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My four enduring lessons from the 1987 crash

Late October 2017 was the 30th anniversary of the 1987 crash and much has been written about it already. There are two key questions relevant for investors today:

  • Are we in a bubble like 1987 that is about to burst? and
  • Why did the Australian market crash further then and take longer to recover (10 years) than in the US (2 years)?

The two questions are related.

The debt-fuelled takeover binge

I have studied every cycle in the Australian and US stock markets since the 1800s and it is clear that the overall Australian market prior to the 1987 crash was the most expensive and vulnerable to crash that it has ever been in its history. There have been bigger bubbles and busts, but the 50% fall in 1987 in only 19 trading days (including a 25% fall on 20 October) was the steepest.

The main causes were loose lending, lax accounting and straight out fraud in many cases. The final trigger was the US/German/Japanese currency war, but the real problem was the extreme level of overpricing. This was worse in Australia than in the US or elsewhere. Most commentators cite the ‘price/earnings’ (PE) ratio of 21 as high. But a ‘price/earnings ratio’ is meaningless because the ‘earnings’ side of the equation was grossly inflated by fraudulent accounting, dodgy valuations and tame, conflicted auditors.

It was the age of the debt-fuelled corporate raiders with bankers throwing money at them. Alan Bond (Bond Corp, Media, Brewing), Robert Holmes à Court (Bell Group, Resources), Ron Brierley (IEL, Brierley Investments), John Spalvins (Adsteam), John Elliott (Elders IXL), Larry Adler (FAI), Russell Goward (Westmex), Chris Skase (Qintex), George Herscue (Hooker), Bruce Judge (Ariadne), Kevin Parry (Parry Corp), and many others. Most collapsed into bankruptcy in the 1990-91 recession, and some went to jail. Many of the big listed companies were caught up in the debt-fuelled takeover fever - even BHP, two of the big banks, the big retailers (Coles, Myer, Woolworths), the TV stations (Nine, Seven, Ten), Fairfax, the brewers, and several raiders themselves. It was all fuelled by ultra-loose lending from the big banks (with the notable exception of NAB) and from the state banks as well (the 1980s lending binge destroyed the State bank of every State except Qld which no longer had one).

At the top of the market the raiders were still cheap with low ‘price/earnings’ ratios: Elders was on 13, Bell Group on 15, IEL on 19, Bell Resources on 12, Adsteam on 11, Hooker on 15, Bond Corp and Ariane on just 9, and FAI on 7! Bargains! PE ratios were meaningless. The problem was in the quality of the reported ‘earnings’.

Are we in a 1987-style market bubble now? No.

Lessons from 1987 have stayed with me

The experience of 1987 affected me personally and it is at the core of my investment philosophy. 1987 serves as a reminder to ignore finance theory and focus on what happens in the real world. Finance theory likes nice neat lines, it assumes markets are always stable and static, that buyers and sellers are perfectly rational, and that returns are ‘random’ and ‘normally distributed’. It dismisses major events like the 1987 crash as random anomalies, simply ignoring them as irrelevant outliers and placing little importance on them.

I believe in the exact opposite - that the extreme outliers are actually the cornerstones of our experiences, they define our lives, and can create or destroy wealth - much more so than so-called ‘normal’ markets.

I was lucky enough to be on right side of both the 1987 boom and the crash. I had started out in the early 1980s as a lender with Citibank and Midland Bank (now HSBC). I learned about booms and busts first-hand by cleaning up the aftermath of bad lending in the late 1970s building boom which collapsed in the early 1980s recession. (Yes, you can lose money in housing - big time - just wait for a recession! Remember them?).

By 1986 I was running a bank financial control operation. Markets were booming again and I was young and single with no debt so I left the safety net of a salary, moved to Sydney, teamed up with three other characters and we set up a boutique investment bank. We were a motley bunch and I was the youngest, a bank financial controller with a couple of law degrees and a speciality in spreadsheets (remember Lotus 1-2-3, the forerunner of Excel?). This picture of me is from a 1987 prospectus.

