Black Monday 1987: What’s Changed?

Thirty years ago this week, the stock market had been very strong since the start of the year and investors vacillated between greed and anxiety. The Dow Jones Industrial Average (DJIA) peaked with a 43% gain by August that year, and had retreated by more than 16% from its peak. Then on October 19, 1987 the DJIA plunged nearly 23% on that one day for the single most horrendous panic-induced selling in Wall Street history, commonly referred to as Black Monday.

What caused the drop? In the prior five years, stocks were up 229% on average while the cumulative earnings per share had grown just 17%, so valuations (price to earnings ratios) had expanded hurriedly. Investors were jittery about high interest rates potentially choking off much-rumored acquisitions and general economic growth. Worries were building that stock gains could not be sustained through year end. Washington floated the idea of a new, higher tax proposal and investors hated it. On Friday of the prior week, stock prices were dropping.

When the markets opened that Monday, sell orders were too numerous for existing systems to function properly and program trading ensued, dumping more and more stocks as they declined. New and complex hedging strategies utilizing derivatives had been introduced in the 80’s, adding to the toxic avalanche. Financial regulators didn’t know how to deal with the situation.

State-of-the-art Quotron machines that reported the price and volume of each stock’s trading via phone lines onto paper at brokerage offices across the country were running sorely late–about 45 minutes behind each trade. Thus an order to sell a stock at the market price was a shot in the dark. Confirmations could not keep up with the trades either, so most didn’t know how their trade was executed until days later. In current terms, a fall of the same magnitude would knock the DJIA down by more than 5,000 points from its current level of 23,000.

I remember that day well, in my broker’s office writing a check for a stock purchase that occurred the prior Thursday, and there was nothing a rational person could do but cut the check. Mike Binger had started his career just a few months earlier. Louis Rukeyser on the popular PBS show Wall Street Week told us, “It’s just money. The people who loved you last week still love you.”

The stock market recovered dramatically the following day, and finished up for the full year. It would be another two years before the DJIA reached its August, 1987 high. Importantly, the panic did not affect the economy or corporate earnings; no recession followed the crash.

Could the same thing happen again? This is a question that has been posed ever since that fateful day.

First of all, financial regulators have expanded oversight and controls, stepping in to stabilize markets in some situations. They have instituted “circuit-breaker” rules which require a stock or the overall market to stop trading temporarily when systems become overloaded with sell trade requests, restoring order.

Secondly, today’s technology has been proven to handle volume that is many times the size of volumes just a few years ago. Trades are made and confirmed in nano-seconds to at-home investors, not just institutional investors, making the process very efficient.

Other sudden one-day declines have occurred since 1987 in stocks as well as other asset classes, although minor by comparison and with little follow-through after the initial decline. Program trading has expanded dramatically, but most quantitative investors have factored liquidity, leverage and investment time horizons into their various metrics.

Much has been learned and a wide variety of economic, corporate and trading data is now at our fingertips. Active money managers can still be counted on to purchase bargains as stocks sell off.

To expand on these Market Reflections or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222.

Posted on October 24, 2017 Read More

Third Quarter Market Review

This was another in a string of profitable quarters for investors. It marks the seventh consecutive quarter of positive returns in the U.S. stock market. Not only were stocks higher in the third quarter, but every major asset class also moved higher. Risk was rewarded in the quarter as more risk equated to higher returns. Emerging market stocks led the way, up 7.89% and U.S. Government Bonds generated a 0.38% return. Everything else in between from U.S. stocks, commodities, gold, and all other bond categories moved higher in the third quarter.

Despite tense political and social headlines, the financial markets are taking their cue from the economy. Strong corporate earnings, stable low interest rates, benign inflation and a confident consumer are leading markets to new record breaking highs on a weekly basis. Anticipation of meaningful personal and corporate tax reform in the U.S. is also supporting the markets. The fourth quarter will shed more light on the likelihood of tax reform in 2018.

Emerging markets and international developed stocks once again led the performance parade as investors found more compelling valuations in foreign stock markets. The Gradient Tactical Rotation Portfolio fully participated in this by investing exclusively in the emerging market momentum sector. U.S. stocks continue their “melt up” as other asset classes are comparatively unattractive. Interest rates are low causing bonds to have very limited upside. Low inflation eliminates any urgency to own commodities. Volatility is non-existent so there is currently no fear factor to own stocks. Strong corporate earnings growth makes stock ownership the best game in town.

