Thatcher, drugs and a rich history of bad behaviour (2nd part of our 1987 Crash Ebook)

Mon 11 Sep 2017

By Brian Dennehy

Membership Access | free

Market commentary

Ahead of “The Crash” in October 1987 it was surprising how much reference there was to the possibility of a crash.
As early as January the legendary student of 1929, John Kenneth Galbraith, said:
“The dynamics of speculation are remorselessly constant...
...those who suffer most will be those who regard current warnings with greatest contempt”

Ahead of “The Crash” in October 1987 it was surprising how much reference there was to the possibility of a crash.
As early as January the legendary student of 1929, John Kenneth Galbraith, said:  
“The dynamics of speculation are remorselessly constant...
...those who suffer most will be those who regard current warnings with greatest contempt”
This quote reflected one of the early cracks in the edifice of the mania that was building.  Another was the extraordinary corruption and fraud which was being uncovered many months before October.
“Insider trading” and “junk bonds” became household phrases, and prison sentences were being handed out like confetti in the US. In the UK the Guinness Affair was rumbling, though no one had yet rumbled Polly Peck and Asil Nadir.
Yet while all of this was going on, the UK stock market was up 19% at the end of the 1st quarter of 1987.
As we moved into April, criminal rings were uncovered operating midst the US stock market, trading drugs for insider information.  Two undercover agents stated that cocaine is either used or accepted by 90% of the people on Wall Street.
Nonetheless the hype was never-ending. In May one flakey US company was promoted by an analyst on the basis that “You are buying a dream”.  This sort of hype was commonplace, and investors were still buying into it.
Turning back to the UK stock market, after a Spring tumble, Margaret Thatcher was comfortably re-elected, following another “budget for equities”, and the UK stock market continued its frothy rise.
In the 2nd quarter of 1987 alone the FTSE 100 index was up another 15%.
As an aside, by July there was growing anxiety over inflation as the oil price hit $22. (what we wouldn’t give for that kind of anxiety now!) It had been under $10 within the previous year.
The UK stock market peaked for the year on 16th July, up 45% in just 7 months. (The Dow Jones would not hit its high for the year until 25th August, when it would be up 44%).
Summer 1987: Reasons to be cautious
As we moved into August, the UK stock market fell sharply over concerns that it would not be able to cope with a raft of huge rights issues.  The FT ran with a “Fear of the Crash” headline on 1st August, albeit on the inside pages.
At a personal level, in August we completed the takeover of a small firm of investment advisers. This made us all the more sensitive to unfolding events.  Nonetheless, markets began to recover again as we entered September.
At this manic stage the market is (and was) inherently unstable, and it is inevitable that the mania will be followed by panic – at least history was absolutely clear on this in our view.

The problem is that there is no way to know what might trigger that panic and when. 
Myself and Linden Weller certainly recall feeling unsettled and cautious at that time in 1987. The words “instinct” and “gut feeling” come to mind when we reflect on how we felt at that time - there was no single overwhelming fact which was making us nervous.  Interestingly a survey conducted by Robert Shiller, at the time of the Crash, also found many large traders and investors expressing the same rather vague sentiment. 
Yet there were plenty of raw facts in the Summer of 1987 to engender caution beyond mere gut feeling:
British Gas and earlier privatisations created an atmosphere in which the general public believed investing was “free money”.
In May 1987 the stock market offer for Sock Shop was 53 times over-subscribed!
One incident which rang a loud bell of unreality was the takeover approach from an advertising agency (Saatchi and Saatchi) for a huge High Street bank (Midland, now HSBC in the UK).
The dividend yield on shares was 3%, but interest on gilts was nearer 10%. The ratio between these two had never been so great, and highlighted a VERY expensive market i.e. surely you would prefer a guaranteed return of 10% in preference to the uncertainty of the stock market?
The consumer spending boom was encouraged by the easy availability of credit, and consumers were not put off by double digit interest rates which would scare us rigid in 2017.
With interest rates at 10% deposit rates were juicy. But the public was more interested in the easy money of the stock market through a raft of privatisations and new issues.
House prices were booming, despite mortgage rates of 12% at best, and nearer 15% for some.  Booming confidence overwhelmed any possible fear of not being able to meet sky-high mortgage repayments.
With only a moment of reflection this was a worrying mix.
Over in the US there were similar but not identical signs.
Paul Volcker was replaced as head of the Federal Reserve in August 1987. A significant part of confidence in the US economy and stock market was based on the key person charged with managing the economy - Volcker.  From 1979 he kept rates very high (peaking at 14% in May 1981) to slay the inflation dragon, which fell from a peak of 11.3% in the 1970s to 3.6% by 1987.  The latter allowed rates to begin falling, a key element in the growing confidence of the 1980s.
Volcker leaving, and being replaced by the relatively unknown Alan Greenspan, was clearly not helpful at this stage in 1987.  There were also obvious imbalances - budget deficit, trade deficit, and low savings rate. Plus the weak dollar had been a global pre-occupation in 1987. 
But none of these were sufficient either alone or combined to cause The Crash.