My four fundamental rules

Rule 1: Recognise when you are in a bubble or a bust. Easy enough from a distance but it’s harder when you are actually in it at the time.

Rule 2: Never buy in a bubble - sell instead. Likewise: never panic sell in a bust - buy instead.

Rule 3: If you’re in a bubble and have nothing to sell, build something and sell it, assuming you have the skills and background to do it quickly. In 1986-87, we built and listed four companies - two gold refineries, a finance company, and a ‘cash box’ (a cash box is the ultimate bubble stock - there's nothing in it except cash but in a bubble people bid up the price anyway).

Rule 4: Never use debt (very unfashionable in the debt-fuelled 1980s. Debt was like big shoulder pads and skinny ties - everyone had them!)

In 1986-87, there were signs of a bubble everywhere - ‘hot stock’ shows on TV, talk back radio, magazines, newspapers (there were no blogs or social media or internet back then and not even mobile phones). There was even a tax-driven reason to lure investors into the market as franking credits were introduced in July 1987. Stock brokers ran seminars in the suburbs convincing people to gear up and buy shares to get access to the hot new toy called franking credits! The same thing happened in the 2007 boom when hundreds of seminars in the suburbs encouraged people to gear up into superannuation to take advantage of the ‘$1 million contribution window’. Thousands of people borrowed money at the top of both of the booms, threw it into the market, and promptly lost most it in the crashes that followed immediately after.

Don’t lose control of your own destiny

The other half of Rule 2 is that in a bust, buy when everybody else is panic selling. If you have no debt (Rule 4) you can survive even the worst crash and retain control. It is sad to see people sold up by margin lenders in busts. When you borrow money, you give control to the lender, and they will sell you up at the worst time.

The All Ordinaries index collapsed by 50% from 2,306 on 21 September 1987 to 1,151 on 11 November 1987 but that masks the fact that hundreds of stocks were left completely without buyers. The true market had probably collapsed 70% or more if there were any buyers to set market prices. We picked over the ashes and bought one of the Elders group companies for $1 (not $1 per share, $1 for the lot, with no debt). It had 35 subsidiaries and we spent the next couple of years sorting through the ruins

1987 was a great learning experience for me. I do have regrets. There were a few things we developed that went nowhere, but if you have no debt the downside is limited. Also, I was probably too careful and should have taken more risk at the time. You can always make more money if you borrow - but I’m too cautious and not that greedy.

The lessons and the same four rules have applied in every cycle since. And because all markets are driven by human fear and greed, hard-wired into human nature, the same four rules will probably apply to all cycles in future as well.

 

Ashley Owen is Chief Investment Officer at advisory firm Stanford Brown and The Lunar Group. He is also a Director of Third Link Investment Managers, a fund that supports Australian charities. This article is general information that does not consider the circumstances of any individual.

 

8 Comments
Chris Pappas
November 07, 2017

To all,
great article & excellent responses. As a "Mum & dad" investor/ trader well before the 87 crash I can relate to each salient point made by the contributors. Although, I don't know how I could have started without some debt & luckily I've had some success. I recall a couple of months before that crash I contacted a broker anonymously (because I expected the broker to think I was stupid) to ask his opinion that BHP (and other stocks) will fall by over 50% because the market was overheated. His response was "You're a F-- idiot" & slammed the phone down. I bet to this day that young "professional" broker is still wondering who that guy was.

hughDive
November 06, 2017

Great article Ashley, the highlight for me was the shot of you from the 1987 prospectus.

Julie
November 05, 2017

The comments here are as good as Ashley's article! I was too young for the 87 crash but went through the GFC as a Financial Adviser. As with Ashley's '87 experience, the GFC did change me.

Difficult to buy the lows as you all say but the way to make a serious gain! Appreciate all the contributions here - might share this with a few clients.

100% agree with Warren on debt. Must say I am wary of margin loans though - as it has been said they can sell you at the worst time. We still use them but keep the LVRs low.

