“The Fourth Time Fails”

It was just a quarter-century ago that Wall Street was shaken to its core by the Oct. 19, 1987, stock market crash.

In one day, the Dow Jones industrial average lost 23 percent of its value. At the time people wondered if it would heralded in a new Depression.

A front page headline in The New York Times asked, “Does 1987 Equal 1929?”

Fortunately it did not – the next recession, a mild one, was more than two years away.

What it did signify was the beginning of the destruction of markets by computers programmed by fallible people and trusted by people who did not understand the computer programs’ limitations.

Trust me – as computers came in – human judgment and good ole common sense went out.

The 1987 villain was something called portfolio insurance. It was a product that used stock index futures and options to assure institutional investors that they need not worry if market prices seemed to be unreasonably high.

Portfolio insurance would let them get out with minimal damage if markets ever began to fall. They would simply sell ever-increasing numbers of futures contracts, a process known as dynamic hedging.

The short position in futures contracts would then offset the losses caused by falls in the stocks they owned.

Portfolio insurance did not start the widespread selling of stocks in 1987. But it made sure that the process got out of hand. As computers dictated that more and more futures be sold, the buyers of those futures not only insisted on sharply lower prices but also hedged their positions by selling the underlying stocks. That drove prices down further, and produced more sell orders from the computers. At the time, many people generally understood how portfolio insurance worked, but there was a belief that its very nature would assure that it could not cause panic. Everyone would know the selling was not coming from anyone with inside information, so others would be willing to step in and buy to take advantage of bargains. Or so it was believed.

But when the crash arrived, few understood much of anything, except that it was like nothing they had ever seen. Anyone who did step in with a buy order quickly regretted the decision.

I was a floor trader at Salomon Brothers back then – a leading brokerage firm in stock trading  – whose members also eventually helped form Long-Term Capital Management here on the Grand Cayman.

Near the end of that Monday, I remember looking up and seeing dozens of young investment bankers lining the trading floor. There was really nothing for them to see; the ticker tape rolling across the side wall was hours behind actual trading. But many no doubt wondered if their world was coming to an end.

The next day, a Tuesday, the Wall Street establishment effectively came together to stem the panic, although what happened gained little attention at the time. As sell orders forced the New York Stock Exchange to halt trading in stock after stock, word came that the Chicago Mercantile Exchange was threatening to halt trading in stock index futures. With many stocks not trading, there was no way to calculate an accurate value of a stock index. The system threatened to grind to a panic-induced halt.

It was then that Mr. Shopkorn got on the phone with Bob Mnuchin, the head stock trader at Goldman Sachs, and Salomon’s principal competitor. I don’t know who initiated the call, but I heard the result. They agreed to tell their floor traders to tell the stock exchange specialists that Goldman and Salomon would submit buy orders to reopen any stock in the Standard & Poor’s 500. Within minutes, prices began to recover.

In the aftermath of that crash, program trading became a whipping boy. It was program traders who had sold stocks as futures prices plunged, and a lot of traditional portfolio managers wrongly believed they had caused the debacle. That was a case of shooting the messenger. The real villains were the money managers who had embraced portfolio insurance. Their computers called for selling futures contracts no matter how much that depressed prices, and the buyers of the futures contracts — the program traders — simply did what they needed to do to protect themselves from losses.

One mutual fund manager got a lot of attention demanding that program trading be stopped, and I called him up. Wasn’t he, I asked, really saying he was against stock index futures?

Oh, no, he replied. He liked futures because he could use them to hedge his stock positions.

Portfolio insurance went out of style quickly, and some circuit breakers were put in to halt trading in the future when prices fell too far on one day. But the real lesson — of over-reliance on computers and under-reliance on human judgment — was not understood or addressed and exist still today – i.e. flash crash.

In 1987, when there was far less competition among exchanges, if a stock’s primary exchange halted trading everyone followed. At each primary exchange there were people with the responsibility of making markets and keeping them orderly — the specialists at the New York exchange and the market makers at Nasdaq. For institutional-size orders, the big brokers like Goldman and Salomon had stepped in to fill the role, which is now known as “providing liquidity” by buying when investors want to sell, and vice-versa.

Excessive belief in computer-generated and certified “models” to forecast such things as the likelihood of mortgage defaults played a role in creating our last financial crisis. The people who originally developed the models had warned that there was a small chance they would not work, but that was forgotten. Had any smart humans been reviewing each new transaction in detail, problems could have been uncovered before they devastated the financial system. But no one — not the banks that put the transactions together, not the rating agencies that certified them, not the monoline insurance companies that guaranteed them, and certainly not the institutional investors who put up the cash — thought they could afford to be vigilant.

Back in 1987 – after much damage was done to my small portfolio – I spent endless nights studying the charts – especially the immediate days that lead up to Black Monday – but nothing seemed to fit – nothing I had been taught up to that point would have indicated to me in the least that we were going to have a sell-off of any real magnitude – especially not a crash.

This revelation was frightening – why put my hard earned money into the market when without warning the whole thing could come crumbling down without the slightest sign or warning.

After literally months of studying I came up with the only reliable indicator that would have given me a heads up just prior to the event. Back-testing it against other sell-offs of lessor magnitude proved it to be astonishing accurate when used with some flexibility.

Rule #17 “The Fourth Time Fails” sounds simple enough – but underneath the hood is a technical behemoth. For today’s lesson I just want you to understand that in general the stock market is built around human frailty that the fourth time fails – be it whatever they endeavor.

In general for the market both support and resistance fail on their fourth test – also many runs from support or resistance fail on their fourth day – but most importantly for now is the fact that test of the Bollinger Band usually fails on it fourth break above.

Below is a chart of the SPY in its current section after a “Gap-up” which resets all patterns.

 SPY Page20140725163408

Above you can clearly see that the SPY has moved in and out of the Bollinger Band on 4 separate occasions since its recent gap-up – then on the fourth attempt it failed on the fourth day. A similar pattern was present back in 1987. Now Rule 17 is not this simple in its technical application – but just the rule in general should give you a leg up to other traders when it comes to market psychology. You’ll have to figure more details concerning the rule on your own – but just being aware of these patterns should be a plus.

Rule #17 also gives us a gap down target represented by the “X” convergence of resistance. If the market gaps down under this resistance then a large sell-off is almost certain for at least four consecutive days if not longer.

To avoid this – the market needs to open above the top resistance line. Using these two guidelines you should buy upon a open above the top support/resistance and sell under the bottom support/resistance.

Through all my years of trading this tool/rule has not only told me where the market is heading – but more importantly where it is not – so I hope it can also be an invaluable assistance for you to bring more consistent profits.

I’ve given you a lot here to digest so if you need more clarity please follow me on Stock Twits or Twitter and send me a message – there are no stupid questions – so ask whatever you want – if you would like for me to follow you back just let me know – because I always prefer to Direct Message (DM) as much as possible.

As always – study more than you trade and you will succeed – good luck – PTP –

Comments are closed.