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Note on the Recent Stock Market Drop & Comparisons to 1987

Every time there is a sharp drop in stocks there is inevitably some comparison to October 19, 1987 (“Black Monday”). That day the Dow fell 22.6%.

Recently, since October 3, the NASDAQ has dropped about 9%. The S&P and Dow are both down about 7%.

This drop is primarily rates-driven and rotational – i.e., disproportionately affects specific sectors, notably the riskiest in the market like tech. We know this because you can track the flows and much of it is going directly into bonds and look at the dispersions in the losses between different sectors.

The increase in yields along the curve leading up to Wednesday was strong and relatively sharp. Because rates have been low, the duration of assets is uniquely long, which makes them much more rate-sensitive than they have been historically.

For example, the math is such that a parallel 20-bp increase along the curve at these rate levels – holding future earnings/cash flow expectations constant – will knock down equity markets 6%-7%.

It’s mechanical like gravity. The higher the rate, the greater the pull will be on financial assets. If this is not compensated by a simultaneous rise in future earnings/cash flow expectations, risk assets will fall.

Market tops are made classically when the rise in rates is faster than the rise in profits. It is not because earnings simply decline. Financial markets are discounting mechanisms. So the drop in earnings typically comes later. This is why asset markets peak before the economy.

Equity markets can actually rise if earnings fall if interest rates decline by more than enough to offset the drop. This was true from Q2 2015 through Q3 2016 on a year-over-year basis. 

Bear markets (20% drop from the high) are often – but not always (especially in emerging markets) – characterized by the resulting effect of the costs of debt servicing becoming greater than the amount of money and new borrowing that can be made to finance it.

When this occurs, lending slows because creditors become increasingly concerned that they won’t be paid back and pressure increases on borrowers to make their payments. The slowdown in spending and investment has an adverse effect on incomes, which compounds the problem further and risk asset prices decline.

With this in mind, every 1-bp shift in the "risk-free rate" is going to change the value of all financial assets fettered to it. More generally, you can replace the "risk-free rate" with the return of any substitute asset, or the concept of the opportunity cost of buying one asset versus another.

Thus, what a company is doing to improve its future cash-producing capabilities is only half the equation concerning the fair value considerations of their securities.

Even then, companies are constrained in their earning potential by the broader growth rate of the economy. What securities outperform and what ones don’t is heavily a function of their competitive advantages (e.g. sector, strategy, assets, etc.), and particular the durability of those advantages.

Accordingly, if the economy in the long-term is growing by 4% nominal per year (2% real growth and 2% inflation), you’re going to get about that return plus some additional contributions from dividends. It is axiomatic that an asset is not going to outperform its earnings potential over the long-run. The other variable – interest rates – will give you strong oscillations in their common stock in between.

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What Was 1987 All About?

1987 was about the FOMC overestimating the strength of the economy and reserve mismanagement that caused them to lose control of their policy rate.

On September 4, 1987 FOMC raised the discount rate from 5.50% to 6.00% and the fed funds rate from 6.75% to 7.25%, up from an effective rate of 5.89% in February. Due to constrained reserve demand, the effective fed funds rate, within just a 10-day period from September 20 to September 30, 1987, spiked from 7.05% to 8.38%, well above the policy rate. 

It fell down to 7.30% on October 7 and rose back to 7.61% on October 19 (the day the market fell). Hence, the effective FFR spiked 36bps higher than the Fed’s official target rate (i.e., 761 minus 725).

One day after the October 19 crash, the effective FFR dropped by 54bps, and by 114bps two days after. October 21 coincided by the bottom in the shortfall of legal reserves – the largest since the Great Depression – supplied by the New York Fed’s reserve “trading desk.”

(Note: The NY Fed is tasked with conducting various operations within the US fixed income and money markets to carry out the Fed’s monetary policy and financial stability initiatives.)

At the same time, 30-year AAA corporate bonds had increased to a yield of 11.06% on October 19, a 277-bp increase from the 8.29% low in January.

Moreover, 30-year fixed rate mortgages increased to 11.26% on October 19, an increase of 223bps from the low in March. The tight monetary policy produced a sharp reduction in legal reserves, which reflects means of payment money, and forced rates up on the short- and long-ends of the curve. This was unwarranted given that the trajectory of real GDP and inflation at the time were both down.

On October 19, the Fed had to increase reserves, which had been insufficiently supplied relative to the demand for them in order to support loan deposits. The reserve requirements at the time aggravated the reserve shortfall and the Fed’s ability to respond to the sharp price declines in financial assets. Many banks had large, inadequate reserve balances and tried to settle these contractual requirements. But the NY Fed failed to amply meet the liquidity demands in the money market until they had to directly flout the way they set monetary policy (i.e., through an interest rate mechanism).

The 1987 crash is a perfect example of the fallacy of being able to control the “money stock” and commercial bank credit creation through an interest rate mechanism. What precisely the net expansion of money and credit in the payments system will be as a result of the given injection of additional reserves or change in the FOMC’s policy rate is only known with a lag. The ramification is an indirect, delayed, and inexact control over the lending and credit creating capacity of the banking system.

Yet the financial media fallaciously pushed the storyline that the 1987 crash was about “programmatic trading” and “portfolio insurance.” This, of course, is rubbish.