Kevin
November 04, 2017

Hi Warren

I agree with most of what you say,I think debt must be used or it is impossible to start basically.From Sam Walton borrowing US$ 25K to start Wal Mart to Frank Lowy borrowing 50,000 or 75,000 pounds way back when to start Westfield.Perhaps that was around 75 yrs average wages at the time,I don't know what average wages were then.

Then myself borrowing around 9 months average wages in the 1980,s and hoping my heart could stand the strain,it hadn't dawned on me then that with 30 yrs of working life ahead of me paying back 9 months wages was not the slightest problem,as long as I had a job.

From memory back then NAB were promoted as being not exposed to the corporate cowboys,CBA being floated off, and WBC and ANZ being on their knees.Experts were saying later NAB got overconfident, and that led to the later problems with Homeside ,CYBG etc.They believed they could do no wrong,I don't know how true or accurate it is.

Buying when prices are low,easy to say,virtually impossible to do.As Rothschild said some 300 yrs ago,the time to buy is when the blood is flowing freely on the streets,not many do it.

When CBA had their capital raising at $71.50 when the share price was around $82 and quickly plunged I couldn't get enough of them,full allocation and more on market.End of the run don't buy chant the crowd.

A few weeks ago when they were down to around $74 greed got the better of me,I'll wait until the low $73 a share then buy, wish I had a $ for every time I have done that, did I buy any? Of course not, it started rising again. I'll probably get the chance again in the future,and probably make exactly the same mistake again.

The 50% is probably right but the crash of 2009 proved that wrong for my portfolio, I think I was running at around 66% equity and had 2 or 3 days of deep depression around the week ending 6/3/2009. Markets hit bottom and I thought a margin call was coming, thankfully they rose quickly the following week and months, it is still burnt into my brain.

Warren Bird
November 03, 2017

Interesting you mention NAB as being an exception to the ultra-loose lending of the banks at the time. I saw an example of the conservative, credit-risk focused attitude that prevailed at NAB back then when, in mid-1989, I toured the world participating in a roadshow with Nobby Clark (CEO of NAB at the time) to sell a global share deal that Merrill Lynch were lead-managing. The most common question that Nobby was asked was about NAB's exposure to Alan Bond and his answer was that, yes, they had debt to Bond Corp, but they had good asset security. "Coralled'' was the term he used. The deal went at $6.76.

Bond survived the 1987 crash but, rather than learning from the mistakes others had made, then went on a debt-funded asset acquiring binge. Hence the questions being asked 2 years after the crash.

This was interesting to me also because a few years earlier, when I shared an office with the late, great Will Buttrose, we heard a great celebration across the hall way. Champagne corks popping and much excitement. I asked what was going on and learned that the bank for which we worked had just won a deal resulting in a large loan to Bond Corp. Will said, "I'd be waiting until the loan was paid off before opening the champagne." That bank lost a lot when Bond Corp went bust in 1991.

So one of my enduring lessons from that period is to pay attention to credit risk metrics and be wary of the risk of a company defaulting. And not to celebrate the taking of a risk, but the achievement of its reward.

I also agree that Ashley's lesson #3 is unethical behaviour and not something I'd gloat about.

I disagree with his rule #4. He's right that many listed entities who fell of the cliff in the '87 Crash did so because of too much debt, as did Bond a couple of years later. But to go from that observation to a glib 'never use debt' is going too far. Lots of successful companies use debt. but they use it wisely and appropriately for the volatility of the industry they're in and their own earnings fluctuations; they gear sensibly, not excessively; and they gear for capital works and growth, not for speculation or to cover up cash flow shortfalls. They optimise their balance sheet, rather than never using debt. The best equity manager I've ever known, Greg Perry, had a limit of 50% gearing built into his stock selection process at First State Fund Managers, recognising that some debt can facilitate earnings and share price growth. I'd rather use that as a simple rule than zero debt.

