Shades of 1987?

A strong Asian economy showing bubble-type characteristics, U.S. bond yields soaring, stocks bouncing around in 1% daily down-then-up-then-down-then up swings, and a new Federal Reserve Chairman to boot.

No, that is not October 2005 I’m describing—that is the summer of 1987.

For those of you too young to recall the sultry September weeks before what at the time appeared to be another Great Crash but was, in retrospect, a mere blip in a Great Bull Market, let me take you back to 1987 with a brief eyewitness account.

The market had jumped by a third in the first eight months of 1987 and peaked on August 25th. Without telling anybody it had peaked, the market began to wobble in a kind of one-step-forward, two-steps-back mode—the result of the Federal Reserve’s persistent interest rate hikes, which provided investors with higher alternate yields to what everybody “knew” were ridiculous equity valuations.

Yet despite the rate hikes, every institutional investor on the planet (including the one I worked at) felt pressure to remain fully invested: nobody wanted to be left behind.

Meanwhile, Japan was in the grips of a stock market bubble and the “smart money” was convinced the Nikkei was going to collapse, which would be the trigger for a U.S. crash—much like today’s concerns about a U.S. real estate bubble and the impact its winding-down would have on the rest of the economy.

And Alan Greenspan had just been appointed as Chairman of the Federal Reserve Board, replacing inflation-fighting Paul Volcker.

As a result, then, like now, stocks experienced wild swings; then, like now, rates were rising; then, like now, all eyes were on Asia; then, like now, nobody knew whether the new Fed Chairman was up to the task of filling his predecessor’s shoes.

The one big difference then versus now was the presence of a wonderfully misnamed financial product called “portfolio insurance.”

Without getting into the details of “portfolio insurance,” which I couldn’t because I never understood the details (although one of the smartest financial guys I’ve ever known had looked into at the time and pronounced “it works”), there was only one downside to the mechanics of the insurance program: when stocks fell, the program sold them.

Which, after weeks of up and down and down and up and down and down price action, is precisely what happened on that grisly 19th of August, 1987.

As far as I can tell, the best thing about the recent week’s up and down and down and up and down and up market is that we don’t have financial institutions loaded up on “portfolio insurance,” which in 1987 turned a normal bear market into a crash.

On the other hand, we do have something we didn’t have much of in 1987—hedge funds, and lots of ‘em.

And with a 1-and-20 fee structure (most hedge funds get a 1% management fee and 20% of any profits), the tolerance for loss on the trillion-dollars or so that they control is very low—because most hedge funds have what is called a “high water mark,” meaning they don’t get paid a bonus for losing money and then making it back.

Furthermore, the institutional investors throwing money at anything called a hedge fund have even lower tolerance for loss, because—unlike the wealthy investors that made up the capital base of the early hedge fund investors—institutions require stable returns, and they are quicker to cut their losses.

Much quicker, as we saw with the convertible arbitrage funds that have shut themselves down this year after absorbing losses which, in the world of equities, could be considered relatively minor.

Just recently, it was reported that a convertible arb fund called Arbitex Master Fund has lost 94% of its assets—from $517 million in January to $30 million at the end of August, with a -13.2% year-to-date investment return.

Imagine what a 13.2% whack in the equity market—which is really nothing too spectacular considering the Dow lost 22% on October 19th, 1987—might trigger among institutional hedge fund investment world.

Why, it could be “portfolio insurance” all over again!

Jeff Matthews I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.