Learning to Embrace Panic Is the Lesson of Black Monday

The Dow Jones Industrial Average crashed 508 points on Oct. 19, 1987 — 30 years ago last Thursday. It was a 22% catastrophe immediately known as Black Monday.

This first crash of the modern financial system seemed to expose a glitch in the markets. But the real danger is that it made a generation of investors afraid.

In reality, investors should not fear crashes. Those are rare. Investors should instead learn to embrace panic, and prepare to take advantage.

The market may have fallen 22% that day, but if that scared you away from stocks, you made a big mistake: The S&P 500 is up 810% since Black Monday, and the Nasdaq-100 is up 3,230%. Microsoft (MSFT) alone is up more than 25,000% since the crash. And biotech Amgen (AMGN) is up some 37,000%.

I’m not arguing against diligence. Understanding risk is important. Stocks can, and do, become too expensive or over-popular. There is nothing wrong with waiting for better opportunities. Just be sure you act in accordance with your research, and not your fears.

Matt Levine is a columnist for Bloomberg View. As an ex-investment banker and mergers-and-acquisition lawyer, Levine has a unique take on risk. He’s insightful and witty. Lately, an important motif has been weaving through most of his columns.

In a nutshell, strategists are worried because professional money managers don’t seem to be worried enough. Call it the “lull before the storm” thesis.

Volatility is supposed to measure investors’ appetite for risk. When it is shrinking, the theory says they are complacent. Volatility, as measured by the S&P 500 Volatility Index ($VIX), is making new lows. Actually, the VIX has been on a steep downward trajectory since the bear market bottom in March 2009.

Strategists say the record complacency is fertile ground for a stock market crash.

Levine, with a tip of the hat to Ben Eisen at The Wall Street Journal, takes the opposing view. When professionals are feeling especially smug, they resort to excessive leverage. It is in their DNA. Think 2008, pre-financial crisis.

But today, they are not doing that. According to Levine, the mood is more a constant state of low-level panic.

When bad news hits, there is no frenzy to unwind huge leveraged positions because pros don’t feel confident enough to add them in the first place.

“You shouldn’t be worried people aren’t worried enough, because the reason they don’t seem worried enough is they are so worried they forget to be worried,” Levine quips.

It is a clever, real-world analysis. And it makes perfect sense. It also explains the unusually subdued rally since 2009. No leverage. There have been no crazy spikes higher. Meanwhile, every dip has found ravenous buyers. The trend has never been in doubt.

In the process, volatility has slumped to one record low after another.

I’m not surprised. Over time, investment strategies that focus on market volatility, and the potential for a stock market crash, have not worked — and probably will never work.

Investors should be constantly poised for spikes of volatility that stem from momentary panics, and capitalize on them.

Panic shakes valuable stocks out of weak hands at low prices. Smarter investors swoop in and pick up those bargains that panics create.

My goal is to find great companies dominating niche industries. I look for growing cash flow, strong operating margins, minimal exposure to the economic cycle, and competitive advantages.

I focus on the ability to deliver scale and value to shareholders year in and year out. Then I try to wait for a momentary panic to buy them at low prices. Because companies in low-volatility businesses tend to fly under most other investors’ radars. They keep doing their thing and quietly become market leaders … all the while rewarding their loyal shareholders with capital appreciation and, in many cases, dividends or other special payments.

Related story: Here’s why most other kinds of stocks, frankly, suck.

In summary, during this 30-year anniversary of Black Monday, investors should try to heed the right lesson of history. They should not anchor their strategies around avoiding crashes. Those happen far too infrequently and, as history shows, the decline becomes a buying opportunity.

Investors should focus on finding the stocks they want to own, then buying them into weakness, when they are priced right.

Best wishes,

Jon Markman