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THE OCTOBER CRASH: EXAMINING THE FLOTSAM
Remarks by Thomas C. Melzer
Estate Planning Council of St. Louis
March 7, 1988
According to Mark Twain, "There are two times in a man's life when
he shouldn't speculate:
when he can't afford it and when he can."
If
nothing else, last October's crash in stock prices ought to have driven
this lesson home.
Now I do not mean to suggest that you, as estate
planners, engage in speculative activities.
Nonetheless, I am sure that
you have concerns about what happened in the stock market.
has
even
extended
responsibility
is
as
far
the
as
conduct
the
Federal
Reserve,
of U.S. monetary
The fall-out
whose
policy
primary
and not
the
functioning of the stock market.
Our concern is motivated by two factors:
to
supply
additional
following the crash.
liquidity
to
the
First, we were called on
financial
system
immediately
This, in itself, is not surprising; but there
continue to be concerns about the interrelationship between cash and
futures market settlement mechanisms and the potential for "gridlock" in
paying for transactions.
Second, we are being recommended as a potential
"super regulatory authority" for financial markets.
Because the stock
markets are so important, both to you as estate planners and to the
nation in general, I am happy to have this opportunity to discuss the
recent market crash and some of the reforms that are currently being
studied.
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A
number
of
more-or-less
official
recently on the stock market crash.
reports
have
been
released
Generally speaking, the reports do
not attempt to identify why stock prices fell initially.
And this failure
to identify the reason for the market's downturn is understandable. After
all, we are still debating the causes of the 1929 market crash.
Instead,
these studies focus on the severity of the market decline that occurred
on October 16 and 19 and investigate the tumultuous trading activity that
occurred then and in subsequent weeks.
The reports agree on one thing:
virtually all of them suggest that
the inability of the New York Stock Exchange ("NYSE") to process the
volume
of
turmoil.
trades
quickly
contributed
significantly
to
the market's
On the other hand, these reports disagree totally about the
reasons for the severity of the market decline on October 16 and 19.
Unfortunately, this substantive disparity of opinion has not been widely
reported in the press or elsewhere.
What has been publicized is the "cascade theory" endorsed by John
Phelan, who is chairman of the NYSE; the Presidential Task Force on
Market Mechanisms (also known as the Brady Commission); and the General
Accounting Office.
Although three other reports—those by the Securities
and Exchange Commission, the Commodity Futures Trading Commission and the
Chicago Mercantile Exchange—do not agree with this view, the cascade
theory of the crash is currently the most widely-discussed explanation of
what happened last October.
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Now, what is this cascade theory and who are the culprits
involved?
The cascade theory identifies futures market traders as the culprits; it
"explains" that "mechanical, price-insensitive selling" by institutions
using portfolio insurance strategies contributed significantly to the
break in stock prices on October 16.
This selling occurred initially and
largely in the futures market; it was then transmitted to the cash market
by index arbitrage.
The resulting decline in cash prices induced even
further selling in the futures market by portfolio insurers, which kicked
off another selling wave—and so on, and so on.
As a result, stock and
futures prices proceeded to "cascade" downward.
You can immediately see that our knowledge of market crashes has
advanced considerably in the 58 years since the 1929 crash.
1929, "Black Tuesday" was
Back in
"explained" by a downward price "spiral."
Today, we know that 1987fs "Bloody Monday" was caused by a downward price
"cascade."
For people who believe this explanation, the way to prevent market
crashes is simple:
markets.
eliminate the link between the futures and cash
Because portfolio insurance and index arbitrage—both forms of
program trading—are the strongest links between the two markets, some
people have argued that these activities should be restricted.
In fact,
the NYSE has already done this, and various proposals currently under
consideration would further restrict these trading strategies.
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To properly appreciate what portfolio insurance and index arbitrage
trading do, a brief explanation of them is necessary.
Portfolio insurance
is simply a relatively cheap method of exercising a stop-loss order for a
large portfolio of stocks.
The objective of portfolio insurance is
simple; it is designed to limit the decrease in the portfolio's value
associated with market declines.
It does this by reducing the equity
exposure of portfolios when there are significant declines in stock
market values.
Rather than reducing equity exposures by selling stock, however,
the initial transaction entails short sales of stock index futures.
The
futures market is used because trades can be made quickly at low transaction costs.
In the longer run, the portfolio is adjusted through cash
market sales; the futures positions are then liquidated.
Of course, no
one can be sure that sales of any instrument, including futures, can be
made at the desired price in a declining market; there is simply not an
infinite amount of liquidity.
Some portfolio insurers, however, may have
incorrectly assumed that there would be.
Index arbitrage is a strategy based on simultaneous trades of stock
index futures and a corresponding basket of stocks in the cash market.
This trading strategy attempts to profit from small and short-lived price
discrepancies for the same group of stocks in the cash and futures
markets.
Cash and futures prices for the same stock (or group of stocks)
typically differ.
This difference—called
the basis—reflects the net
cost of carrying the stocks over the period covered
by the futures
contract. These costs, in turn, depend on the relevant interest rate and
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the dividends
the stocks
are
expected
to
pay during
the interval.
Occasionally, the observed basis may diverge from the cost of carry. When
this occurs, profits can be made if simultaneous trades can be placed in
the two markets—purchasing
the relatively
selling the relatively high-priced one.
low-priced
instrument and
As a result of such arbitrage,
of course, this "gap" disappears; the basis returns to the cost of carry.
As you may know, index arbitrage has been severely restricted since
the crash.
