Morning Report: Reflections on the Crash of 1987 10/19/17

Vital Statistics:

Last Change
S&P Futures 2547.0 -13.0
Eurostoxx Index 388.1 -3.5
Oil (WTI) 51.2 -0.9
US dollar index 86.5 -0.2
10 Year Govt Bond Yield 2.31%
Current Coupon Fannie Mae TBA 102.875
Current Coupon Ginnie Mae TBA 103.938
30 Year Fixed Rate Mortgage 3.9

Stocks are lower this morning on overseas weakness. Bonds and MBS are down small.

Initial Jobless Claims fell to 220,000 last week which was the lowest since we still had a military draft. If you correct for population growth, the number is even more impressive. Note that last week included the Columbus Day holiday, so the number should be taken with a grain of salt.

The Conference Board Index of Leading Economic Indicators slipped in September for the first time in a year as hurricanes depressed activity. The main source of weakness was in the labor market and residential construction.

The Fed’s Beige Book summary of economic conditions reported that activity was between “modest” and “moderate” for all of the 12 districts in September. Hurricane-related disruptions were reported as a drag on the economy. The labor market remains tight, with shortages in many industries, including construction, health care, and transportation. While wage growth overall remains soft, we are seeing some evidence of wage pressure increasing in these areas, as firms are adding signing bonuses, overtime, and other non-wage benefits.

The trend of larger houses and smaller outdoor spaces is being reversed, as materials costs are making larger homes unaffordable for many buyers. The average square footage of outdoor space has increased 7,048 square feet. Yard sizes peaked in the mid 70s, at around 12,000 feet before bigger and bigger houses became the norm. Since 1973, the average size of a single family home increased 62% to 2,467 square feet.

For an example of rising materials costs (aka sticks and bricks) here is a chart of lumber futures going back to the mid 80s. We are at prices not seen since the bubble.

lumber futures

You see some of this in the suburbs of Manhattan, where luxury homes languishThis home was first listed at $17.35 million in 2 years ago, cut to $11.5 million and still hasn’t sold. It was taken off the market in September. All real estate is local, and the Northeast is pretty much the opposite of the West Coast, where demand is overwhelming supply.

Brian Montgomery, Donald Trump’s nominee to run the FHA, represented banks for years, helping them fight penalties imposed by the agency. Many on the left are worried that he will be unable to think solely from the perspective of the public interest. The government wants to see more FHA lending, but the Obama Administration’s use of the False Claims Act (which awards treble damages) has driven the business to smaller non-bank lenders. HUD Chairman Ben Carson recognizes the issues with FHA lending, and wants to see a more balanced approach.

Today is the 30 year anniversary of the Crash of 1987, where markets fell 23% in one day. Many people blamed program trading and wonder if the same thing could happen today as high frequency traders dominate the market. That is certainly a possibility, however high frequency traders usually step away from the markets once volatility kicks up, so they probably wouldn’t force stocks down, the way portfolio insurance did in the mid 80s. The biggest risk today is that liquidity will vanish at the worst possible time. Technology and regulation have reduced stock trading commissions and bid / ask spreads to almost nothing, and have driven the market-maker and stock specialist (the “traffic cops” who helped maintain an orderly market) out of business.  IMO, flash crashes we have seen will probably be the model this time around, where volume becomes so light that a few market sell orders can drive stocks down to nothing. We saw this happen before, where well-known, profitable and solvent companies were driven to a penny a share. The next crash will be an interesting test whether exchange traded funds are all they are cracked up to be as well, especially if we see a big divergence between NAV and trading prices.

The Crash of 87 also ushered in the Greenspan Put, which got its name after Fed Chairman Alan Greenspan assured the markets that the Fed stood by ready to provide liquidity as needed in the aftermath of the crash. This probably prevented the crash from turning into a wholesale financial crisis, however that policy became more or less codified to where the Fed began to ease whenever asset markets had a hiccup. It prevented a recession in the mid-90s, which could have occurred after any one of financial hiccups, whether the MBS implosion in 1994, Long Term Capital Management, or the Asian Financial Crisis. The idea that the Fed would save the day with interest rate cuts or more liquidity whenever asset prices fell became known as the Greenspan Put, which had the effect of lowering risk premiums and making investors more willing to pay high multiples or earnings. Stocks became a “can’t miss” proposition. (Remember the talking heads on CNBC? Don’t worry about P/E ratios – just buy “quality” companies.) The poster child of this theory was Cisco Systems, which hit a high of over $77 a share in early 2000 and is less than half that today, over 17 years later.


The Greenspan Put also set the stage for the residential real estate bubble of the mid 00s. Years of easy money found its way into different asset classes, especially the residential real estate market. Nobody wanted to talk about Cisco any more, they were too busy flipping condos in Las Vegas. Rock bottom interest rates had investors reaching for yield, which made for an insatiable appetite for mortgage backed securities. We all know how that ended. And even today, people are willing to tie up their money for 30 years lending to the US government at 2.8% while we have a Federal reserve hell-bent on creating inflation. Or they are invested in auto asset backed securities, lending for 8 years at 3.2% for an asset that depreciates like sushi. It is strange to think how this state of affairs was largely the unintended consequence of well-intentioned Fed policy in the aftermath of the Crash of 1987.

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