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Forecasting Folly

By Mike Adams

There are not many of us around who remember “Black Monday”, October 19, 1987. It was the single largest percentage drop the market has ever seen. Following the drop, the pundits and gurus predicted it was just the beginning of a larger trend. At the time, I actually tallied up how many talking heads were pessimists and how many were optimists. When the count hit 35 to zero, I quit counting. The talking heads said the Fed would raise rates, and the economy was headed for a recession or even a depression. In fact, one person I heard predicted “there would be blood running in the streets”. The pundits said the bull market that started in 1979 and ran to 1987 was long and overdone. They said the stocks were overvalued and had further to drop. The picture they painted was doom and gloom. Not one said, “I do not know how Black Monday happened”. Every single expert had an answer. Not one of them was correct. Not one!

I do not know why the market in 2022 has caved as it has, but I wonder if the real reason is closer to what happened in 1987 than what today’s “experts” are saying.

Let me give you a picture of that day in 1987.

I had licensed in June of the 1986 as a stockbroker and made 100 prospecting calls every day seeking new clients. I had a small book of maybe 110 accounts and between $1 and $1.5 million in assets. I was a fledgling rookie in the business.

Friday, October 16 had already been a shock when the DOW dropped 108 points (that equates to about 1,500 points in today’s market). I had arrived before the market opened (6:30am Seattle time), turned on my Quotron machine, and readied myself for the opening of the market. The bullpen was already alive with my fellow rookie brokers waiting for the market to open and listening to the PaineWebber market strategists on the “squawk box”. The squawk box gave us stockbrokers the latest take on what the day would bring. That Monday morning was going to open weak and probably settle down.

The strategists were almost right about the opening. The DOW, which had closed at 2246 on Friday, opened and plunged more than 100 points in the first half hour (about 1400 in today’s DOW). I sat mesmerized by the Quotron.

Paine Webber had been pushing covered call writing, which showed how a client could get superior returns by buying the stock and selling the call option. It was great, they said, for conservative income accounts because the call would tend to generate additional income. The way they explained it to us rookies, it was almost like a dividend. I had purchased Chrysler stock at $52 per share and sold the $55 call for $2.50. If the stock got called away at $55, my clients would get a $2.50 profit on the stock and an additional $2.50 for the sale of the option. As a rookie that sounded like a good deal to me, and it had worked well with other stocks I had bought and sold for my clients.

In that first half hour, the market plunged, and so did the price of Chrysler. After thirty minutes, the drop seemed to be coming to an end as the rate of fall tapered off. The DOW, while not dropping as quickly, still decreased another 50 points (700 in today’s DOW) as we watched. The squawk box was alive with strategists still singing a positive song. I had not made a single dial to my prospects or clients. I was too fascinated by what I was seeing (and a little mortified by the price decline in Chrysler).

Instead of leveling off as the squawk box speakers anticipated, the DOW turned down sharply and dropped another 110 points (1600 points today). In the first hour and a half, the DOW had lost almost 10%. In today’s terms, that would be over 3,000 points! I continued to be glued to my Quotron; it was like watching a car-crash.

The DOW suddenly reversed and began to climb only to reverse again and fall another 200 points (2600 equivalent). Once again it rallied only to fizzle and plunge.

The DOW would end October 19 down 508 points, cutting 25% off the index. Adding the drop from the previous Friday, that equates to about 10,000 points in the DOW today.

My Chrysler stock? It fell from $52 to $12. That day, I learned the risk in covered calls is that the upside gain is limited to the strike price plus the amount of the option. The downside is only limited by zero. It was that experience which formed my strategy of only investing in stocks with twice the upside as downside. But that is another story.

October 19, 1987 is the worst one-day loss in market history. If I was fascinated watching the Quotron during that drop, I was even more fascinated by the running commentary put on by the pundits and gurus trying to explain what each plunge was telling everyone about the stocks and stock market.

