Charles retired in his mid 50s in May 2016 from a career in Canadian banking. He relies exclusively on income from rental properties and a dividend income stream from a portfolio he amassed over several years.
Some of you experienced the bursting of the dot.com bubble and some may have experienced déjà vu when the Financial Crisis hit.
How many of you, however, remember being an equity investor on Black Monday (October 19th, 1987)? The headlines from Black Monday would rattle even the most confident investor:
‘Stocks Plunge 508 Amid Panicky Selling’ – Wall Street Journal
‘Stocks Plunge 508 Points, A Drop of 22.6%; 604 Million Volume Nearly Doubles Record’ – The New York Times
‘Stock Market Suffers Largest Loss in History As Dow Industrial Average Drops 508 Points’ – The Washington Post
For those of you unfamiliar with Black Monday, this is when the Dow Jones Industrial Average caught everyone by surprise and plunged 22.6% in one day! While the plunge now appears as a mere blip on a long-term chart I encourage you to narrow the time frame of this chart.
If you were fully invested at the time, I can assure you it was not a blip… Especially if you had been employing the use of leverage in an effort to juice your investment returns.
I have purposely decided to focus this article on the lessons I learned from Black Monday as opposed to the ‘dot.com Bubble’ and the ‘Financial Crisis’. My rationale for doing so is that there were multiple warning signs of an impending market implosion before the ‘dot.com Bubble’ and the ‘Financial Crisis’. While there were some warning signs prior to Black Monday, they were not as readily apparent.
Before we delve into what triggered Black Monday, let me highlight what I feel were some of the most basic warning signs any prudent investor should have seen regarding the ‘dot.com bubble’ and the ‘Financial Crisis’.
It was not uncommon to read about a company with minimal, or no, revenue that was trading at nosebleed levels and whose stock price was increasing at alarming rates over very short periods of time. In many cases, price-to-earnings ratios couldn’t even be calculated because the earnings component of the ratio was non-existent.
In other instances you had profitable companies with viable business models which also burned investors because investors tossed caution to the wind. Online trading platforms were becoming increasingly popular and many individual investors decided to enter the equities market; some people quit their full-time jobs to take up day trading.
In addition to not having a clue how to evaluate a company, a large percentage of retail investors entered the market well after the start of the dot.com bubble. While many investors may have invested in companies with real products, a viable business model, and strong financials, the mistake they made was to invest in companies trading at stratospheric price-to-earnings multiples (eg. Microsoft (MSFT), Intel (INTC) and Cisco (CSCO)). If you pull up a stock chart for Intel and Cisco you will see that an investor who invested in these two companies at the height of the dot.com bubble has not fared too well. If you look at the stock chart for Microsoft, you will see investors had to be extremely patient before they recouped their investment.
Looking at the NASDAQ chart it is readily apparent that some investors were going to get burned in a big way when the bubble burst!
In the case of the Financial Crisis, warning signs were front and center of an imminent blow up. You didn’t even have to look at any index chart. You just needed to listen to the news or to talk to people who were purchasing real estate!
I distinctly remember having a conversation with a total stranger while I was on vacation in Florida in 2006. We were sitting by the pool and he was encouraging me to join him to attend a sales center for a new condominium development in the Fort Myers area. He was an appraiser in the state of Ohio and he was looking to acquire rental properties in a warmer climate. I declined his invitation.
The following day, we spoke again while sitting by the pool. Not only had he signed an agreement to acquire a rental property, he had signed agreements to acquire 3 properties!
Imagine that… His income was generated from real estate and his investments were in real estate. Talk about putting your ‘eggs in one basket’ at the wrong time!
Stories of ‘LIAR’, ‘SISA’, ‘100%’ and ‘NINJA’ loans were also prevalent. You had individuals with no/low incomes acquiring multiple properties for rental purposes which were 100% financed. Heck, you also had loans where the borrower was unable to cover the interest component of the negotiated mortgage payment. That wasn’t a problem! The shortfall would get tacked on to the principal amount of the mortgage. When it came time to renew the mortgage, the outstanding balance would be greater than the original amount of the mortgage. Once again, this was not a problem because the increase in the value of the property down the road was going to exceed the balance of the outstanding mortgage. You would then be able to sell the property, repay the mortgage, and have surplus funds to then purchase a ‘better’ property. We all know how that worked out!
Why Was Black Monday Different?
Black Monday was different. Not only was the magnitude and speed of the market correction unprecedented, it was the first time turmoil hit every market at once.
Typically, crashes had been confined to specific markets (ie. the bond market, commodity markets, the gold market, the stock market). In the case of Black Monday, every market and every geographic region was hit. In essence what occurred was a complete failure of ALL traditional financial safeguards.
