Before October 19, 1987, few people believed a one-day decline of 10% was possible. The last time it happened was almost six decades earlier on October 29, 1929, Black Tuesday.
Before Black Tuesday, the worst day was the day before — October 28, 1929. Those two days were the only days of double-digit losses for the Dow prior to 1987.
Of course, those stats perfectly describe the limits of market history — it can hinder our view of what’s possible. Anyone who woke up the morning of October 19th and believed a 10% loss was impossible was shocked by the closing bell.
The SEC’s report on that day offers some insight into the fear:
Analysis of trading suggests that the initial decline that immediately preceded the October 19 market break was triggered by changes in investor perceptions regarding investment fundamentals and economic conditions. With these changes as the “trigger,” institutional stock selling was the largest single direct factor responsible for the initial opening declines on October 19. Finally, panic selling in a broad range of stocks — caused by a variety of factors — coupled with a complete absence of buyers (except at distressed levels), was primarily responsible for the free-fall decline that characterized the final hour of trading on the NYSE on October 19.
The day ended with a 22.6% loss!
The crash was first blamed on program trading. “Computers caused it,” they said. Really, the program trading activity was a consequence of the panic. But when things go wrong, the focus is on the immediate outcome, not long-term causes.
Seth Klarman explained why blame missed the mark that day:
Whenever the stock market goes through one of its crashes or mini crashes, the search for an explanation immediately begins. The finger pointing has an overwhelming tendency to miss the mark, however. Partly, this is because the wrong questions are being asked and answered. People seeking answers to why the market plunged usually emphasize the immediate events that precipitated a selling panic, when in fact these events are but minor symptoms of much more severe underlying problems.
Many experts have identified program trading as a major cause of the stock market crash two years ago and of last Friday’s panic as well. While it is true that derivative securities such as options and futures divert capital away from real investments, program trading gets an undeserved bad rap in the aftermath of market crashes. Program trading is very straightforward arbitrage technique whereby professionals take advantage of discrepancies between actual stock prices and stock futures prices.
A month after the crash, Fortune ran a story where it detailed some of the worst losers. The Waltons, Packard, Hewlett, Kroc, Busch, Gates, Buffett and others watched hundreds of millions to billions of dollars wiped from their net worth.
We know Buffett didn’t panic from his $346 million hit. I doubt any of the other families listed along with him did either. And why would they? They all owned pieces of solid businesses, with earnings, and great prospects for future growth. One bad day in the market wasn’t going to change that.
Instead, Buffett retold Ben Graham’s story of Mr. Market in Berkshire’s annual letter that year.
Mr. Market is a manic depressive fellow who throws around wacky prices for shares in a business. You can listen or you can ignore him. You can follow his lead or you can take advantage of his folly. It’s your choice.
Buffett alluded to the opportunities for average investor’s thanks to the brilliance and brains on Wall Street and their use of portfolio insurance:
Ben’s Mr. Market allegory may seem out-of-date in today’s investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising “Take two aspirins”?
The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben’s Mr. Market concept firmly in mind…
Many commentators, however, have drawn an incorrect conclusion upon observing recent events: They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys. This conclusion is dead wrong: Such markets are ideal for any investor — small or large — so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.
However, it was Peter Lynch who probably summed up 1987 the best. He cut a vacation short after losing a third of the Magellan Fund in two days. He explained the why behind the crash this way:
Well, I think people had not analyzed ’87 very well. I think you really have to put it in perspective. 1982, the market’s 777. It’s all the way to ’86. You have the move to 1700. In four years — the market moves from 777 to 1700 in four years. Then in nine months it puts on a thousand points. So it puts on a thousand points in four years, then puts on another thousand points in the next nine months. So in August of 1987 it’s 2700. It’s gone up a thousand points in nine months. Then it falls a thousand points in two months, 500 points the last day. So if the market got sideways at 1700, no one would have worried, but it went up a thousand in nine-ten months and then a thousand in two months, and half of it in one day, you would have said…”The world’s over.” It was the same price.
So it was really a question of the market just kept going up and up and it just went to such an incredible high price by historic, price earnings multiple load, dividend yields, all the other statistics, but people forget that basically it was unchanged in 12 months. If you looked at September, 1986 to October ’87, the market was unchanged. It had a thousand point up and a thousand points down and they only remember the down. They thought, “Oh, my goodness, this is the crash. It’s all over. It’s going to go to 200 and I’m going to selling apples and pencils,” you know. But it wasn’t. It was a very unique phenomenon because companies were doing fine. Just, you know, you’d call up a company and say, “We can’t figure it out. We’re doin’ well. Our orders are good. Our balance sheet’s good.” “We just announced we’re gonna buy some of our stock. We can’t figure out why it’s going down so much.”
So from 1982 to 1986, the market rose roughly 117%. In 1987, the market spiked 44% from January to August. Then it slid…all the way back down.
Yet, surprising everyone, 1987 ended the year positive 2%! The ’87 market went nowhere from start to finish. Yet, it went everywhere in between.
The October 1987 Market Break
Klarman: Who’s to Blame When the Market Drops? Analysis Often Misses the Mark
The Great Crash: What Happened and What’s Next – Fortune
1987 Berkshire Annual Letter
Peter Lynch: Betting on the Market – Frontline
This post was originally published on October 18, 2017.