In reality, what happened was “portfolio insurance”. Many of the brokerage firms and big investors had set up computer algorithms to protect their gains when stocks were in a bull market. When Friday turned down, the algorithms began to function and alert the traders to sell. In 1987, computers were not making the trades. Computers were sending alerts to operators who would then “push a button” that would send an order to the stock exchanges to sell a $25 million basket of stocks. That process began on Monday morning with traders hitting the button to sell. But the number of sell orders began to overwhelm the system and “playbacks” to the operators were delayed. Those playbacks were the confirmation that the order to sell had been executed and the stocks were sold. The operators, not receiving playbacks from the overwhelmed system, thought their trades had not gone through, so they hit the button to sell a second time, dropping another $25 million in assets. When that playback also did not come immediately, they hit the button again, and again, and again all day long.

It took some weeks for experts to come to that conclusion. In the meantime, the pundits and gurus had plenty of theories to fill the airwaves. First, the Fed was set to raise interest rates, and that spelled trouble for the economy. They reasoned the market was telling us on October 19 that we were headed for a recession and a strong bear market. The pundits were pretty sure that the Fed was going to put us into tough times, there was little doubt about it.

One mutual fund wholesaler announced $1 trillion had been wiped out of the economy. He insisted that by the weekend things would be so bad that Nordstrom would be so empty you could hear a pin drop. It was Christmas shopping season, and I suggested to my wife that Saturday we go to Nordstrom. She agreed, and it was almost impossible to get into the store, it was so packed with people. I told my wife someone must not have told these people they had lost one trillion dollars.

I wonder if there are not parallels between 1987 and today. Computers analyze huge amounts of data, far more than humans can. The computers search for patterns to determine a strategy for buying and selling. If someone flips a coin six times and it comes down H-H-H-H-H-H, that begins to look like a pattern. Given that pattern, it appears there would be a 100% chance of the next flip would be H. As humans, we know that the odds are 50-50. Because of that, we know that once in every 64 times a coin is flipped, the pattern will be H-H-H-H-H-H. This illustration is oversimplification, of course.

Computers looking at history see that (1) the Fed raised rates in 1987, (2) the bull market ran for over 8 years, (3) the market more than tripled in the bull market since 1979, and (4) a number of growth stocks quadrupled or quintupled during that bull market. The results were that stocks fell 25% in one day. Computers looking at history see that (1) the Fed raised rates in 1999, (2) the secular bull market ran for over 20 years, (3) the market grew over ten-fold since 1979, (4) many stocks increased six or ten or 15-fold, and (5) some stocks soared in value. The result was the NASDAQ falling 78% in the crash.

There are differences. Exodus Communications was typical of a number of stocks in 1999. It had limited or no earnings, was hemorrhaging cash, but had soared to a market cap of $32 billion. Exodus was in such bad financial shape it would file for bankruptcy in 2001. There is a significant difference in 2022. The companies in 2022 are seeing record revenues, record profits, and are creating record levels of cash. I am not sure the computers recognize those fundamental differences. There is little data available for pandemics and their recovery for the computer algorithms to evaluate. I wonder if the patterns the computers are seeing are not dissimilar to the H-H-H-H-H-H pattern without understanding the probability of every head is 50%.

It is hard for me to understand why stocks with earnings doubling year over year, with revenues growing 40 percent, and creating big chunks of cash should drop 50% to 70% in price. It makes no sense to my human brain, no more than a 100% prediction of the next flip of that coin being an H based on the historical pattern of H-H-H-H-H-H.

In 1987, in spite of all the projections of recession and further stock declines, the market recovered about 1/3 of the drop in 90 days and the remaining 2/3 before October 1988. In the longer-term, the prices of the stocks reflected the value of the companies. I am optimistic that fundamentals will return.

I am always legally required to say that past performance is no guarantee of future results.

Article Written by: Mike Adams, President & Principal

Adams Financial Concepts LTD

1001 Fourth Ave, Suite 4330, Seattle WA 98011

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