THE CRASH OF 1987: WHAT DID IT REALLY MEAN?
Donald G.M. Coxe, Chief Portfolio Strategist, Wertheim Schroder
Chairman: A.A. van Straubenzee President
A year ago yesterday we all remember where we were and what we were doing. It was one of those historic days.
I am in the executive search business, which has nothing to do with anything. Except that on October 19, 1987, our little firm was working on six assignments for clients in the investment business. By October 20, four of the projects had been cancelled. The remaining two had been cancelled by month's end.
So, like most of you in the room who felt the terrible effect of Black Monday, I was not excluded.
Good fortune made it possible for me to participate in the investment business for almost 10 years. During that time I saw the 69 salad days turn to gloom. I saw a recession that appeared in the mid 70s, and I saw the horror of the 1980 downturn.
But then I observed five super years. Those of us associated with the investment business object to the word greed - after all we know the risk and many here have taken it willingly and some have paid a heavy price.
The investment business is probably among the most exciting in the world, because it is usually where the action is and it is ever changing. But the small investor finds it hard to understand what options are, and swaps, and junk bonds, and LBOs, and hedging, fundamental vs. technical, top down asset mix and bottom up stock pricing.
You have to admit, ladies and gentlemen, it does get rather confusing. And it gets even more so when the economy appears buoyant, but few new issues are emerging and the only game in town seems to be mergers and acquisitions.
According to The Farm Implement News: "A recession is a period in which you tighten your belt; a depression a period in which you have no belt; and, when you have no pants to hold up, it's a panic."
But Black Monday knocked even our socks off.
Well, here we are, a year and one day later, and we have with us an outstanding Canadian who is on Wall Street with Wertheim Schroder as a strategist.
Don Coxe is no stranger to most of us. He writes the Back Page in Canadian Business Magazine. He had an outstanding career with MuCana, the investment counselling arm of Mutual Life Assurance Company of Canada. And, he had great success with Gordon Securities before being lured to the smell of the grease paint and the roar of the crowd.
We are pleased to have him back among us, even for a short time, because we know he, if anyone, can enlighten us on The Crash of 87-One Year Later.
It is a pleasure to be with you today. That kind of opening remark risks the instant response that it is merely trite. What speaker ever began by saying he or she was unhappy to be with the gathering? Recognizing that the distinction between civility and banality can be blurred, I reiterate my pleasure. My reasons derive of more than the merely ordinary.
First, I am back in my hometown after months of travel, speaking to a group that includes many of my friends and family, whom I don't see nearly as often as I'd love to. Secondly, I am glad not just to be here, but in unscathed, and unscarred form. That assertion does not merely refer to the risks inherent in being a global strategist on Wall Street, a risky position in all but the best of times - and these times, though better than a year ago, certainly aren't the best of times for brokers.
No, I allude to an event that took place high in Banff National Park last month, when my wife, son and I were hiking on a lonely trail. We encountered a grizzly bear mother with cubs, forcing a rather hasty retreat singing gospel hymns. That choice of joyful noise because we wanted everything going for us except the bear.
To me, a grizzly bear is one of the few things in Canada more terrifying than the manifesto of the New Democratic Party. After we reached the safety of the parking lot, my son remarked that, all the way down the trail, he had been reflecting that it would have been a symbolic form of death for a stock market strategist to be killed by a bear. We are gathered here this day in remembrance of the death, by a sudden bear attack, of a great and good friend, the Ronald Reagan bull market. A spectacular death was, I guess, a fitting end for that most splendid of bull markets. And, given that Mr. Reagan's political career was born in a television appearance, it is surely poetic that his stock market extravaganza should exit in what was the ultimate capitalist debacle for TV.
It was made to order for TV journalism: it happened worldwide, sequentially, in real time, like some giant tsunami washing across the globe. It touched an atavistic nerve in most of us, arousing instant fears that this Crash, too, would lead to a depression. And, finally, its origins were complex, but the commentators could seem to explain it without assuming that the audience had a deep knowledge of the subject or, in most cases, having little more than outdated prejudices themselves.
