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Chronicle of the Conspiracy
Join us as we discover, document, expose and challenge the bad people, the bad institutions and the bad ideas that stand in the way of wealth creation -- and show you how to fight back!

Friday, October 19, 2007

THE TRUTH ABOUT THE CRASH OF 1987   Now it can be told! Twenty years after the great stock market crash of October 19, 1987, when the Dow Jones Industrial Average fell by more than 22% in a single day, the truth about why it happened can now be revealed.

And believe me, I know what really happened. Because I caused the crash myself. Yep, it was me. With a little help from some market manipulation, a lot of bad judgment and some colossal mistakes.

Back then I ran portfolio management and trading for Wells Fargo Investment Advisors. With $69 billion under management, we were then the world's largest institutional investment manager. The company is now called Barclays Global Investors, and with almost $2 trillion under management, it's still the world's largest.

In 1987 Wells Fargo was by far the largest player in the two strategies that caused the crash. One was "program trading," the simultaneous execution of hundreds of stock trades with a single electronic order. The other was "portfolio insurance," a hedging strategy that used program trading and stock index futures to hedge the downside risk in institutional stock portfolios.

According to official government reports issued in the aftermath of the crash, program trading and portfolio insurance combined to cause the crash. The portfolio insurance strategy required that Wells Fargo execute program trades, selling all 500 stocks in the S&P 500, over and over as the market declined. With every execution, the market declined even more. And that triggered the next execution.

Wells managed portfolio insurance strategies for America's largest pension plans. But other giant pension plans just used us to manage their S&P 500 index funds, managing the portfolio insurance part themselves. On the day of the crash, we were executing plenty of sell programs for our own portfolio insurance strategies all day. At the same time, clients called to say, "Sell a billion S&P, right now" -- and we did. Then they called again. And we sold again. And again.

That's why I say I caused the crash. It was my team's finger that was on the sell button. It was our job to push it, and we pushed it.

Our execution of portfolio insurance and program trading strategies were blamed for the crash in the official government reports. But here's what got left out of the official story: the whole thing was triggered by a massive market manipulation by a major Wall Street investment bank. Lest I end up in litigation about this, that firm will remain nameless.

Here's how it happened.

Before the crash, it was widely discussed among professional investors that the combination of portfolio insurance and program trading could cause a cascading market decline, as each step downward caused portfolio insurance strategies to do more program selling, which in turn would cause a steeper decline, and more selling, and so on.

One especially aggressive head trader on the proprietary trading desk of one particularly aggressive investment bank had followed that discussion, and it gave him an evil idea. What would happen, he wondered, if he started massively short-selling stock index futures, driving the stock market down single-handedly as long as he dared to sell enough contracts -- thus setting off the cascade. Once the cascade was set in motion, he could keep selling, knowing that the portfolio insurers would drive the market lower and lower. Eventually he'd cover his shorts at a huge profit.

It worked. And this man was in a great position to know that it would. His firm acted as broker for all the largest portfolio insurers, including Wells Fargo. So he knew exactly how much the market would have to decline to set off the portfolio insurers' sell programs. In other words, he had inside information. All he had to do to make a fortune was use that information, betray his own clients' trust in his firm, and threaten the world financial system by causing the biggest stock market crash in history.

So the crash of Monday, October 19, 1987, was started as a crime. But it ended as a comedy of errors the next morning, Tuesday, October 20.

Monday night after the market closed, hedge fund mega-manager George Soros became convinced that the world stood on the brink of a global depression. He felt sure that the downward spiral begun on Monday would continue, and he resolved to get out of stocks as quickly as possible.

An hour or so after the market opened on Tuesday morning, he placed an order to sell about $1.6 billion in stock index futures. It was a market order, which means he didn't specify a price -- just sell, no matter what.

By today's standards, $1.6 billion may not sound like much. But in 1987, that was about as big as a trade could get. But then, something astonishing happened that made the trade even bigger.

Somehow, in all the pandemonium on the trading floor in Chicago where the stock index futures were traded, Soros's order got doubled. The ticket got printed twice. So instead of a sell order for $1.6 billion, it was $3.2 billion. All at once. At the market.

His order hit the futures market like a boulder dropped in a shallow pond. Over the next hour, the futures fell almost 27%, an even larger drop than the market had sustained in the previous day's historic crash. The drop in the futures market caused renewed panic in the stock market, and for much of the day it looked like Soros was going to be right -- the meltdown appeared to be continuing.

