From: https://brucewilds.blogspot.com/2020/01/buy-dip-american-tradition-since-1987.html
Sunday, January 19, 2020
Buy The Dip, An American Tradition
Since 1987
Buy the
dip has been an American tradition since 1987. The first truly modern global financial crisis unfolded in the
autumn of that year. October 19, 1987, has
become the day known infamously as “Black Monday". It set forth a chain
reaction of market distress that sent global stock exchanges plummeting in a
matter of hours. In the United States, the Dow Jones Industrial Average (DJIA) dropped 22.6 percent in a single
trading session. This loss remains the largest one-day stock market
decline in history and marks the sharpest market downturn in the United States
since the Great Depression.
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The important significance of this event lies
in the fact Black Monday
underscored the concept of “globalization",
which was still quite new at the time. The event demonstrated the extent to which
financial markets worldwide had become intertwined and technologically
interconnected. This led to several noteworthy reforms,
including exchanges developing provisions to pause trading temporarily in the event of rapid
market sell-offs. More importantly, it forever altered the Federal Reserve’s
response on how to use “liquidity” as a tool
to stem financial crises.
Leading up to this event the stock markets raced upward during the first half
of 1987 gaining a whopping
44 percent in just seven months. This, of course, created concerns of an
asset bubble, however, few market traders expected the market could unravel so
viciously. Prior to US markets opening for trading on Monday morning, stock
markets in and around Asia began plunging. In response investors rapidly began
to liquidate positions, and the number of sell orders vastly outnumbered
willing buyers near previous prices, creating a cascade in stock markets.
Thomas Thrall, a senior professional at the Federal Reserve Bank of
Chicago, who was then a trader at the Chicago Mercantile Exchange
later said, “It felt really scary, people started to understand the
interconnectedness of markets around the globe.”
Without a doubt, several new developments in the market enlarged and
exacerbated the losses on Black Monday. Things like international investors
becoming more active in US markets and new products from US investment firms,
known as “portfolio insurance” had become very popular. These included the use of options and derivatives. A number of structural flaws also fueled the
losses. At the time of the crisis, stock, options, and futures markets used different timelines for the
clearing and settlements of trades, creating the potential for negative trading
account balances and forced liquidations.
That is when, Alan
Greenspan, then Federal Reserve chairman, came forward on October 20, 1987,
with a statement that would shape traders' actions for decades. Fed
Chairman Alan Greenspan said,
“The Federal Reserve, consistent with its responsibilities as the Nation's
central bank, affirmed today its readiness to serve as a source
of liquidity to support the economic and financial system” Prior to
this markets were seen as a much riskier venture. The great legacy from the
events taking place in 1987 is rooted in the actions and swift response of the
Fed, that the central bank would backstop markets. This premise has grown over time.
After Black Monday, regulators overhauled trade-clearing protocols and
developed new rules. One of the most important is known as circuit breakers which allow
exchanges to halt trading temporarily in instances of exceptionally
large price declines. Under these rules, the New York Stock Exchange will
temporarily halt trading
when the S&P 500 stock index declines 7 percent, 13 percent, and 20
percent. This is done in order to provide investors
time to make better informed decisions during periods of high market volatility
and reduce the chance of panic. Risk managers also re-calibrated the way they
valued options.
Unlike previous financial crises, the Black Monday decline was not associated with a deposit run or any
other problem in the banking sector. Still, it was very important
because the Fed’s response set a precedent that has over time when
coupled with other events massively
increased the moral hazard associated with intervention in free markets. Following
the rout stock markets quickly recovered a majority of their Black Monday
losses. In just two trading sessions, the DJIA gained back 57 percent, of the
Black Monday downturn. Because
of the Fed action in less than two years, the US stock markets surpassed their pre-crash
highs and was not followed by an economic recession.
And now for the grand point of this post, we should not underestimate
how the Fed’s response to Black Monday ushered in a new era of investor
confidence in the central bank’s ability to control market downturns.
The actions by Fed Chairman Greenspan galvanized the mantras
"buy the dip" and "don't fight the Fed" and powered them to
the top of trading lexicons. It has also been a key factor in
allowing the stock market [equity and FIRE economy markets altogether?] to
morph into a much larger symbol of the economy than it merits. This is
reflected in how over the decades growth in the
financial sector has soared dwarfing that in the real economy.
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To all those market
aficionados that forget markets
can fall and for decades fail to regain their luster I point to the Japanese
markets and their fierce meltdown in 1990. The chart to
the right above would look far more depressing had the market trends
over the last decade coupled with buying from the central Bank Of Japan not bolstered its performance. We
should also remember many
market high-flyers simply vanish into a deep hole and that during the 1930s the
Fed was unable to bring the economy out of its funk,.
Another often overlooked issue is how changes in tax laws over the years have
moved more wealth into stocks. These include the often forgotten and seldom
mentioned changes many made by the Bush administration following the dotcom
bust and 9-11. These factors and money constantly funneled into markets by
pension funds and such coupled with soaring central bank liquidity has
levitated markets to record high, after record high, despite stagnant fundamentals.
It seems the "fear of missing out" and exuberance has caused many
investors to become blind to the idea that years of profits can vanish in a
blink of the eye.
This should force us to question the utter madness displayed in the widening disconnect between
current valuations and underlying fundamentals. It could be argued that
because of these actions QE has amplified speculation as investors seeking
yield now feel almost invulnerable to future losses. We can cast away all the terms and warnings about "moral
hazards" and "slippery slopes", however that does not
guarantee they will not return to haunt us. Historically our hubris and
arrogance has shined as a beacon illuminating the fact that every time those in
high finance declare it is different this time they have been proven
wrong.
Posted by Bruce Wilds at 9:09 AM