I recollect starting my career in banking in 1980. At the time there was no widespread use of financial derivatives. It wasn’t until a few years later when several giant pension funds and roughly 300 of the largest banks conducting business in the US started employing investment strategies which linked the options, futures, and stock markets unlike that ever witnessed.
By the time 1987 rolled around, the types of investors heavily engaged in the stock market were considerably different from prior decades. Giant institutional investors, including pension funds, had been actively been investing in the bond and mortgage markets. The shifting of their assets into the equities market, however, only started in the 1970s. The magnitude of the funds under their administration was so enormous that when the shift started it was swift and the inflows to the equity market were sizable.
In his fascinating book, The Money Flood: How Pension Funds Revolutionized Investing, the author delves into the impact of these new institutional entrants into the equities market. Prior to reading his book I was totally unaware that these types of investors had grown their stake in the stock market by nearly 20% each year between 1974 and 1980. This was BEFORE even more institutional cash flowed into the market during the robust bull market that started August 1982!
Black Monday was also the first meltdown heavily impacted by a growing reliance on computers to deliver orders to the market and to move cash between markets. Investors who were not around in the 1980s probably do not understand just how far we have come in 3.5 – 4 decades from a technology perspective!
Back in the late 1980s, the NYSE had automated parts of the process to handle customer orders. Its systems, however, were overwhelmed during the panic by the sheer magnitude of the number of orders delivered by the computers hooked up to Wall Street trading desks. In fact, the automated Federal Reserve system upon which banks relied to transfer cash was disabled for several hours at a time due to the sheer volume of transactions.
Black Monday was also different from the subsequent two major corrections because, in my opinion, this market correction did not have the same degree of warning flags. Perhaps this is because media coverage of the financial markets was undeveloped. I certainly do not remember news channels which overloaded viewers with market related information to the extent we experience today. Furthermore, we did not have internet access; those in their 20s and 30s reading this are probably wondering “How did you live? Did you rub two sticks together to start a fire to cook your meals?”
What typically happened back in the 1980s was you might hear of some news breaking event on the radio. If you were busy at work there was a strong probability that you didn’t hear about news breaking events unless it was by word of mouth or you were at home and the television channel was tuned to the evening news. If you failed to catch up on the news in the evening, you typically read about what happened the previous day when you opened the newspaper the following morning.
Lessons I Learned from Black Monday
The following are the things I learned after having lived through Black Monday.
Lesson 1: The #1 thing is that ‘stuff’ will happen and it can be swift and unexpected.
Lesson 2: As with anything else in life it is extremely important to have specific and measurable goals and objectives. If you keep your ‘eye on the prize’ it will help you ‘weather the storms’ that may arise.
Lesson 3: If you have expenditures which will be incurred within the next couple of years then investing in equities is probably not the place to park your money. Don’t believe me? Ask someone who had money invested in equities and had purchased a house with a closing date in the Spring of 2001!
Lesson 4: It might be all well and good to invest in equities but if you have a ‘boatload’ of high interest debt or if your free cash flow is negligible you are well advised to seriously consider making changes in these areas before investing in equities. Remember, ‘it is tough to soar with the eagles if the pigeons are doing a number on your head’.
Lesson 5: Learn how to analyze industries and companies and how to read financial statements.
Lesson 7: Look for industries with high barriers to entry and for monopolies or oligopolies (ie. do you see new national or multi-national railway companies springing up all over the place?);
Lesson 8: Don’t chase yield! In this current low interest rate environment you should be extremely cautious before initiating positions in equities with high single or double digit dividend yields;
Lesson 10: Tune out the noise. A huge percentage of what is broadcast on the media with respect to investing is ‘nice to know’ but be wary about relying on what you hear when making long-term investment decisions.
Lesson 11: Are you employing the use of leverage to help juice your investment returns? If so, remember leverage is a double-edged sword. In Berkshire Hathaway’s 2010 letter to shareholders Warren Buffett shared his position on the use of leverage (the Life and Debt section commences on page 21 of 27). Buffett’s view on leverage is that it can be addictive and significantly increases risk, which can result in bankruptcy for either individuals or corporations.
Lesson 12: Here is another pearl of wisdom from Warren Buffett:
“Only when the tide goes out do you discover who’s been swimming naked.”
We are a little over 8 years into the current bull market. I was expecting a correction by now but clearly I can’t accurately predict the future. I do know, however, that investors would be wise to adopt some degree of caution.
If, and when, we do get a market correction I would like you to look upon it as an opportunity to acquire shares in good, solid companies. Don’t be like those who panic, sell, and crystallize their losses. Re-read the previous section of this article and hopefully you’ll benefit from the lessons I learned from Black Monday.
Thanks for reading this article. Please send any feedback, corrections, or questions to [email protected]
Article by Charles Fournier, Sure Dividend