But he was right for the wrong reason. It was a mistake. A mistake of judgment to sell so much in the first place (Soros must remember that as one of the worst trades he ever made) and another mistake on top of that for his broker to sell twice as many contracts than Soros had ordered. By the end of the day, the stock market and the futures market found their footing, and the foundation for a sustainable recovery was in place.

The crash, then, was an artificial creation -- the product of error and manipulation. It wasn't a actual investor expectations about earnings, the economy, or anything else. So it caused no lasting harm to investors -- stocks actually showed a positive return in calendar 1987, all told. And it did no lasting damage to the economy.

Maybe some day the true story will be told about the panic that markets have been through the last three months. This time around I didn't have a front-row seat like I did in 1987, so I'm not in a position to know that story. But I'll bet there's one out there, waiting to be told.

Like the 1987 crash, I'll bet the sub-prime meltdown will enter the history book as little more than a curiosity -- no lasting harm to investors, and no lasting damage to the economy.

Posted by Donald L. Luskin at 1:09 AM | link  

HAPPY ANNIVERSARY!   Reader Liv Douglas reminds me that this is the 20th anniversary of the stock market crash of October 19, 1987. Thanks, Liv -- I'll be writing my column about this. In the meantime, here are Liv's thoughts:
Today marks the 20th anniversary of the infamous stock market crash of 1987. Had you paid attention to Big Media at the time, you'd have sold your stocks, gone into cash and hunkered down for the [inevitable] recession or, perhaps, depression.

Big Media was, once again, woefully wrong. If you bought the Dow at 1,738 at the end of October 19, 1987, you'd now be sitting on a Dow of 13,889 (yesterday's close). The media only missed a 12,151-point rally. That's a 10.95% compound annual return, excluding dividends.

The S&P500 closed at 225.06 on that woeful day in 1987. It now trades at 1540.08. That translates into a 10.09% compound annual return, excluding dividends. Despite two recessions, a couple wars, terrorist attacks, Bill Clinton in the White House for 8 years, and a crash in tech stocks in 2000-2002, the stock market has paid the long-term investor handsomely.

This is truly a case of being "poor and stupid" if you believed Big Media back on 10/19/87. If you ignored the hype, you're probably "rich and unstupid" now. The media hasn't let up. It continues to predict doom and gloom. Currently, it's the "subprime slime", the "mortgage meltdown", and the "credit crunch."

If Big Media is wrong again, expect to see the Dow at 53,746 in 20 years. Sounds ridiculous? Not really. I'm only assuming a 7% gain compounded annually. At a 10% annual return, the Dow will trade at 93,438 in 20 years. But don't expect to see these figures touted by the media. These figures seem as looney as if, in October 1987, you predicted a Dow of 14,000 by October 2007. Funny how things turned out.

Posted by Donald L. Luskin at 1:06 AM | link  

INDEED IT WOULD   I'm not sure I approve of Rupert Murdoch's plans for the Wall Street Journal. But his plans for the New York Times are right on target.
Mr Murdoch, who is set to complete his turbulent $5bn (£2.5bn) takeover of Wall Street Journal publisher Dow Jones later this year, last night said he wanted to move the newspaper beyond its financial roots and target mainstream competitors such as the New York Times(...)The 76-year-old head of News Corporation also said he would like to increase the newspaper's coverage of cultural issues, in order to take advantage of the advertising opportunities available from the likes of movie studios. "I want to add major coverage of the arts, fashion and culture," he added. When asked whether he was aiming to kill the New York Times, Mr Murdoch replied simply: "That would be nice."
Thanks to "Irrational Exuberance" for the link.

Posted by Donald L. Luskin at 1:04 AM | link  

WHO SAYS THE DOLLAR IS WEAK?   Our monetary affairs correspondent "Irrational Exuberance" notes that the dollar is, in fact, quite strong:
...a big jump in the U.S. dollar's exchange rate against the Zimbabwe dollar. "People are asking for a million and getting it in big bank-to-bank transfers," one dealer said. "Cash for cash is anything above 750,000 to one." Just a few days ago, in the first week of October, 520,000 Zimbabwe dollars were needed to buy $1 on the black market. The rate was 400,000 for one in mid-September. "There's too little foreign exchange out there and too many chasing it," said the dealer...