“Tensions were building” according to Manuel Johnson, vice chairman of the Federal Reserve under Volcker and Greenspan - and in particular he said “the divergence between the pricing of bond and equity markets had been obvious for quite a while”.  It was expected that there would be a reaction - it was the magnitude which was “a total shock” he said, as we will see.
In 1986 there were rumblings about the dangers of new portfolio insurance and index arbitrage (more on that later). But there was no drive to understand these better, beyond a study which was commissioned in July 1987 by John Phelan, chairman of the New York stock exchange.  His concerns were largely ignored because a lot of money was being made through these innovations - that feels like 2007/8, on which watch “The Big Short”.
Manuel Johnson says there were “concerns” over these financial innovations.  But the truth is that even if they understood them technically, they did not fully understand the dangers.  There was also a laissez-faire attitude, a bias against interference.
Valuations were not extreme (though John Phelan says they were “reasonably high”).  That they were not extreme can be illustrated by a long term chart of a measure widely used today, the cyclically-adjusted price earnings ratio, CAPE. Looking at the CAPE chart below for the US stock market, Black Monday barely registers - though see how 2017 stands out. 
Similarly on a simpler price earnings ratio, based on the current years earnings.  This spiked up through 20 in Spring/Summer 1987, but it had been flirting with 20 for more than a decade from the early 1960s - so this was far from an overwhelming worry. This measure was somewhat lower in the UK.
But there was one clear warning for John Phelan: “If you wanted to park your car in New York you got three stock tips from the attendant”.  So no big valuation concern - but a very clear concern about investor behaviour, just as in the UK.

Rich history of bad behaviour
It was the behaviour of investors in particular which concerned us at the time.  There was already a rich literature on stock market manias, from the 19th century work of Mackay to the recent classic of Charles Kindleberger, “Manias, Panics, and Crashes”. 
What lies at the heart of a mania was captured more recently by Akerlof and Shiller.  Extremes are caused by the inter-action of confidence, greed and fear, temptations, envy, resentment and illusions. And, in the case of a mania, they are held together by a good story, widely believed, which binds the crowd of investors more tightly together.
The story was very powerful. 
The 1970s had been very tough, and the Thatcher government wanted everyone to believe in a better today and an even better future. It certainly didn’t stop with privatisation windfalls.  
For example, the FT called the 1986 budget a “budget for equities” - income tax was cut, allowances raised, money supply target increased, interest rates cut. 
To ensure the widest possible participation in this largesse the Government also introduced a “right to buy” for Council house tenants. Discounts were up to 50%, and 100% mortgages were guaranteed to be made available by the local council.  More free money. 
The fire was well and truly being stoked.
In the US too. The markets had already been reaching higher all-time highs in 1985 and 1986.  Then in October 1986 President Reagan slashed the top rate of tax from 50% to 28%. There were now just two tax rates, and a raft of simplifications. From the day before the Tax Reform Act of 1986 was signed the stock market took off, and rose by over 50% in the next 10 months.
Before the worst crashes of the 20th century (such as 1907,1929,1987, and 2000) the market was already performing well but then had a parabolic rise (something like 50% in a year).  This is the transition from a boom to a manic phase - driven by extreme investor behaviour rather than fundamentals.
There was a well established mania by the Summer of 1987.
The stock market is itself a measure of confidence - the problem is knowing when this confidence goes too far, too fast.
What we did (and still do) is measure the gap between the stock market index today and its long term trend (being the 200 day moving average).  When the index is 15% above the long term trend it is ringing a loud bell, and the higher it goes the louder the ringing!  In simple terms this tells us that the market has gone up too far too fast.  
By April 1987 the FTSE 100 index was 15% above its long term trend, and by August it was an extraordinary 30% above.  This simple, and effective, measure on its own made us very concerned. We had clearly entered a very dangerous phase.
Interestingly, as we saw earlier, stock markets were not particularly over-valued when judged against company profits.  So there was no classic investment bubble with a mix of extreme investor behaviour and extreme valuations.
First and foremost this was a behavioural bubble - a bubble in confidence. Not just any old confidence - but that of a crowd, the investing herd driven by the powerful scent of money.  For most investors there was seemingly unstoppable momentum.
“Madness is rare in individuals, but in groups, parties and nations, it is the rule”  (Nietzsche)
NEXT TIME:  October 1987: A series of unfortunate coincidences


Market commentary

Share this post: