an overvalued currency may accelerate the inevitablechange in exchange rates.Volatile financial prices are an important characteristic of marketcrises. Another characteristic is a flight to safety. Market crises are alsocharacterized by a lack of liquidity and a sharp increase in the liquidityrisk premium. The sharp increase in liquidity risk can have devastating effects on traders pursuing certain arbitrage trading strategies, asLong-Term Capital Management (LTCM) found out during 1998.LTCM was a large hedge fund that specialized in convergence,conditional convergence, and relative value arbitrage trading strategies to exploit price differences among similar securities. (The fundwas also engaged in various directional bets that accounted forapproximately one-fifth of its trades.) Because most price differencesamong similar securities are small, LTCM was highly levered toincrease potential profits. Although the fund diversified its betsacross markets, many of LTCM’s trading strategies were liquidityprovision strategies and subject to the risk of a sudden change in theliquidity premium.24 Simply stated, LTCM held illiquid securities andhedged its exposure to interest rate risk by shorting liquid defaultfree securities. In such an environment, hedges can backfire astraders lose money on both the illiquid securities held long and theliquid securities that were shorted. Leverage magnifies the losses.Like the Hunt brothers, LTCM faced cash flow risk as a resultof the flight to safety during the liquidity crisis. LTCM lost almost
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$4 billion. Even though its convergence trades were right in the longrun (i.e., the expected convergence occurred), the firm had troublesurviving in the short-term. The firm was effectively bailed out by aconsortium of investment banking firms.The August 17, 1998 devaluation of the rouble and default byRussia on its rouble and foreign currency denominated sovereigndebt is blamed for exacerbating a sharp selloff in emerging marketdebt and prompting a flight to safety. Some attribute the near collapse of LTCM to this event. The near collapse of the hedge fundLong Term Capital Management in late August and September of1998 highlights several trading risks. One risk is the danger ofunwinding a position when too many other participants have thesame trading position on. It also highlights the importance of liquidityrisk. In a liquidity crisis, there are only two relevant assets: cash or itsequivalents and everything else. The highly levered nature of arbitrage funds means that such firms are susceptible to massive losses iftheir hedges go awry during a liquidity crisis.Although individual stocks may experience sudden large pricemoves up or down that greatly exceed changes in the overall marketmuch public attention is focused on the sharp declines in the overallmarket associated with market crashes. This makes analysis of the catalysts that precipitate a market crash especially interesting. The stockmarket crash of 1929 occurred over two days with the Dow JonesIndustrial Average falling 12.8% on Black Monday and another11.7% on Black Tuesday. The stock market crash of 1987 occurredwithin a single day, Monday, October 19, 1987.
The Crash of 1987On Friday, October 16, 1987, the Dow Jones Industrial Average fell108.36 points, or 4.6%, on record volume of 343 million shares. Thesharp decline precipitated a minor flight to quality and safety at the
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end of the trading day. Treasury bills were bid up. Treasury bondswere not. The market decline on Friday came on top of a 95.46-pointdecline in the DJIA on Wednesday and (coupled with other dailychanges) resulted in a 9.5% decline in the DJIA for the week. Interestingly, some news accounts attributed the Friday, October 16, 1987decline to concern among market participants that the stock marketrally was over.25 Although it is impossible to ascertain if that wasindeed the catalyst for the sharp selloff, it is interesting that somemarket observers believed that the prospect of an end to the stockmarket’s rally was enough to trigger a decline in stock prices on Friday, October 16, 1987.Whatever the cause of the decline on Friday and earlier in theweek, many market participants were anxious about the course anddirection of the market. Some market observers and policymakersadvocate trading halts as a means to settle anxious market participantsand thereby calm volatile markets. Indeed, the Presidential TaskForce on Market Mechanisms—which was formed in the wake ofthe October 1987 crash—recommended the imposition of circuitbreakers (i.e., mandatory trading halts when prices move by a setamount up or down) on stock and stock index futures markets toreduce the likelihood of future stock market crashes. It is not apparent that if circuit breakers had been operative before the marketcrash that it would have made any difference. In this instance, market participants had a natural two-day trading halt—the weekend—toreflect on the market. Rather than calming market jitters, the weekend trading halt exacerbated them because they could not get out oftheir positions.On Monday, October 19, 1987, the stock market reopened. Bythe end of the trading day, the stock market had plunged 508 pointson the DJIA, or 22.6%, on record volume of 604.33 million shares.26This was the second largest one-day decline in the history of the U.S.stock market, exceeded only by a 24% decline on December 14, 1914when the NYSE reopened after being closed for several months after
