A History of the United States in Five Crashes

Book Preface

Crash. It’s a kinetic and evocative word and dramatic and frightening. It
means there’s a story to be told, because when two cars collide or a plane plummets from the sky there’s rarely a single cause. When the stock market crashes, vast sums are lost and people’s lives are changed, often drastically. But equally dramatic are the stories leading up to the crashes in the stock market, because amid the wreckage there are heroes, people who recognized the causes and catalysts and warned us of the immense drop looming or who did their best to stop it once it was in motion.
We invest in the stock market for many reasons, each of them good, including funding retirements and educations. The irony is that in funding our retirement we create new jobs. In financing educations we create more technology to learn about. The impact isn’t felt just here; as those investments are deployed around the world, problems are solved, new industries are created, and international economies grow—the American investor has probably done more good in this world than anyone else, with the exception of the American soldier.
The stories of markets, including of the modern stock market crashes, are ultimately fascinating personal stories. Some people saw the crashes coming, some unwittingly sped up the drop, some were more malicious, and some were just stupid or reckless.
What’s engrossing, and a bit scary, is that most of the people responsible for the modern stock market crashes thought they were operating in the public good. From a president who wanted more power for himself and less for “malefactors of great wealth”; to another public official who in an effort to help a friend fed a bubble that ultimately crashed; to academics who created an ingenious methodology that was supposed to wring most of the risk out of investing but instead manufactured an enormous new risk; to those who worked to make certain that every American could enjoy the satisfaction of owning his or her own home; and finally, to the ones who thought that automation would make trading less expensive and more efficient—those at the heart of these crashes were, without exception, warned that the courses they’d set were dangerous. We’ll read about the people and the warnings with the hope of learning to heed those warnings in the future.
But the subject isn’t just one of personal intrigue. The impact on investors has been profound. If one had invested $1 in the Dow Jones Industrial Average on December 31, 1899, it would have grown to $156.88 at the close of trading on the day of the last modern stock market crash. If that investor had avoided just one day, October 19, 1987, the balance would instead be $202.71. If that investor had avoided the five worst days, that balance would be $319.24, more than doubling his or her return.
Unfortunately, stock market crashes cost more than just money. They breed fear that causes people to refuse to invest, making it nearly impossible to finance creation of those jobs and advancement of those economies. And they create other unforeseen but enthralling problems. For example, it was a loss of confidence and refusal to invest in the early 1970s that led to the creation of the contraption that fueled the crash of Black Monday, October 19, 1987. We’ll learn the entire story.
For all the protections we put in place, stock market crashes are a function of the way markets, and the men and women who run them, operate. And that human element of the stock market is what makes crashes endlessly fascinating and also creates a unique prism through which we can view the prologue to the next crash while it is still likely years away. But as time passes, we forget the lessons learned, and as the particulars change, we lose sight of the fact that crashes don’t have a single cause that is easy to recognize before the damage is done. Instead every crash is caused by a unique confluence of usually personal events. Despite understanding this and despite our best efforts, it’s impossible to crash-proof our financial system, just as it’s impossible to eliminate automobile accidents. No matter how well engineered the car, no matter how conscientious the driver, someone will be human, perhaps when assembling one of the thousands of critical parts, or when operating one of the thousands of critical parts, or perhaps in a combination of both. Or perhaps the weather will just be bad or the other driver will be drunk.
Confirmation that our stock market will crash again can be found in the understanding that markets continue to crash, even though the five modern stock market crashes are strikingly similar and should teach us something. They share important phenomena, and some of them should be obvious to us, including steep appreciation in the stock market. Precisely how the market appreciates is common to the crashes; two-year periods of particularly aggressive buying inside a robust decade are common just before most of the crashes. Less obvious commonalities also appear, including new financial contraptions that we are (overly) confident we understand, only to learn that they inject uncertainty and leverage into the stock market at its weakest moment. The government also makes its appearance, often in an effort to eliminate a real inequity like competition-killing industrial monopolies or abusive leveraged buyouts. But the government often chooses the worst possible moment to intervene, having waited until the financial stresses are finally too much for their constituencies. When an external catalyst—often natural or geopolitical—pushes the system past the tipping point the market crashes, and the warnings that are also common to each of the crashes seem remarkably prescient. Why didn’t we listen?
Given the commonalities, how do we keep getting ourselves into situations in which we convince ourselves that this time it’s different? Often it’s the nature of the contraption that convinces us that much of the risk has been wrung out of the stock market.
In the 1920s the investment trust promised professional financial management and diversification, both of which were thought to reduce or eliminate risk, but instead the investment trusts increased risk. In the 1980s a wonder of complex mathematics known as portfolio insurance promised to provide a floor below which the value of a portfolio simply could not fall. Instead it increased the depth and velocity of the drop. Thirty years later, investment bankers and institutional investors were seduced by even more complex mathematics into believing that the value of mortgage-backed securities could not fall below a certain level.
While we watch these dangers build, the unknowable or unforeseeable element is the catalyst that will set it off. In 1907 it was as random as an earthquake, while in 2010 it was a riot in a place far away. Each of the catalysts initially seemed to have little, if anything, to do with finance. But our modern economies are intimately connected by finance—insurance in the case of an earthquake on our west coast or the price of crude oil and geopolitical turmoil in the Middle East, or the common European currency when it seems a country is dissolving into violence. These unpredictable catalysts take on critical financial importance.
The observable elements are necessary for a crash to occur but they aren’t sufficient. We should be able to recognize when a crash is possible even if we can’t be certain one will occur. If a catalyst is never introduced, the result will likely be years of poor stock market returns rather than the lightning bolt that creates chaos that destroys the fortunes of people who don’t know how they can recover.
It’s easy to believe the differences between our current financial world and that of even a few years ago—some call them advances—render another crash impossible. Unfortunately, it’s often those very changes that breed the next crash. In 1907 the simple act of paying an insurance claim could take weeks. To compensate for the losses incurred in the 1906 San Francisco earthquake, gold had to be loaded onto ships in London (the insurers were overwhelmingly British); they then sailed west. In the era before the 1914 opening of the Panama Canal, the trip would take weeks, and the only way to shorten it was to make port in Boston or New York and transfer the gold to a train that would set out on the multiday trip to San Francisco.