ashley
November 02, 2017

thanks chris,
a couple of points -
"US market very expensive" - yes on some measures, no on others. Even if it is expensive, that doesn't mean it will crash. Markets can run and do often for years before correcting. The overall the market is trading on around 16 times forward earnings, and on earnings per share growth assumptions of around 13% for next year. Neither of these are aggressive. If you look at it stock by stock, most are reasonable and much of the earnings growth is already locked in from the recent oil/gas rebound (Exxon, Chevron, Conoco, Devon, EOG, Phillips66, etc), and also from the positive impact of rising interest rates on the banks. If you back out those, the earnings growth for the rest o the market next year looks decidedly pedestrian - less than a third of the 2017 earnings growth actually achieved.
Even the 'hot' IT sector doesn't appear stretched - and is assuming only 11% EPS growth next year after a healthy 30% this year. Apple is on 14, Intel 12, IBM 10, Cisco 13, Msoft 21, Google 24, FB 26. Amazon just keeps growing and plenty has been written about it already. There are some genuinely expensive stocks like Adobe, but most appear reasonable.
But this is just my opinion - and talk is cheap. The US market is easy to short if you are bearish.

Bitcoin - I have written about the Bitcoin bubble elsewhere on Cuffelinks. The good news is that the Chicago Mercantile Exchange is setting up a futures market for Bitcoin in the next couple of months so that will make it easy for to buy it or short it if you think it is going to go up or down.

"Chinese foreign reserves are drying up" - not really. Foreign reserves peaked at a fraction above US$4trillion in June 2014, then fell by a fraction less than $1 trillion by the start of 2017 after the RMB devaluations and weakening trade accelerated the capital flight in 2005&6. So far in 2017 the tightening of capital controls, export growth rebound and strengthening RMB have increased reserves by about 4%. With continued USD weakness and early signs of demand growth in Europe and even Japan, Chinese reserves will probably keep increasing slowly.

Will the Chinese banking system collapse (again)? Of course, just like the total freezing of credit and restructure of the entire banking system and rounds of emergency recapitalisations in 1998, 2001 and 2004 to clean up the orgy of bad lending from the early 1990s. It has happened before and it will happen again - but this time the government has more than $3trillion in reserves, and the big state owned banks have been raising plenty of capital recently (mostly from foreigners!)

One thing to remember is that for the majority of the debts (and probably a vast majority of bad debts) the lenders and the borrowers are all just different arms of the government (Banks, SOEs, provincial governments, SPVs, etc - are all ultimately owned and controlled by government, which is increasingly controlled by just one man - Xi). So swapping debt for equity should be relatively painless. The process has already begun. Retail investors in WMPs (in which banks package up bad debts and sell them over the counter to retail investors) will also get burned but the government will probably bail them out to prevent riots and civil unrest.
If you want to see a real bubble - take a look at Chinese N-shares!
cheers

ashley

Chris
November 02, 2017

Ashley, you say that we’re not in a 1987 style market bubble now, but I disagree.

Maybe not so overtly filled with corporate raiders and merger activity, and maybe not so in Australia (given that our market is only just trying to get above the 6,000 point level), but certainly in the US market, it is very expensive and hinging on the hopes of tax reforms and continued strong earnings. If either / both of those disappear, it will be like Wile E Coyote when he runs off the edge of the cliff and there’s nothing underneath to support him.

Bitcoin and all these other cryptocurrencies certainly ARE in a bubble; various other commentators and investment professionals have made their feelings known, there are taxi / Uber drivers who are talking about getting into it and one man (Didi Taihuttu) has sold pretty much everything he and his family own -from their 2,500-square-foot house, to their shoes - and traded it in for Bitcoin.

All that you need is something like that (or a default in the Chinese banking system because their holdings of foreign reserves are drying up), and that has a contagion effect on other, unrelated markets.

Nick
November 02, 2017

Rule 3 sounds like financial engineering and not the most ethical of pursuits.

 

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