1:30 p.m. by
On October 19, this trading
the backlog
of
orders
strategy was limited
on the NYSE's
Turnaround ("DOT") automated execution system.
Designated
after
Order
As a result, arbitrageurs
were unable to trade simultaneously in the cash and futures markets;
moreover, it was impossible for them to accurately assess the cash price
of the relevant basket of stocks.
Since October 19, the NYSE has imposed
formal restrictions on use of its DOT System by index arbitrageurs and
other program traders.
In addition, proponents of the cascade theory have suggested reforms
that would restrict trading in stock index futures for any purpose. These
proposed restrictions include limits on price swings in index futures
contracts and associated trading halts, limits on short positions and
higher margin requirements.
Before being swept away by the cascade theory and its prescriptions
for fixing the stock markets, it is worthwhile to consider a few of the
benefits of stock index futures contracts.
the liquidity of stock positions.
First, index futures increase
They do so by reducing transactions
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costs and by allowing
stockholders
to hedge their stock portfolios.
Transaction costs are considerably lower in the futures market than in
the cash market.
For example, the cost of trading one S&P 500 futures
contract is about $500 less than trading an equivalent basket of stocks
in the cash market.
It is precisely because these transaction costs are
so much lower that portfolio insurers, for example, chose to liquidate
portions of their portfolios by selling futures instead of selling their
stocks in the cash market.
Index
futures
also
enable
stockholders
unanticipated changes in stock values.
changes to someone who is willing
to
hedge
against
Hedging shifts the risk of price
to bear it.
In short, it is a
relatively low-cost method of insuring the value of a stock portfolio.
In addition to enhancing liquidity, futures markets reveal valuable
information.
The spread (or basis) between the price of a stock index
futures contract and the cash price of the corresponding basket of stocks
is the market's estimate of the cost of carrying stocks from the present
to the maturity date of the futures contract.
In other words, the spread
is the market's forecast of the change in the value of the basket of
stocks
between
these
two
dates.
This
valuable
information,
which
currently you can obtain for the price of a newspaper, would be expensive
to produce in the absence of closely-linked cash and futures markets.
Now it is clear that restricting index arbitrage will reduce these
benefits.
Thus, the key issue is whether these restrictions would make
the next crash less severe than the last one.
While the evidence is
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incomplete, some preliminary observations cast considerable doubt on this
claim.
The S&P 500 futures contract, which represents 75 percent of the
U.S. stock index futures market, had only about $20 billion in "face
value" of open positions on October 15.
In comparison, shares listed on
the NYSE totaled $2.6 trillion on the same day.
It seems unlikely that
futures positions worth less than one percent of total stock market value
could have contributed significantly to the roughly 20 percent fall in
stock values on October 19.
What's more, index futures did not exist in foreign markets; yet
these collapsed about as much as or more than the U.S. market.
example,
between
October 16
and
23,
the
U.K.
market
declined
For
by
22 percent, the German and Japanese markets by 12 percent, the French
market by 10 percent and the U.S. market by 13 percent.
Index futures did not even exist in 1907 and 1929, yet these market
breaks were as significant in percentage terms as the 1987 break.
Index arbitrage stopped at 1:30 p.m. on October 19, yet the Dow
sunk by more than 300 points afterwards.
Furthermore, though index
arbitrage was severely restricted in the subsequent weeks, this did not
prevent a further significant break in stock prices on October 26.
Finally, roughly 90 percent of the trades made on the NYSE on
October 19 were not associated with index arbitrage in any way, and less
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than 2.5 percent of the value of publicly traded
stocks were under
portfolio insurance at the time of the October break in stock prices.
In conclusion, evidence, while sketchy and anecdotal, does not
support the potential usefulness of the reforms suggested by proponents
of the cascade theory.
suggested
regulations
Of course, it would not be the first time that
have
failed.
Wesley
Clair
Mitchell, a noted
student of business cycles, once said:
"By a combination of various agencies such as public regulation of
the
prospectuses
of
new
companies,
legislation
supported
by
efficient administration against fraudulent promotion, more rigid
requirements
on
the
part
of
stock
exchanges
concerning
the
securities admitted to official lists, more efficient agencies for
giving investors information, and more conservative policy on the
part of banks toward speculative booms, we have learned to avoid
certain of the rashest errors committed by earlier generations."
At first blush, this sounds like a summary of the reforms following
"Black Tuesday" in 1929. Actually, Mitchell wrote this in 1913 about the
legislative and regulatory changes instituted after the Panic of 1907.
An
even
more
amusing
comment
about
our
currently
proposed
regulations comes from London; a recent report by the London Stock
Exchange
advocates
the
adoption
of
index
arbitrage.
Their
study
concludes that "the existence of wide pricing anomalies between cash and
derivative markets
[that developed during the crash] demonstrates the
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need
for
the
London market
to encourage
techniques, such as index
arbitrage, which help provide convergence of these markets/'
It is troubling that suggested reforms for U.S. equity markets to
restrict or ban index arbitrage could very easily build permanent pricing
anomalies into our capital markets.
Stock prices, like all asset prices,
depend upon expectations about future events and circumstances, however
little this may be justified by subsequent realizations.
In the words of
Irving Fisher, "Our present acts must be controlled by the future, not as
it actually is, but as it appears to us through the veil of chance."
People are not omniscient.
On rare occasions, they guess wrong en
masse with the result that significant breaks in stock prices (up as well
as down) occur when the mistake is realized.
prevent this.
No amount of regulation can
I am concerned that some of the suggested regulatory
changes could actually increase the frequency of these mistakes by making
the job of predicting the future even more difficult.
@FedFRASER