A year later, both the terror on the floors of the stock exchanges and the terror on TV seem almost unreal. Indeed, in both Canada and the U.S., far from facing a depression, we have such robust economies that the central banks are practising precisely the same monetary policies as those that helped induce the Crash, because of their fear that overexuberant consumers will produce serious inflation. And I have it on the very best authority that Toronto housing prices are up smartly since the Crash.
So was Black Monday just an aberration, a mere shock without transcendent meaning, such as the trade of Wayne
Gretzky? Was it, as a befuddled Reagan said that day, a case of profit-taking? Was it, as the Brady Commission later diagnosed it, mostly a case of computers run amok? That assessment has gained, I should note, a wide following, because it pleased so many constituencies; it delighted the politicians because it didn't assign them any blame for failing to face up to the budget deficit; it pleased most investors, who had long been resentful of the growth of computer-based trading strategies, and it satisfied the TV journalists, because it could be summed up in three minutes of airtime.
Any explanation with that kind of support is prima facie wrong. I believe that Mr. Brady's experimentation with financial Ludditism was a venture in triviality. He ignored the profound tectonic shifts in the underpinnings of global financial markets. It is as if a committee of inquiry after the San Francisco earthquake had made no reference to the San Andreas fault, and had ascribed all the deaths to inadequate emergency procedures.
To me, the Crash was an historic event with deep meaning. It was the ending, not with a whimper, but a bang, of a fourdecade historical continuum, the postwar era, built on the twin assumptions of American military and financial hegemony. We have entered, after those death throes of the old order, a new, and more uncertain kind of economic, financial, and strategic environment. The Crash was the equivalent of the death, by a slip of the surgical scalpel, of a terminally ill cancer patient - a mere acceleration of an inevitable demise. The out-of-control computers simply telescoped the time of the inevitable ending.
When I agreed with your organizers to discuss the Crash as the end of an era, I felt reasonably confident about the assign-. ment. However, I learned some very disturbing information last week in Hong Kong that makes me feel diffident today. I had prepared the first draft of today's remarks on a laptop computer while en route to the Far East. While I was in Hong Kong, the Chairman of Merrill Lynch came to town for a speech to a business group. Mr. Schreyer began his remarks by citing, with approval, a psychological study on the interaction between speakers and audiences.
According to this study, only one-quarter of the typical audience listens to a speech the whole way through; another one-quarter tunes in and out; the remaining half, he asserted, spends virtually the full time of the speech in silent sexual fantasizing. Coming from such a lofty source, that is a troubling - indeed a pernicious - analysis.
It is particularly disconcerting for me today, because I know so many of the people in the room, and that arouses the most unspeakerly temptation to let my mind wander from the text, trying to decide which half of the audience is which.
Forcing myself to today's agenda, and urging all of you to suppress your urges, let me note an arresting coincidence: a year after the death of the post-war era, voters in both Canada and the U.S. are facing national elections. If the Crash had meaning, then the next governments of both countries will have as their core priority the devising of strategies to deal with this new kind of world economic order.
I have visited three Canadian provinces and 12 of the states during the campaigns, and have found no evidence that politicians are discussing the important questions. Although that is a depressing thought, there is, for Canadians, a bright side to a dull election campaign that has tried to evade the key questions. That consolation comes because our elections have become more fun than their American counterparts.
Canadian elections are somewhat participatory because of the lawn sign wars. Through these public displays of affection by a supposedly reserved people, we all get involved, both as displayers, and as counters as we drive through the ridings. Americans have given up on lawn signs. Indeed, after weeks of searching lawns from sea to shining sea for just one George Bush sign, I found myself willing to settle for a Dukakis sign, and was denied even that modest uplift. During elections at least, the American ethic has a stern emphasis on lawn order.
That is possible because TV has transmogrified the American electoral process, lobotomizing most of its enthusiasm, openness, and willingness to discuss complex issues. The biting arguments and public flag-waving of a Roosevelt or Truman-style campaign have given way to 30-second sound bites and visits to flag factories, while the complex concepts of think tanks are eschewed in favour of poses in tank turrets.
What should the politicians be telling the people as a result of the Crash?