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World War I started in July 1914. Figure 9.6 depicts the October 19,1987 stock market crash. A sense of the breadth and depth of thedecline in stock prices is captured in the following excerpt of an October 19, 1987 article by Peter Coy of the Associated Press.…The market [decline] fed on itself in wave after wave ofselling…Earlier Monday panic selling gripped [foreign] stockexchanges…And…continued with ferocity Tuesday morningas share prices plunged when the Tokyo and Australian stockmarkets opened…The Wall Street rout was all the more stunning because theredid not seem to be any major news event that caused it. Aselling trend that picked up speed in the middle of last weeksimply gained unstoppable momentum and turned into afrenzy……Money continued to pour out of stocks and bonds into goldand short-term Treasury securities, which are considered safehavens in times of crisis…The price of a benchmark 30-yearTreasury bond with a face value of $1,000 fell about $5 as itsyield rose to 10.2 percent by 3:30 P.M. EDT.The dollar was also relatively stable…The price of gold…gained another $12 an ounce to $483 an ounce by 3:30 P.M.EDT.27The report argues that there were underlying concerns amongmany market participants about “rising interest rates and a weakeningdollar” and that money continued to “pour out of stocks and bondsinto gold and short-term Treasury securities.” The excerpt points outthat the Treasury long bond had declined one-half point by 3:30 P.M.This initial negative reaction of the Treasury long bond to the stockmarket crash stands in sharp contrast to the frenzied positive reactionthat occurred later that night when the market experienced thelargest one-day rally ever in Treasury bonds. To be sure, the bondmarket closed before the equity market closed, but it was apparenteven before the bond market closed that equity markets would likelyexperience a record point loss and a percentage loss far in excess ofthe Black Monday component of the October 1929 crash.
10/19/87date.open 2247.39date.high 2247.39date.low 1738.74date.close 1738.74
2700.002600.002500.002400.0010/19/87
2300.002200.002100.002000.001900.001800.001700.001600.007/1/87
8/1/87
9/1/87
10/1/87
Daily trading range of the Dow Jones Industrial Average from July 1, 1987 to December 31, 1987.
FIGURE 9.6
11/1/87
12/1/87
CHAPTER 9 • BUBBLES, CRASHES, CORNERS, AND MARKET CRISES
2800.00
The October 19, 1987 crash.
283
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TRADING CATALYSTS
Notice that the preceding excerpt suggests that there was noobvious external trigger for the sharp decline in stock prices. If anything, the account seems to suggest that the decline resulted fromwave after wave of selling that fed upon each other. Floyd Norrisdescribed the action in the October 26, 1987 issue of Barron’s asfollows.…Just what set off the selling at the opening Monday is notcompletely clear. Portfolio insurance played the largest role,but that alone could not be the whole story…[M]ostly whathappened was panic. After the first wave of selling sent pricesdown more than 200 DJIA points, there was a rally thatgained back more than 100 of them…The portfolio insurerskept selling [stocks or futures]…The DJIA dipped below1960 to show a drop of 12.8% for the day, and soon there wastalk of Oct. 28, 1929, or Black Monday…when a record12.8% decline set off a crash…[P]rices soon rallied, with theDow climbing back to the 2000 level. But that level couldn’thold, and when prices fell below 1950, the remaining declinewas precipitous.28To be sure, other explanations were offered at the time as potential catalysts for the crash such as comments by U.S. Treasury Secretary James Baker that the U.S. would pursue a weak dollar strategyagainst the Japanese yen and German mark or a proposed bill byCongressional Democrats to increase taxes and discourage hostiletakeovers. However, even when other catalysts were blamed for precipitating the crash, program trading (in the form of index arbitragebetween individual stocks and stock index futures contracts) andportfolio insurance were blamed for the exacerbating the severity ofthe crash.Portfolio insurance was a very popular risk-management technique during the mid 1980s. The essential idea behind it is to replicatea synthetic put option on a portfolio in order to limit the downside risk
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of equity portfolios.29 However, put options are expensive and shortlived. To minimize the cost of acquiring portfolio insurance, fundmanagers were persuaded that they could sell an appropriate numberof stock index futures contracts after the cash stock market fell by acertain percentage or trigger amount. The dollar amount of stockindex futures sold would only be a fraction of the total value of theportfolio. A commonly used rule was to sell stock index futures equivalent in value to twice the percentage amount of the portfolio as thetrigger percentage market decline. If stock prices fell further, thelosses on the long stock portfolio would be partially offset by gains onthe short futures stock index futures position. Additional declinesbeyond a certain percentage would trigger additional selling of stockindex futures. The trigger points for many large insured portfolioswere well-known to market participants. Indeed, one investmentbank, Kidder Peabody, pursued a policy where it would announce toother market participants whenever it wanted to enter or exit a position due to a portfolio insurance transaction. The idea was to get better prices for its transactions by assuring counterparties that the firmwas not executing a large order because its customer had informationthat the counterparties did not have. How well this strategy worked onOctober 19, 1987 is not clear.Portfolio insurance was partially the victim of its own success. Thetechnique worked well for portfolios that sold stock index futures onFriday, October 16, 1987. The technique did not work as well forthose portfolios that sold or attempted to sell stock index futures onMonday, October 19, 1987. The technique relied on a flawed underlying assumption that there would always be someone willing to buystock index futures at small deviations from the current price. Thismeant that market participants who were short on the day of the crashhad every reason to believe that the selloff would worsen as the dayprogressed and more sell orders flowed in from portfolio insurers. Italso meant that locals or scalpers in the stock index futures pits had noincentive to take the other side of the sell orders except at sharply
