For those of us who were watching that day, October 19, 1987 is forever seared into the memory banks. One doesn’t easily forget a 20% correction in the stock market that arrived in a matter of hours.
This reporter, working at a small trade magazine at the time, remembers the day vividly. The daily routine at the office began as usual, but as the morning gave way to afternoon all ears turned to the radio (the medium of choice for breaking news in those days). By 2 p.m, no one was working; all gathered in the conference room, listening to the updates on the spectacular collapse in stock prices. The selling grew more intense as the minutes ticked by. By the close of trading, we could only guess at what a 20% drop meant for the weeks and months ahead.
The obvious analogy was the crash of 1929 and the Great Depression that followed. Would history repeat itself in 1987 and beyond? Fortunately, the answer was “no.” The massive selling of October 19, 1987 was an isolated event, virtually unrelated to the economy. The Federal Reserve played a pivotal role in stopping the chaos in the market from infecting the general economy. Rather than squeezing credit supply, as the central bank did in the early 1930s, the Fed learned its lesson and instead pumped huge amounts of liquidity into the system in the days and weeks after the ’87 crash. By most accounts, that timely act was crucial in containing the carnage.
Twenty years on, what have we learned as investors? Buy on the dips. That has become the mantra for many, and the lesson was forged in 1987 and several times since. The latest example has come in the last several months. Reacting to the subprime woes of August, Bernanke and company dispatched an aggressive 50-basis-point cut in interest rates last month. The medicine worked its magic once again. The late-summer correction in U.S. stocks has since reversed, and the Fed’s timely injection of liquidity has figured prominently in the renaissance.
In fact, the Fed has come through for the bulls each and every time trouble has reared its ugly head. Buying on the dips has been a fabulously profitable strategy over the past 20 years. Investors, as a result, are a more confident bunch today than in 1987.
There are few absolute truths in investing, but a member of that exclusive club is the iron law that expected returns and trailing performance are negatively correlated. To the extent that prices have run up in the past, future performance will be lower. That may or may not hold over the short term, which we loosely define as less than five years. But if we look out over longer stretches, the rash of bull markets in virtually everything gives us pause for calculating future returns.
Strategic-minded investors will recognize that after a portfolio is broadly diversified among the major asset classes–stocks, bonds, commodities and real estate–the remaining question of great import is how much cash, if any, to hold. The question’s always timely, of course, and arguably even more so these days.
For the past 20 years, cash has only been a drag on performance. If you expect the next 20 years to be the same, cash still looks like trash. Pondering the future as informed by the past, however, one might wonder if the Fed can continue smoothing over the rough spots indefinitely with no blowback of consequence. If you have some doubts, perhaps holding a bit more cash than usual has merit, if only as a tool for taking advantage of future turmoil.
Then again, perhaps the bulls can keep roaring for longer than a reasonable observer might expect. It’s easy to think so. Risk has paid off big time and so we’ve all been beneficiaries for the better part of past 20 years. As a result, we’re all at risk of extrapolating the past into the future and assume that winning is a constant. But having won the risk game for so long, it’s only prudent to consider if wealth preservation should now take precedence. The answer will vary for each and every investor. But generally speaking, with most markets at or near record highs, now’s as good a time as any to ask the tough questions. Let the inquiry begin.