By 2010, the time required to consummate even the most complicated financial transaction had been reduced to a fraction of a second. Traders in Chicago or New York knew that they could effect a trade in about 20 milliseconds (one-fiftieth of a second). But 20 milliseconds was an eternity compared to what could happen when communications firms erected expensive microwave towers, which could shave 5 milliseconds off execution time. This often made all the difference in a market when the focus had shifted from what something was worth to how quickly it could be bought or sold.
This very advance in speed generated its own problem. As the system that relied on the speed of nearly instantaneous electronic trading was degraded, often without humans recognizing the delay, entirely new problems were created that led to a new kind of crash.
Einstein said that imagination is more important than knowledge because knowledge is limited to all we know and understand. He could have been referring to the causes of the past stock market crashes. On the other hand, imagination allows us to understand that even though the players have changed, the game is the same and we can imagine how the market will crash again.
This book tells the stories of what led up to the crashes of 1907, 1929, 1987, 2008, and 2010, the crashes themselves, and the elements shared by each past crash. Americans in the 1930s wondered if the stock market would ever regain the level reached on September 3, 1929. Even though the Great Depression, World War II, and a quarter century intervened, the stock market eventually reclaimed that level. The American stock market has always reclaimed its pre-crash level, but the danger isn’t that money is lost, it’s that time is lost as Americans turn from the market, reluctant to invest and participate in the recovery if lifestyles, retirements, and educations are at stake.
The stories are fascinating, but this book is also intended to give the American investor—one who, over time, has done so much good in this world—insight into the circumstances that can foster a crash. Forewarned is forearmed. If we’re paying attention.