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lower prices. Portfolio insurance is a form of positive feedback trading. Arguably, the sell orders from portfolio insurers and the expectations of other market participants of those orders exacerbated theprice decline.On November 5, 1987, U.S. President Ronald W. Reaganordered the creation of the Presidential Task Force on Market Mechanisms (commonly called the Brady Commission because it waschaired by Dillon Read investment banker Nicholas Brady) to investigate the causes of the stock market crash. The Task Force viewedthe crash from the perspective of several days starting on Wednesday,October 14, 1987 and ending on Tuesday, October 20, 1987. The TaskForce had the following comments on the causes and nature of thedecline.On Wednesday morning, October 14, 1987, the U.S. equitymarket began the most severe one-week decline in its history.The Dow stood at over 2,500 on Wednesday morning. Bynoon on Tuesday of the next week, it was just above 1,700, adecline of almost one third. Worse still, at the same time onTuesday, the S&P 500 futures contract would imply a Dowlevel near 1,400…During October 14 to 16, the Dow fell by over 250 points.The selling was triggered primarily by two proximate causes:disappointingly poor merchandise trade figures, which putdownward pressure on the dollar in currency markets andupward pressure on long term interest rates; and the filing ofanti-takeover tax legislation, which caused risk arbitrageurs tosell stocks of takeover candidates resulting in their precipitatedecline and a general ripple effect throughout the market.The market’s decline created a huge overhang of sellingpressure—enough to crush the equity markets in the following week. This overhang was concentrated within two categories of reactive sellers, portfolio insurers and a few mutualfund groups, and exacerbated by the actions of aggressive
CHAPTER 9 • BUBBLES, CRASHES, CORNERS, AND MARKET CRISES
trading-oriented institutions selling in anticipation of furtherdeclines…[T]he typical portfolio insurance model calls forstock sales in excess of 20 percent of a portfolio in response toa 10 percent decline in the market.Various sources indicate that $60 to $90 billion of equityassets were under portfolio insurance administration at thetime of the market break. Two consequences were evident.First, portfolio insurers were very active sellers during theWednesday to Friday period. In the futures market, wherethey concentrated their activity during the week, they soldthe equivalent in stocks of approximately $530 million onWednesday, $965 million on Thursday and $2.1 billion onFriday. Second, they approached Monday with a hugeamount of selling already dictated by their models. With themarket already down 10 percent, their models dictated that,at a minimum, $12 billion (20 percent of $60 billion) of equities should already have been sold. Less than $4 billion had infact been sold.A small number of mutual fund groups were also confrontedwith an overhang…On Friday alone, customer redemptionsat these funds exceeded fund sales of stock by $750 million…These funds also received substantial redemptionrequests over the weekend.The activities of a small number of aggressive tradingoriented institutions both contributed to the decline duringthis week and posed the prospect of further selling pressureon Monday. These traders could well understand the strategies of the portfolio insurers and mutual funds. They couldanticipate the selling those institutions would have to do inreaction to the market’s decline. They could also see thoseinstitutions falling behind in their selling programs. The situation presented an opportunity for these traders to sell inanticipation of the forced selling by portfolio insurers andmutual funds, with the prospect of repurchasing at lowerprices…
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Index arbitrage was active throughout the three day period totransmit selling pressure from the futures market to the stockmarket. But…it was the timing of arbitrage activities, ratherthan the aggregate daily level, which had specific impact onthe stock market.30The preceding excerpt views the crash as part of a larger oneweek period of market turbulence. Although it suggests that therewere two trading catalysts for the selloff, it is clear that the existenceof “reactive” and “price-insensitive” sellers sharply exacerbated theseverity of the decline. The excerpt also illustrates the game-likenature of trading when it discusses the role that “a small number ofaggressive trading-oriented institutions” that understood the reactiveand price-insensitive “strategies of the portfolio insurers and mutualfunds” and could anticipate the future selling these market participants “would have to do in reaction to the market decline”—that is,there was an opportunity to short the market that was not related tofundamental economic factors but to the likely trading behavior ofsome market participants.A closer examination of the price action on Monday, October 19,1987 illustrates the important role that portfolio insurers and reactivemutual funds played in exacerbating the price declines during the dayof the crash. It also highlights the impact that the cessation of indexarbitrage after 2:00 P.M. had on the market. Again, the Brady Commission’s report describes it as follows.[Foreign markets fell before New York opened on Monday,October 19, 1987. By midday London] was down 10 percent.Selling of U.S. stocks on the London market was stoked bysome U.S. mutual fund managers who tried to beat theexpected selling on the NYSE by lightening up in London…[T]he S&P 500 futures also opened down under heavy sellingpressure by portfolio insurers. During the first half hour oftrading, a few portfolio insurers sold futures equivalent to justunder $400 million of stocks, 28 percent of public volume.