Posted by Donald L. Luskin at 1:02 AM | link  

Thursday, October 18, 2007

KUDLOW REPLAY   In which I endorse Ron Paul for president, and absolutely insist on talking about the New York Times.

Update... Larry has the money quote.

Posted by Donald L. Luskin at 12:42 AM | link  

Wednesday, October 17, 2007

IS THERE NO ECONOMIST BEYOND THE REACH   ...of sin and corruption? Apparently not. Thanks to Jon Redden for the link.

Posted by Donald L. Luskin at 6:54 PM | link  

IT'S NOT ONLY GEORGE W. BUSH WHO TALKS TO GOD   Direct communication with the Lord persuades Barack Obama to go green.
"When God created the Earth he entrusted us to take responsibility to take care of that Earth," Obama says, and we are not living up to our responsibility to ensure our children's future.
It's seen in the press as a sign of derangement that George W. Bush consults God on the war in Iraq. But environmentalism is a religion -- so this fits right in. Thanks to reader Richard Sinda, who adds,
I think he needs to go on record with how long the earth has been in existence. If the earth is really old, and has been through many changes, how does God expect us to stop climate change? But maybe he's a creationist.

Posted by Donald L. Luskin at 8:28 AM | link  

DOES ANYBODY REALLY KNOW WHAT CENTURY IT IS?   Welcome to the "Spitzer 2010" website, where grand inquisitor Eliot Spitzer prepares to run for a second term as New York governor. But perhaps he's thinking of the presidency, not aware that there will not be an election in 2010. The introductory text on the homepage suggests he doesn't quite know what year it is. Or even what century.
We must transform our government so that it is as ethical and wise as all of New York, as we must rebuild our economy so that it is ready to compete on the global stage in the next century.
Thanks to Mark Spahn for the link.

Posted by Donald L. Luskin at 8:24 AM | link  

LET'S HOPE IT DOESN'T TAKE A WHOLE DECADE   Hoover Institution's Henry Miller puts Al Gore's Nobel in context:
Portuguese neurologist Egas Moniz received the 1949 Nobel Prize in medicine for "his discovery of the therapeutic value of [prefrontal lobotomy] in certain psychoses," including depression and schizophrenia. The prefrontal lobotomy operation, in which the nerve fibers connecting the frontal lobe with other parts of the brain were cut, and which often made patients zombie-like, would be repudiated by the medical community within a decade.

Al Gore, the latest recipient of the Nobel Peace Prize, is a similarly poor choice, one likely not to stand the test of time.

Thanks to Jameson Campaign for the link.

Posted by Donald L. Luskin at 8:19 AM | link  

Tuesday, October 16, 2007

FOX REPLAY   Here I am in my debut performance on the Fox Business Network, during it's debut performance as a competitor for CNBC and Bloomberg. They'll get it together, but it seems there was a fair share of production glitches this week, including a weird anamorphic distortion during my first "hit" (and the fact that the producers left me sitting there in the studio for a half hour after I was done, not telling me I was "clear." I made a little whoops of my own, citing 2003 instead of 2002 as the year that Sarbanes Oxley was enacted. Oh well...

Posted by Donald L. Luskin at 5:54 PM | link  

WHO ARE THOSE GUYS   ...who won the Nobel Prize in Economics yesterday? And do they believe in markets, or don't they? An op-ed from this morning's Wall Street Journal:
Yesterday Leonid Hurwicz, Eric Maskin and Roger Myerson won the Nobel Prize in Economic Science for their pioneering work in the field of "mechanism design."


Leonid Hurwicz, in his classic papers "On the Concept and Possibility of Informational Decentralization" (1969), "On Informationally Decentralized Systems" (1972), and "The Design of Mechanisms for Resource Allocation" (1973), embraced Hayek's challenge. He developed mechanism-design theory to test the logic of the Mises-Hayek contention that socialism could not possibly mobilize the dispersed knowledge in society in a way that would permit rational economic calculation for the alternative uses of scarce resources. Mises and Hayek argued that replacing the invisible hand of the market with the guided one of government would not work. Mr. Hurwicz wanted to see if they were right, and under what conditions one could say they were wrong.

