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Brian Andrew, CFA

Lessons From A Crash

Thirty years ago this Thursday, I was a budding analyst working with two very good stock portfolio managers. I had been on the job three months. On Monday, Oct. 19, 1987, the stock market “crashed.” The S&P 500 Index fell 21% that day after falling 10% the week before. My much more experienced colleagues were convinced that nothing had fundamentally changed for corporations’ earning power, and we spent the late afternoon and evening lining up stock purchases for Tuesday morning.

At 6 p.m., the head of the trust company came into the conference room where we were working and asked us to liquidate 25% of our stock portfolios the next morning. I was about to get my first lesson in portfolio management.

Market Timing

The trust company manager was gripped by the emotional reaction he had to seeing stocks down 25% or more and wanted to own fewer of them. His rationale for reducing the position of our company was only a function of one thought: “What if it goes lower?”

We know that stock prices are made up of many things. Partly, they reflect actual corporate earnings and expectations for future growth in those earnings. They also are prone to change based on the sentiment of stock investors. Of course sentiment can be affected by any number of things – most importantly the perspective of the other investors.

The head of our trust company was reacting to the decline in prices that resulted from a change in sentiment, likely exacerbated by what at the time was called “portfolio insurance.” Computing power was at a premium back then, so the number of people involved in these algorithmic strategies trading futures was nominal (about $60 billion). The idea was to reduce equity exposure automatically when markets began to decline. The more they went down, the more selling took place.

The prior week, the U.S. Secretary of the Treasury had chided the German central bank to either inflate the mark (this was before the Euro) or the U.S. was going to devalue the dollar. This kind of sabre rattling at a time when sentiment had already turned very negative helped to worsen the problem for stocks.

There was plenty of negative sentiment then but no real change in the outlook for fundamental corporate earnings.

The next morning we liquidated our 25% as instructed. The S&P 500 index had sold off from a summer high near 337 and bottomed just below 225 for a 33% loss. However, buyers entered the market seeing that fundamentals had not changed, and the S&P 500 finished the year with a positive return above 6%. It was December before we were allowed to take on new positions and as a result we underperformed for the year. The entire group’s incentives were withheld due to poor performance.

Lessons Learned

The first lesson learned is that market timing is a binary activity. You must not only predict when to exit the market properly, you have to determine when to get back in. To be successful, you generally have to get back in when it feels most uncomfortable.

Looking to add to our positions on that Tuesday morning was very uncomfortable. The news media (powerful even long before the internet) was talking about impending doom. To buy in the face of this took courage. I believe this was an example of the famous Warren Buffet quote, “Sell when others are most greedy and buy when others are most fearful.” People were fearful that Tuesday.

We see this kind of market timing behavior now, for different reasons. Today, many investors feel the market has over run its course and we are due for an imminent decline. As people wait for the downturn, they raise cash and then feel like they are missing out on the rally or, worse, when the market does sell off, they are reluctant to put it back to work. When is it appropriate to go back into the market? When it’s down 5%, 10%, 15%? Of course it is nearly impossible to know in advance, and that’s the trouble with market timing.

Today’s equity market suggests the rally will continue. Corporate revenue, earnings and operating margins are all very good and support stock prices moving higher. Positive investor sentiment as reflected in the positive asset flows into stocks also remains a booster. This sentiment can change at any time; however, over longer periods of time, stock investors are an optimistic bunch. And why not? From January 1950 to June 2017, a portfolio invested mostly in stocks was up 80% of the time using one-year holding periods. If you use five-year periods, it’s 100%.

Investing in stocks, then, is a time horizon game. Over time, stocks will produce a reasonable rate of return, albeit with much more volatility than many other assets. The volatility is the price we pay for that higher return. Time is the thing you need to combat that volatility, along with a diversified portfolio of other assets. The S&P 500 Index was near 300 when I began as an analyst (it is interesting to note that the index closed at 676 on March 9, 2009, almost 21 years later). Today it stands at 2,559. That’s a 752% return for a period of just over 30 years.

We believe it’s more important to use the market’s rally as an opportunity to rebalance portfolios back to their strategic targets. In doing so we are reducing the size of our winning positions and adding to those that may not have participated as fully. This isn’t just an exercise across asset classes but within them as well. We have large cap growth positions that have more than a 20% return and small cap value positions that have returned less than 10% since the beginning of the year. Our objective is to trim winners and buy the less fortunate.

In 1987, I learned that managers are fallible. I’ve used that lesson to admit my mistakes, learn from them and keep moving forward.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.