CHAPTER 9 • BUBBLES, CRASHES, CORNERS, AND MARKET CRISES
By the scheduled 9:30 A.M. opening on the NYSE, specialistsfaced large order imbalances…[and as a result] did not opentrading in their stocks during the first hour…[Some portfolioinsurers started to sell stock directly rather than stock indexfutures.]…The selling pressure in futures led to discounts of historicsize. In response to these huge discounts, three mechanismscame into play to transmit selling pressure from futures tostocks. First, index arbitrage executed $1.7 billion of programsales through DOT [the NYSE’s designated order turnaroundsystem], matched by equivalent futures purchases. Second,there were additional straight program sales of stock equal to$2.3 billion. Most of this was portfolio insurance sellingdiverted from the futures market to the stock market by thelarge discount. Taken together, arbitrage and straight sell programs totaled $4 billion, almost 20 percent of the sales on thefirst 600 million share day in the NYSE’s history…Starting around 11:40 A.M., portfolio insurance sales overwhelmed the rally. Between then and 2:00 P.M., the Dow fellfrom 2140 to 1950, a decline of just under 9 percent. The last100 points of this decline occurred after reports began circulating that the NYSE might close…Over these two hours, thefutures index fell 14.5 percent. Portfolio insurance activityintensified. Between 11:40 A.M. and 2:00 P.M., in the futuresmarket portfolio insurers sold approximately 10,000 contracts, equivalent to about $1.3 billion and representing about41 percent of futures volume exclusive of market makers (i.e.,locals). In addition, portfolio insurers authorized to sell stockdirectly sold approximately $900 million in stocks on theNYSE during this period. In the stock and futures marketscombined, portfolio insurers contributed over $3.7 billion inselling pressure by early afternoon…After about 2:00 P.M.,index arbitrage slowed because of concerns about delays inDOT and the consequent ineffective execution of basketsales…Relieved of these selling pressures…the Dow ralliedback to the psychological important 2,000 level by 2:24 P.M.
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The result of the withdrawal of some index arbitrage anddiverted portfolio insurer sales from the DOT system wasthat neither mechanism was sufficient to keep the stock andfutures markets from disconnecting…The rest of Monday afternoon was disastrous. Heavy futuresselling continued by a few portfolio insurers. In the last hourand one half of futures trading, these institutions sold 6,000contracts, the equivalent of $600 million of stock…[The virtual absence of index arbitrage activity resulted in futurescontracts trading at] a discount of 20 index points…All told, Monday, October 19 was perhaps the worst day inthe history of U.S. equity markets. By the close of trading, theDow index had fallen 508 points, almost 23 percent, on volume of 604 million shares worth just under $21 billion. Evenworse, the S&P 500 futures had fallen 29 percent on total volume of 162,000 contracts valued at almost $20 billion.This record volume was concentrated among relatively fewinstitutions…The contribution of a small number of portfolioinsurers and mutual funds to the Monday selling pressure iseven more striking. Out of total NYSE sales of just under $21billion, sell programs by three portfolio insurers made up justunder $2 billion. Block sales of individual stocks by a fewmutual funds accounted for another $900 million. About 90percent of these sales were executed by one mutual fundgroup. In the futures market, portfolio insurer sales amountedto the equivalent of $4 billion of stocks or 34,500 contracts,equal to over 40 percent of futures volume, exclusive of locals’transactions; $2.8 billion was done by only three insurers…Huge as this selling pressure from portfolio insurers was, itwas a small fraction of the sales dictated by the formulas oftheir models.31The report indicates that portfolio insurers executed only a smallfraction of the amount of selling they should have executed if theyfollowed their models faithfully—that is, $20 to $30 billion. Simply
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stated, as bad as the crash was, it could have been much worse. Theexcerpt also suggests that the crash was even worse (29% versus22.6%) if one measured it by the decline of stock index futures. Thereport describes Monday, October 19, 1987 as “perhaps the worst dayin the history of U.S. equity markets.” Yet, the report makes clear thatthe behavior of only a few large portfolio insurers and mutual fundsexerted most of the adverse effect on prices on