Those efforts are at the foundation of the field that was honored by the Nobel Prize committee. To function properly, any economic system must, as Hayek pointed out, structure incentives so that the dispersed and sometimes conflicting knowledge in society is mobilized to realize the gains from exchange and innovation.

Last year Mr. Myerson acknowledged his own debt to Mr. Hurwicz -- and thus Hayek -- in "Fundamental Theory of Institutions: A Lecture in Honor of Leo Hurwicz." The incentive-compatibility issue has highlighted the problems of moral hazard and adverse selection (perverse behavior due to incentives caused by rules that are supposed protect us and selection problems due to imperfect information). Mr. Hurwicz helped repair a mid-20th century neglect of institutions in economic analysis.

While we celebrate the brilliance of Messrs. Hurwicz, Maskin and Myerson, we should also remember that Hayek's challenge provided their inspiration. Hayek concluded that the private-property rights that come with the rule of law, freedom of contract, and freedom of association is still the one mechanism design that mobilizes and utilizes the dispersed information in an economy. Furthermore, it does so in a way that tends to capture the gains from trade and innovation so that wealth is continually created and humanity is made better off.

Posted by Donald L. Luskin at 7:47 AM | link  

Monday, October 15, 2007

GUESS WHO DIDN'T? the Nobel Prize in economics, I mean. The winners were cited for their theories that "allows us to distinguish situations in which markets work well from those in which they do not." The loser believes there is no situation in which markets work at all.

Posted by Donald L. Luskin at 8:18 AM | link  

Sunday, October 14, 2007

DEBORAH SOLOMON: THE NEW JAYSON BLAIR   Deborah Solomon's weekly short interviews in the New York Times Magazine are the most irritating possible example of the snotty, smarmy, smug and holier-than-thou attitude that pervades the entire enterprise that is the Times. Now "public editor" Clark Hoyt has exposed her for the fraud she is.
Though presented in a way that suggests a verbatim transcript, the order of the interview is sometimes altered, and the wording of questions is changed.. And, Solomon told me, “Very early on, I might have inserted a question retroactively, so the interview would flow better,” a practice she said she no longer uses.

“Questions For” came under fire recently when a reporter for New York Press, a free alternative weekly, interviewed two high-profile journalists — Amy Dickinson, the advice columnist who followed Ann Landers at The Chicago Tribune, and Ira Glass, creator of the public radio program “This American Life” — who said their published interviews with Solomon contained questions she never asked.

...The Times Magazine published an angry letter from NBC’s Tim Russert, who said that the portrayal of his interview with her was “misleading, callous and hurtful.”

Russert, the author of two books about his father, told me that the interview had been presented as an opportunity to talk about his mom on Mother’s Day. Instead, the interview, headlined, “All About My Father,” featured a seemingly insensitive Russert dodging Solomon’s questions about his mother. “I talked at great length about my mother,” he said, but none of it appeared in the published interview. Russert said that Solomon combined questions and took “an answer and transposed it to another question.”

Gerald Marzorati, the editor of the magazine, said, “We examined his complaint and found it more or less justified.” Russert had talked about his mother, Marzorati said, and Solomon made it appear that he had not. Solomon said, “I made a mistake not putting in what he said about his mother.” Afterward, Marzorati said, a new policy was put in place, requiring that Solomon give the tapes of her interviews to her editor or a magazine researcher, in case a subject raised an objection. It was then, Solomon said, that she also stopped inserting retroactive questions.

Oh, there's more...
The [Ira] Glass interview was published last March, after the new safeguards were in place. Glass, who was just starting a television version of “This American Life” on Showtime, was stung by this printed exchange with Solomon: Q: “What do you think of the network?” A: “I don’t meet many people who are talking about shows on Showtime.”

He did not deny saying it, but he said he was sure it came during a long conversation about how the network marketed itself. “I don’t believe she asked me that question,” he said. “If she did, it certainly didn’t precede that answer.”

Glass said, “If I’m remembering this wrong,” the tape would establish what was said. But Solomon and the magazine editors can’t find it.

Here's the best part, where Solomon is caught bragging about her lack of journalistic ethics:
In an interview with Columbia Journalism Review in 2005, Solomon said: “Feel free to mix the pieces of this interview around, which is what I do.”

“Is there a general protocol on that?” her questioner asked.

“There’s no Q. and A. protocol,” Solomon replied. “You can write the manual.”

Posted by Donald L. Luskin at 11:34 AM | link