The Federal Reserve left their key short-term interest rate unchanged at 1.00-1.25% after a 25 basis point hike in each of the first two quarters. The Fed’s next headline action will be the reduction of their inflated balance sheet by selling trillions of dollars of bonds they purchased during the multiple post financial crisis quantitative easing programs. This process will begin in the fourth quarter and will take years to unwind. Expect relative stability in bonds as rates remain low, but inch higher over time.

The 10-year U.S. Treasury Note finished the quarter with a 2.32% yield, down a few basis points since the beginning of the year. The yield curve has flattened this year as the short-term interest rates moved higher and longer-term interest rates are slightly lower. Credit spreads are locked in at the tightest levels of the year thanks to the strong equity market and a healthy risk appetite from investors. Investment grade spreads and high yield spreads remain very tight, helping these sectors outperform government bonds.

Stocks typically have two or three 5-10% corrections within a calendar year. This is normal and expected. This year, the stock market has yet to produce even one 5% correction. If we do finally get a correction in the fourth quarter, remember to use it as an opportunity to buy low. Do not throw in the towel on your financial plan the next time the market is down 5% from its new all-time high. Stay your course, stay invested.


To expand on these Market Commentaries or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222

Posted on October 2, 2017 Read More

What is happening with REITs?

As we look on the year, we have seen several asset classes performing well. Bonds have shown positive performance and equity markets have been very strong. Alternative assets, like precious metals, have also had a strong year thus far. The chart below reflects the performance of several broad category ETFs on a year to date basis.

The above data also reflects the relatively disappointing performance in US Real Estate Investment Trusts, or REITs. Despite having more stock like risk and volatility, REIT returns have been closer to that of bonds than stocks. Based on the data below, we can see that long-term REIT returns are closely aligned to stock returns, and the underperformance has really been a function of the last year.

The information below reflects some of the reasons for the underperformance of REITs over the last year.

The anticipation of rising interest rates 

REIT performance is affected by the trends in interest rates. The reasons are two-fold. First, a significant source of the return in REITs is via the dividend yield. As coupon rates for bonds rise, investors can get higher income from their safer assets. This creates a negative effect for REITs as investors transition to safer assets to generate their needed income. Second, many REITs have long term contracts with their tenants and cannot pass through increasing debt costs, and as a result, are less profitable overall.

What has been surprising, is that while short term rates have risen, there has been a year to date decline in long term interest rates. The 10-year treasury has gone from 2.45% at the beginning of the year to 2.25% currently. Therefore, we have not seen the headwind of rising long term rates that would cause a drop in REIT performance. The market, however, tends to value securities based on what we expect to happen in the future. The consensus, while wrong thus far, still expects rates to rise in 2017 and into 2018. That anticipation of rising rates will likely act as a headwind for REIT valuations.

Concerns around pricing and square footage growth

REITs are primarily invested in real estate properties. To grow, they must fill the space they have, increase prices on their existing clients, and / or increase the amount of rented square footage. This requires an increased demand for square footage amongst tenants, and while that has been the case for industries like residential and industrial, other industries like retail have had more concerning trends on square footage. We have seen several store closures among large end and mall-based retailers over the last year as the percentage of shopping done online continues to increase. This has led to disruption among the retail based REITs as pricing and overall growth are called into question. As seen below, retail and mall focused REITs have performed very poorly during this period, and this has had a large effect on the REIT space overall as retail remains the largest percentage holdings of most common REIT indices.

Our position is that, despite the recent underperformance, REITs should still have a place in client portfolios. The reasons are:

  • Diversification: REITs investments have lower correlations to US stocks and provide a diversified source of total return
  • Income: US REITs are mandated to pay a large percentage of income back to shareholders. This creates long-term sustainable (and likely rising) source of income for clients
  • Long term return: Per, from the period of 1990-2016, REITs provided a compound average total return rate of 11.45%*

As with any asset class, there will be times where it is “in favor” or “out of favor”. Predicting when or how long an asset class will be in or out of favor is very difficult, and is precisely why we diversify.

To expand on these Market Reflections or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222.


Posted on September 20, 2017 Read More
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