The Crash came when the system of co-ordinated central bank management of global liquidity collapsed under the weight of a worldwide run against the world reserve unit, the American dollar. That it came at a time when stocks were overvalued anyway guaranteed a precipitous drop. But the consequences of the sudden end of the post-war era would have been almost as gut-wrenching had the market been trading at more modest price-earnings ratios.
The Crash had its origins in the gradual decline of the U.S. from being overwhelmingly the strongest economic and military power to being an overcommitted elder statesman in a fiercely competitive world. The post-war era was the most sustained period of growth in human prosperity and freedom in history because it was driven by the most benign imperialist ever, the United States. The U.S. rebuilt war-torn economies, opened its markets to foreign goods, goaded colonial empires into extinction, and shouldered a disproportionate share of the burden of keeping Communism at bay.
Under the American nuclear umbrella, and with the example of democratic capitalism it displayed, Europe and Japan were, by the 70s, able to challenge American economic leadership. Their opportunity came when Paul Volcker, in what was to be the last unilateral act of American financial hegemony, smashed world inflation by draconic tight money policies which had the side effect of driving the American dollar to over-valued levels.
Making the dollar more precious than gold was the only way to defeat inflation, but it was a disastrous policy for American industry. Many American manufacturers had lost their competitive edge anyway, because of complacency that America was destined to stay on top forever, no matter how flaccid its managers, how profligate its government, or how watered-down and inadequate its public education system.
The economic gods punish such hubris severely, and even as the edifice complex that was one of its attributes was overbuilding offices and shopping malls from Houston to Boston, thereby undermining the banking and savings and loan industries, the competitive position of much of the American goods-producing industry was crumbling. The trade deficit reached terrifying levels, and the fiscal deficit looked to be out of control.
Paul Volcker's attempt to restore the dollar to its former throne never had a much greater chance than did Bonnie Prince Charlie. Meanwhile, Ronald Reagan was engaged in another costly - but more successful - effort to revive the past: he was rebuilding America's tattered military capability, a necessary, but painful undertaking. That it may have unlocked the door to peace didn't make the strategy any cheaper.
By 1985, it was apparent that the U.S. was staggering under its twin burdens, while its allies' economies were flourishing from the U.S. trade deficit. Something drastic had to be done. It was - on September 21, 1985, when shrewd dealmaker James Baker convened, at the Plaza Hotel in New York, a meeting of the Finance Ministers of the five leading industrial powers. He got agreement on a deal to devalue the dollar. The object was to make American industry more competitive through a lower dollar, and to fund the fiscal and trade deficits during the time it would take Washington to get its house in order. Thus was born a new financial creature: global liquidity, co-parented by, and managed by, central banks.
So impressive was this new creation that in February 1987 the founding fathers got together at the Louvre with new club member Canada to build a safety net for a dollar that now looked to be in free fall. Announcement of that deal sparked a worldwide rush into American stocks and bonds. Foreign investors decided that if they couldn't lose by buying American, they were going to get as much of it as they could.
That almost-orgiastic combination of foreign desire and attractive American assets was consummated in a 500-point runup in the Dow Jones Average, an effulgence that stimulated similar activity abroad. It was the first huge rally ever on Wall Street accomplished when American individual investors and pension funds were heavy sellers throughout. The world's first experiment with global liquidity was the biggest tonic for stock markets ever seen. But over-consumption of tonics can be dangerous to one's health.
The central bankers couldn't maintain forever the myth that the dollar was really worth more than 145 yen. Although they bloated their own exchange reserves by gigantic openmarket acquisition of dollars, they met their comeuppance in late August 1987 when the publication of the June U.S. trade deficit knocked out the last vestiges of market optimism that the dollar devaluation had gone far enough.
Once foreign investors sniffed that another dollar tumble was inevitable, they dumped U.S. stocks and bonds. Private bankers worldwide operating in the Eurodollar market smelt blood, and managed to get short the almost unbelievable total of $143.5 billion in the weeks before the Crash.
Meanwhile, the U.S. Federal Reserve Board, now led by new Chairman Alan Greenspan, was pursuing an extremely tight money policy to try to defend the dollar and fight inflation. Central bankers abroad, faced with this concerted flight from the dollar, bought more than $100 billion, but they finally buckled in October. The private bankers were shorting the dollar, private investors were fleeing from it, and the Fed had stopped printing them.
