Ronald D. Peyton, president and chief executive officer, Callan Associates Inc., San Francisco, said, "The 1987 crash was one of the best ways that a market correction can happen . . . because it was of such short duration that no one could do anything stupid reacting to it.
"The majority of (pension) funds held the course . . . and were amply rewarded for it because there was an immediate correction back the other way."
But Robert D. Arnott, president and chief investment officer at First Quadrant Corp., Pasadena, Calif., believes the October 1987 crash "is important to remember. Absolutely. It's the one example in the last half-century where we see markets behave in a highly volatile and discontinuous way."
By discontinuous, he means, for example, "the price of a stock can instantaneously fall from, say, $100 to $80 without any opportunity to think through during the decline your options in controlling risk."
"Certain lessons are important to remember from 1987," Mr. Arnott said.
One lesson, he said: "People have to have risk management ideas nailed down before risk management is needed. You can't come in after the damage has occurred and think about risk management."
Another, he said, probably is not the correct or appropriate lesson: "When the market tumbles, it always comes back."
The market "can take a great deal of time to come back. In the 1987 crash, it took two years for the market to come back," Mr. Arnott noted.
This lesson encourages complacency, Mr. Arnott added. "You buy on blips and it all comes out OK. People have been conditioned to believe that when the market falls, you buy. That's not always a good strategy. The 1929 market drop took until 1954 to recover, even ignoring the opportunity costs of other markets."
He said people forget high reward goes hand in hand with high risk. "We haven't seen the risk part since 1987, or since 1982," when the bull market began.
Industry reforms itself
Whatever the lessons learned, Mr. Glauber, the Brady Commission's chief staffer, noted the market reforms that followed Black Monday were put in place largely by the industry itself, rather than by government. Among the most important, he cited limited cross-margining between futures and stock positions.
"Stocks and futures can be used to coordinate trading strategy," he said. "And the financing should be coordinated, too."
With better communications and more capital for specialists, he said, the exchanges can process a higher level of volume, perhaps more than three times what they could in 1987.
Bill Jurika, principal with Jurika & Voyles, Oakland, Calif., sees the crash as a correction that is "just natural history in this business."
"It's certainly something that can easily happen and you can take advantage of them a lot better if you have some balance to your portfolio."
But unlike in 1987, he said, today people have a high percentage of stock in their asset base. "Any significant correction could cause a wealth effect, which could impact the economy."
Callan's Mr. Peyton noted the crash of 1987, and the subsequent recovery, reinforces the concept that institutional investors such as pension funds need to "stick to the long term."
"People responsible for running the funds know this, but their immediate overseers don't always know this. That's where the pressure to do potentially damaging moves often comes from."
Mr. Glauber said the crash showed how chaotic the market could become. On the five days around that Oct. 19, from the preceding Wednesday until the following Tuesday, he said, "the total turnover in the market was only 3% of market capitalization. But it was accompanied by a 33% decline in the market" over those days.
"You see how fragile the markets are," Mr. Glauber continued. "The deepest and most liquid in the world fell in chaos."
New risk-protection strategy
Since the crash, tactical asset allocation has replaced portfolio insurance as the most used or at least most publicized risk-protection strategy.
Some pension executives are "seriously concerned about overvaluation, yet want to enjoy its upside potential," said Mark Riepe, vice president with Ibbotson Associates Inc., Chicago.
These sponsors remain in equities but "are moving into more defensive strategies that are less sensitive to market changes," he said.
Many sponsors have hired TAA managers to downsize their risk, but if the market keeps going up, "those strategies can become expensive," Mr. Riepe said.
Mr. Arnott estimates pension funds and other investors have an estimated $100 billion in TAA strategies. In addition, he estimates there is $10 billion to $20 billion in option writing strategies, including call writing.
By contrast, in 1987 there was an estimated $80 billion in portfolio insurance.
"TAA is nominally larger than portfolio insurance was in 1987," Mr. Arnott said. "But the market was much smaller in 1987," giving portfolio insurance more significance.
"Some of the strategies that were a significant part of stock market trading in 1987 had the tendency to amplify market movements," Mr. Arnott said. Portfolio insurance was the most prominent of them.
"In these strategies, as the market rises your risk tolerance rises, so you buy more stock," he said. "As the market falls, your risk tolerance falls, so you sell stock. These strategies put pressure on the market and exacerbate movements in the market.
