Monday, 29 October 2007

Blast from the Past

Two unrelated cases happened over the past week that compelled me to pen down my thoughts on them. Both are, of course related to the markets, but they aren't related to one another. The common tether that binds them is investor psychology. Read on...

Black Monday

October 19, 2007 marked the 20th anniversary of the demonic 'Black Monday' crash that shook the markets exactly 2 decades ago. On Monday, October 19, 1987, the Dow remarkably dropped over 20% in one day's trade. Most global equity markets suffered declines of over 20% by the end of that fateful October month.

Experts continue to argue about the possible causes behind the collapse. Program trading, bulk selling, overpricing, illiquidity were all put forth as reasons behind the event.
In this section, I will write about human psychology 2 decades since. Maybe there was some pattern somewhere?
The table shows 1-day price change for selected major world indices on three specific dates, beginning with 'Black Monday' of October 19, 1987.

A very interesting pattern comes out of the table. One can see that major world indices dropped quite a bit, on October 19, 1997, exactly 10 years after 'Black Monday'. The 1997 fall, although not major in terms of magnitude strikes a chord when seen in relation to the general sentiment surrounding equities in the late 90s. The internet frenzy had begun and equity markets around the world were mostly moving in one direction...UP...But on the fateful 10th anniversary, most major global markets chose to fell together. The 20th anniversary did not bring with it any cheer either! Again equity markets dropped together and this time the percentage decline was bigger than in 1997.

Did the underlying economic fundamentals driving the respective countries change in a day? Were world markets suddenly gripped with a bout of collective enlightenment, which forced them to pay respect to their past?

This is where investor behavior comes into the picture. Nothing had changed in a day. In fact, over the 2 decade period, prosperity had only increased globally. GDP, GDP per capita, science, technology had all advanced rapidly. But investor thinking didn't change much.

In my opinion - and I am venturing into the esoteric sounding area called 'cognitive psychology' - human beings take decisions with their eyes stuck to the rear view mirror. An unlikely event as a 20% fall was enough to fill people hearts with fear and uncertainty. Every time the dreaded date came up, investors around the globe chose to let go of their rationalities for a day and sold off...Sold off till Black Monday became a self-fulfilling prophecy.

Go-Go CEO (during a Bull Run)...and Go-Go CEO (after the bubble bursts!)
The second event is a classic in many ways. It occurs so often that investors have forgotten to even acknowledge them.

CEO joins the firm during the onset of a prosperous bull run --> Investors push the CEO towards making investments that enhances their return (and conveniently forget the risk involved) --> CEO obliges and invests in areas that probably he himself doesn't fully comprehend --> For sometime the good times continue --> CEO is King.

--> Bubble bursts --> Pain begins --> Company takes a write-down --> People hunt for a scapegoat --> Get one in the CEO --> Kick him out -- Bye bye CEO!

This is what happened with the CEO of Merrill Lynch, Stan O'Neil. The brokerage took a hit of close to $8 billion related to subprime mortgages, resulting in its biggest quarterly loss since its beginnings 93 years ago. Although the CEO is no saint, I find it intriguing that nobody thought of ousting him when he was busy investing in these risky assets. (Maybe they didn't because nobody understood or wanted to accept the risks involved). The CEO is shown the door when he accepts and rectifies his mistake. Hmm...

The CEO was known as a guy with a stomach for 'risks' and was seen by many as the one who directed Merrill's entry into the subprime mortgages segment. So to that extent the axe had fallen rightfully...But the stock went up 10%, coinciding with this bit of news!!!

Maybe the good times will begin once again...

Every day of watching the markets, makes me embrace the theory that ultimately the winner is the one who is able to control his behavior better than anybody else in the markets. Greed, expectation, euphoria and fear are emotions that co-exist in investors, sometimes unfortunately leading them to their downfall.

A Buffet adage is in place here.

"We simply attempt to be fearful when others are greed, and greedy when others are fearful."