The greatest liquidity crisis in the dollar area in post-war history was thus inevitable. That crisis smashed the stock markets here, and set off aftershocks around the world.
So the end of the Reagan bull market also marked the end of the post-war era, because no one, certainly not George Bush, believes that the U.S. could, or should, climb back to a lonely throne. The U.S. is now the primus inter pares of an international grouping that hasn't yet written its own operating rules. Why was there no economic collapse after the Crash? First, over-all global liquidity was adequate, because the Plaza Agreement had set off the biggest expansion in total liquidity ever seen. Therefore the dollar liquidity crisis was offset, in great measure, by liquidity in European and Asian currencies.
Secondly, the Crash forced the Fed to slash U.S. interest rates, sending the bond market into orbit, and knocking Eurodollar rates down to levels that could be met by Third World debtors on the $450 billion in floating-rate loans owed to private banks. The single most crucial financial relationship for the banking system is the ratio between commodity prices and Eurodollars, because those 45 overstressed LDC borrowers have no hope of meeting their interest costs if dollar rates are high and commodity prices are low. On the day before the Crash, that spread was at its most perilous in history. Had the Crash not occurred, we would have faced, within weeks or months, the greatest worldwide banking crisis since the Great Depression. A simultaneous worldwide default by most of the Third World debtors would have wiped out the equity in so many of the West's biggest banks that a catastrophe would have been certain.
From that perspective, the Crash was probably the salvation of the international banking system. Regrettably, the Crash did not convince politicians in the dollar area - Canada and the U.S. - that the rest of the world could not fund their fiscal indiscipline for much longer. Nor did most North American politicians reflect on the fragility of the North American economy exposed by the Crash, or on the heightened competition from across both the Pacific and Atlantic as new trading zones emerged. In particular, Canada's extreme vulnerability to the effects of the creation of a true Common Market in Europe in 1992. And the astonishing growth of the new East Asia Co-Prosperity Sphere hasn't convinced enough Canadian politicians that this country and the
U.S. had better get on with free trade in a hurry.
Yes, we dodged the bullet a year ago. But don't let anyone try to reassure you that the Crash came because of excessive speculation in the stock market, and that it was therefore just another stock market adjustment. Last year's market, while unquestionably over-enthusiastic, was not of the South Sea Bubble or 1973 Nifty Fifty Variety. It was not based on an illusion of endlessly rising price-earnings ratios, but on a deeper illusion - that Wall Street and Pennsylvania Avenue were still the addresses of the guarantors of endless peace and prosperity.
Our economies have survived the Crash: indeed, they were assisted by it, because of the fall in interest rates and the further devaluation of the American dollar, and with it the Canadian dollar. Industrialists and workers across Canada should be grateful that the Crash came when it did, and with consequences that, to date, are so salutary.
But the world is now leaderless, and we have entered an era where co-operation among the advanced nations is not just a question of convenience, but, for North America, of survival.
Myths, properly understood, are symbolic bases for social, military, or other useful cohesion. The myth that the U.S. could maintain indefinitely both the greatest share of the cost of the defence of the Free World and the strength of the world reserve currency was a highly profitable anachronism for governments from Singapore to Switzerland.
The Crash exploded the myth.
We must come to terms with a new, and as yet undefined, reality. The stock markets of most of the world have been trading in a sideways pattern this year, consistent with this transition stage to a new kind of economic and financial alignment which will give investors the benchmarks needed to assign values to stocks and bonds across national boundaries.
An optimist might say that the Crash ended an era in which one overburdened power yielded to a splendid new era of international co-operation. In that environment, a new global bull market would soon begin that would eclipse the best that stock markets could do in the Americo-hegemonic world of the past. Such an optimist might note that the central ideals of American capitalism - democracy and a society based on individual initiative - were fast on their way to affirmation around the Globe. That kind of optimist would view the Crash as the mythic death from which great new organisms drew their lives.
I identify myself with that optimistic forecast.
The appreciation of the meeting was expressed by John F. Bankes, VicePresident, Investment Banking, First Boston Canada Ltd., and a Director of The Empire Club of Canada.