A year before the market crash, Mr. Arnott was critical of the ability of the market to handle the execution of a portfolio insurance strategy. He doubted the futures market would have the liquidity to handle a surge in trading in the event of a sharp decline in the stock market.
Mr. Kirby agrees. "The professors who dreamed it up assumed infinite liquidity," he said.
Dampening market movements
"Today's strategies have the opposite effect," Mr. Arnott said.
"TAA and option writing strategies tend to dampen market movements. When the market is rising, you begin to sell. When the market is falling, you begin to buy. These two strategies have a salutary effect on market movements.
"But both sets of strategies (TAA and option writing) are too small to have a material impact on market movements," Mr. Arnott said.
Donald G.M. Coxe, chairman and chief strategist at Harris Investment Management Inc., Chicago, said TAA has removed pressure from the market.
"TAA strategies have gotten people to move (a little) from stocks to bonds," Mr. Coxe said. "That takes risk out of the system."
By contrast, at the time of the 1987 crash, he said, "pension funds were still adding to their equity exposure." But now pension funds have been rebalancing.
In addition, he said, "We've made the system safer by democratizing it" through the huge growth in mutual funds.
"Pension funds are selling to 35 million mutual fund buyers, who are unlikely to sell at once" in the event of a crash.
Mr. Kirby said the Brady Commission suggested treating all of the markets - stocks and bonds, futures and options - as a single market. While the eventual reforms didn't go that far, Mr. Kirby is pleased they did begin to provide a link. Today, stocks and derivative positions can be used to some extent to margin investments in the other markets, lessening the need to raise cash by selling positions to cover margins.
As for today's market, Mr. Kirby said, despite its lofty, near record level, "I don't think the market is overpriced. Twenty times earnings on the S&P 500 is maybe the high end of the range, but it's in the range of reasonableness."
To cause another crash on the scale of Oct. 19, Mr. Kirby said, "You'd need a spring-loaded trigger," possibly in derivatives. "There are high bets out there in derivatives. I'm not confident everyone knows the risk of their positions."
The proposal on derivatives disclosure by the Financial Accounting Standards Board would lessen the chances of misunderstood positions posing undue risk to the market, he said.
"Count me in on the FASB proposal," Mr. Kirby said.Comparing '87 and '97
Harris Investments' Mr. Coxe doubts the current market is ripe for a crash.
"The comparison between 1987 and 1997 is misleading and unhelpful," he said. Among the differences:
In 1987, there was rising inflation. In 1997, there is falling inflation and a real threat of deflation.
Then, the dollar was on the decline and many were trying to prop it up. Now, the dollar is strong and many are selling it.
The nation's fiscal position is much stronger. Then, there was a great need to finance the fiscal deficit.
Then, the bond market was falling. Now, the bond market is rising, or at least is steady.
In 1987 the American banking system was one of the weakest of the major countries in the world. In 1997, it is one of the strongest and might even be overcapitalized.
"Stock market crashes can't occur beside a strong banking system," Mr. Coxe said. "Crashes are a financial event, the result of a weak banking system.
"We can't have a crash unless the dollar crashes, or the banks fail, or inflation rises."
"A market ready to crash is overconcentrating on former leaders," Mr. Coxe said. But this market isn't concentrating on a few stocks, he added.
"The Russell 2000 (small stock index) is hitting new highs," Mr. Coxe said. "That's a sign the market is correcting." It is broadening its base in stocks.
Although the current market might be overvalued, he added, what brings a crash is constriction of money flow.
"The blood flow is liquidity in the financial system," he said. "Constriction occurs when banks have trouble and can't borrow abroad because of currency problems. As soon as you have an air of panic about currency, then you have trouble."
Today, he noted, "pension funds have the biggest exposure to the foreign markets they've ever had, and those markets are getting trashed. But their U.S. portfolio is doing fine."
"International over a very long period of time is the right strategy," he said. "In crash situations, long-term averages don't help you."
Learning from the 1987 crash, Robert Scott, deputy executive director, Colorado Public Employees' Retirement Association, Denver, said, "If you have a long-term asset allocation strategy, you ought to just stay the course. Don't do tactical asset allocation; I think you have just as much opportunity to get burned as you do to win. I just don't think the excesses that existed in 1987 exist today."
Phil Levine contributed to this story.