Black Monday

http://www.american.com/archive/2007/september-0907/the-hunt-for-black-october

Many of you may have seen this but I thought this was very good and wanted to make several comments. Unlike many events in financial history the 1987 stock crash does not have all that much written on it. You have a book written on RJR Nabisco, a book on 1998 and LTCM, a book chronicling things like Tulip Mania and the South Seas Stock Bubble but nothing major written that I have seen on the biggest one day equity % drop in American history. This is not a compare and contrast to today but rather what happened in 1987 and possible reasons. It is a history lesson and because of my love for market history I wanted to put it on here.

Most of the literature you do read write almost exclusively on the evils of what is now defunct portfolio insurance. Well in my mind this may have complicated the outcome but it wasn't the cause. I think this article points that out implicitly pointing out that:

By the end of the day, the Nikkei index had dropped 15 percent—the biggest one-day decline since its creation in 1949. In Hong Kong, the index plunged 45 percent, causing the market there to be shut for nearly a week. The FTSE, London’s benchmark, was down 12 percent. Of 23 major markets, 19 lost at least one-fifth of their value during the terrible month of October.

Well guess what? None of these markets had portfolio insurance. I get alot of eye rolling from my buddies everytime I bring up the dollar over the past year but I think currency fluctuations play one of the biggest factors in big market swings (the panics, crashes) and it is so rarely talked about. It is the most fundamental economic piece of any sovereign nation. The dollar being the dominate currency the past 60 years makes it paramount to the global stability and global growth.

Today we are on the cusp of potentially having a crises because of the dollar. Currency typically fluctuate around each other which is fine as long as the moves are not gigantic and do not happen to quickly. If you look at curencies moving around the dollar, the dollar continuously moves up and down but typically in a band of around 20% or so over several years. It will weaken and then strengthen in a continuous pattern. Today we are right at the lowest levels in history for the dollar. A sudden or dramatic break to the downside could have serious consequences in the United States and worldwide. I thought one of the more interesting points of the link above was how much the dollar was in flux preceding the 1987 crash. I did some additional research and discovered some interesting things. The trade weighted index of the US Dollar peaked in 1985 right around 140. It moved almost straight downward until the crash in 1987 to around 88. That is a huge move in two years!! This led to some of the things happening right before the 1987 crash.

Referring to the large move down Thursday October 15th

Others believed the fall was triggered by Treasury Secretary James Baker, who said that the United States could “accommodate further adjustments” in the value of the dollar—code for a willingness to accept further declines in the U.S. currency.

and over the weekend before black Monday:

Adding to the overheated climate was growing friction between the United States and West Germany over currency valuations. Baker said on “Meet the Press” on Sunday, October 18, “We will not sit back in this country and watch surplus countries jack up their interest rates and squeeze growth worldwide on the expectation that the United States somehow will follow by raising its interest rates.” Questioned moments after the show (and off-camera) by an influential economist, Henry Kaufman, about the wisdom of making such a strong statement, Baker replied, “Henry, some things need to be said.”

with Volcker piping in:

Paul Volcker, whose tenure at the Fed ended two months before Black Monday, has written that the crash can be traced to “the feeling that the promising efforts toward coordination of economic and exchange rate policies were breaking down.” The editorial page of The Wall Street Journal was a vocal proponent of the same idea, citing the brewing feud between the Bundesbank and Baker, the Treasury secretary, as well as the longer-term problem of the dollar’s continued depreciation. “We think the threat the market saw was a dollar collapse, the severing of international cooperation and the victory of protectionism around the world,” said a Journal editorial on the first anniversary of Black Monday.

all this led to:

Connecting the problems abroad with the scrum between Baker and the Bundesbank, Reynolds concluded the crash was part of an “international financial panic.” In this view, global forces overwhelmed the good news at home (solid economic growth, a lower-than-expected budget deficit, and moderate interest rates).

This article gives many other possible reasons and I am sure they all played a part. Like I said I am not trying to do a comparison contrast because I do not think one necessarily exists necess, I am just showing again why the Fed is going to have difficulty lowering interest rates beyond an initial 50 bips. The dollar is back to the forefront of what investors need to be keeping an eye on and back as one of the factors dictating monetary policy. Many investors, especially my age, have no concept whatsoever how currency can play such a big part in global equity markets. One of the reasons is because it really has not in the past 10 years but in the last 100 years it has had a major impact numerous times. You hear about the unwinding of the Yen carry trade today but currently it goes much deeper than that.

The Fed is handcuffed to a certain extent and it will be interesting to see how it all plays out.