The 1987 crash was arguably caused by portfolio insurance, one of whose basic principles was that each of its practitioners could close open (long) positions before everyone else tried to get out. If I understand the mechanics of putting on the carry trade, it embodies the same basic idea, with all but the swiftest being crushed as the crowd runs for the exits.
Could that be the link between 1987 and 2004?
Minyan Ben Richter
I wrote a piece entitled "The Rear View Mirror" that explains the very large role that portfolio insurance played in the 1987 crash. What the reader is referring to, and what portfolio insurance caused in stocks in 1987, can be termed "compression": too many market participants trying to exit all at the same time. Over an unspecified period of time, a market becomes saturated with too many participants with too much money. Because they are entering for other reasons than value, at some point selling begets selling.
Portfolio insurance was a structural cause of compression. There are other more psychological causes like momentum trading: buying something because it is going up and selling it because it is going down. Over some unspecified period of time, buying begets buying where trading is not based on any value per se, but on price. Each up-tick in price attracts the next momentum buyer. At some point the market becomes exhausted since there is demand only from one source, those who hope that there is another behind them that will pay a higher price; there is no demand from the ultimate buyers, the buyers of value. At this point, marginal selling begins to cause more selling as the last participant realizes that he may indeed be the last.
In order to better understand momentum, let's look at an extreme case called a Ponzi scheme.
One day Sheryl got a call from her neighbor Francesca. "Sheryl, if you are not doing anything tonight, you have to come with me to this party they call the Pyramid held once a month. One of the girls down at the office got me involved two months ago. I know it sounds too good to be true, but I think I have found a fool proof way to make lots of money for no work."
Sheryl was skeptical, but agreed to go and on the way Francesca described how the "party" works. "First I gave $1000 to my friend who was already involved in the Pyramid. This gave me the right to participate in the process. My friend keeps $500 and gives $500 to the person that got her involved, her "sponsor". My friend also has several others that she sponsored and receives half of their money that they bring in. Any money she receives she then passes on half up to her sponsor, who then gives half of that amount to her sponsor, and so on.
"They call it the Pyramid because there are layers of people on up to just one person that started it. Smaller and smaller amounts of money flow up to these people, but there are so many below them that they are making a fortune. The more people we get involved, the more money we will make. First I sponsor you and then you sponsor others. I think this could go on for a long time; there are a lot of people out there!"
Sheryl was excited by Francesca's enthusiasm, that is until she got to the party. She entered the party hall, a huge place, and was shocked at the number of people milling around. There had to be 1000 people there! Sheryl looked up at the back wall where they had a huge board that looked like a pyramid. On the board were name plates, all arranged in a diagram that resembled a corporate personnel chart: lines connected names that led up to fewer and fewer names at the top. Along the sides of the names were numbers that indicated amounts paid and amounts received. Some of the names at the top had staggering amounts of money, a good advertisement for most. But Sheryl was not most.
She couldn't take her eyes off of the lowest rung, while most kept looking at the highest. While most were hopeful and excited that they too could make the kind of money that those at the top had made, Sheryl was getting more and more concerned that those at the bottom had not. And there were a lot of them. What if they couldn't get anymore people in? What type of person plays this sort of game and how many more could there be? Most people were conservative, she certainly was. Sheryl was thinking more about the risk than the reward at this point.
Sheryl turned to her friend and told her that this game was not for her. Her friend looked crestfallen. A few bystanders heard their conversation. As Sheryl walked out the door and left her friend standing there, rumors started flying, as they inevitably do. "The game was having trouble bringing in other people" one person whispered. All of a sudden the psychology of the room changed. Soon several others walked out the door, much to the consternation of their prospective sponsors.
A week later Sheryl saw Francesca in the coffee shop, looking rather sheepish. Francesca told her the horrible story of how the whole Pyramid collapsed in just a few days. All those including Francesca on the bottom rung had lost their "investment".
Sheryl was sorry for her friend, but couldn't help but smile on the way out the door.
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