Black Monday 1987

Kingswell asked Lynch about the folly of forecasting macro events, and his answer was that the consistent failure of macro forecasts — across decades, across forecasters, across regimes — is itself the strongest evidence that the activity does not pay. Lynch's Magellan record was built without a single correct macro call: he owned stocks through the 1979 oil shock, the 1981-82 recession, the 1987 crash, and the savings-and-loan crisis. In each case the macro forecasters were divided, and in each case the right action was to own businesses whose operating economics survived the macro event. Lynch's framing was that the macro economy has too many variables for any forecaster to model, and that the forecasts that turn out correct are usually correct for the wrong reasons. The forecasters who predicted the 1987 crash did so on the basis of a U.S. trade-deficit argument that turned out to be unrelated to the actual cause (portfolio-insurance mechanics). Being right for the wrong reason is no better than being wrong, because the rightness cannot be repeated. Lynch's Magellan compounding came from refusing to bet on macro forecasts and concentrating on the micro — the businesses whose cash flows he could underwrite from primary research. The article also touched on Lynch's view of 'Future Man' — his phrase for the contemporary habit of treating technological change as a foregone conclusion. Lynch's argument was that technology adoption curves are uncertain, that the beneficiaries of any given technology shift are usually not the companies the headlines mention, and that the investor who buys 'the future' at a hundred times earnings is paying for a forecast that has historically been wrong more often than right. He preferred to find the established businesses that the future, when it arrived, would benefit — and to buy them at prices that did not require the future to arrive on schedule.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Further Thoughts on Sea Change In May, I wrote a follow-up memo to Sea Change (December 2022) that was shared exclusively with Oaktree clients. In Further Thoughts on Sea Change, I argued that the trends I had highlighted in the original memo collectively represented a sweeping alteration of the investment environment that called for significant capital reallocation. This memo was originally sent to Oaktree clients on May 30, 2023.1 This Time It Really Might Be Different On October 11, 1987, I first came across the saying “this time it’s different.” According to an article in The New York Times by Anise C. Wallace, Sir John Templeton had warned that when investors say times are different, it’s usually in an effort to rationalize valuations that appear high relative to history – and it’s usually done to investors’ ultimate detriment. In 1987, it was high equity prices in general; the article I cite was written just eight days before Black Monday, when the Dow Jones Industrial Average declined by 22.6% in a single day. A dozen years later, the new thing people were excited about was the prospect that the Internet would change the world. This belief served to justify ultra-high prices (and p/e ratios of infinity) for digital and e-commerce stocks, many of which went on to lose more than 90% of their value over the next year or so.

to risk free as you can get) of close to 5%, why take the risk of investing in equities? The short answer is because equities provide a better return. For the period 1928–2023 (the earliest for which I can get reliable data), the annualised return on 10 Year US Treasury Bonds was 4.6% whereas the S&P 500 compounded at 9.8% with dividends reinvested#. This of course includes the Great Depression and World War Two as well as other more recent and lesser incidents like the 1987 Crash, the Dotcom meltdown, the Great Financial Crisis of 2008–09 and the Covid pandemic. This is unsurprising. Equities benefit from a feature which no other asset class, including bonds, can provide: a portion of the profit or cash flow which belongs to the shareholders is reinvested each year by the company. This is the retained profit which is not paid out as dividends, and its investment is the source of compounding which underpins the returns of long-term investment. In my view this is the least discussed and appreciated aspect of equity investment versus all other asset classes. So, if equities outperform bonds why are investors so keen to hold bonds at the moment? The answer of course is that whilst equities may outperform bonds over long periods of time, there is no guarantee that equities will provide this superior return in any given period, and in fact they may lose value for periods of time, as they did in 2022.cartoon:

Here’s how I built up to the conclusion cited above: It’s easy to say that something approaching panic is present in the markets. We’ve seen record percentage declines several times within the last month (exceeded since 1940 only by Black Monday – October 19, 1987 – when the S&P 500 declined by 20.4% in a day). This week and last included down days as follows: -7.6%, -9.5%, -12.0%, and -5.2% yesterday. These are enormous losses. . . . . . . there has been a rush to cash. Both long positions and short positions have been closed out – a sure sign of chaos and uncertainty. Cash in money market funds has © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The four most dangerous words in investing are “this time it’s different,” according to John Templeton, the 74-year-old mutual fund manager. At stock market tops and bottoms, investors invariably use this rationale to justify their emotion-driven decisions. Over the next year, many investors are likely to repeat those four words as they defend higher stock prices. But they should treat them with the same consideration they give “the check’s in the mail.” No matter what brokers or money managers say, bull markets do not last forever. It didn’t take a year. Just eight days later, the world experienced “Black Monday,” when the Dow Jones Industrial Average dropped by 22.6% in a single day. Another justification for bull markets is often found in the belief that certain businesses are guaranteed to enjoy a terrific future. This applies to the Nifty-Fifty growth companies in the late 1960s; disc drive manufacturers in the ’80s; and telecom, Internet and e-commerce companies in the late ’90s. Each of these developments was believed to be capable of changing the world, such that the past realities of business need not constrain investors’ imaginations and willingness to pay up. And they did change the world. Nevertheless, the highly elevated asset valuations they were thought to justify didn’t hold. In many bull markets, one or more groups are anointed as what I call “super stocks.

These things are innovative; they’re the reflection of people’s minds as applied to financial problems. But the tendencies of the human mind itself tend to rhyme over the years. By the way, the first time I ever came across the saying you mentioned – “It’s different this time” – was October the 11th of 1987. There was an article in The New York Times entitled “Why This Market Cycle Isn’t Different.” It talked about the fact that people often say it’s different this time and that this saying is generally employed to explain why historical norms don’t apply anymore: norms of valuation and the rhymes that I was just talking about. Anise Wallace wrote that article – it made a big impression on me – and she said, “You know what? This time it’s no different; these things will eventually lead to the same outcomes as they always have.” [The assertion that things were different was being used at the time to justify the very high stock market valuations. As it happens, the article ran just eight days before “Black Monday,” on which the Dow Jones Industrial Average declined by 22.6% in a single day.] Wallace mentioned that Sir John Templeton said, “About 20% of the time, things actually do change.” I wrote another memo within the last two years in which I said that, given the ubiquity of technology and the high rate of innovation, I think things actually do change more than 20% of the time. So you shouldn’t bet your life on the fact that the world doesn’t change.

There was nothing old-fashioned about his view of the economy or his grasp of changes in the world of finance. But alongside his innovative, cutting-edge work in portfolio theory, you’d still notice his fondness for old- fashioned, Midwestern values and habits. On the serious side, in business matters he was $%% percent concerned about any conflicts of interest. It never mattered to him if “everyone else was doing it”; that was never an acceptable answer to a question of professional ethics. This is a field with so much wealth being made, where it’s easy to lose sight of a tenth of one percent going astray, or one small corner of a bond coupon getting clipped off. For him basic honesty was at the core. It was a little like his sense of fairplay on the field, so if things got rough or bad calls got made, he was immediately right in the center of it. He could be all these things, the investment innova- tor, the fierce competitor, and the champion of the little guy. Timothy Sullivan (!." #$%&), Senior Director of Private Equity David always had tremendous confidence. There was a striking demonstration of that, back in $&#", a really defining moment in David’s career. I had only been in the office a little more than a year and he’d been there just a year or so longer. On Black Monday in October $&#", there was a real crash, when the mar- ket lost () percent of its value in one afternoon. A lot of people feared it would be $&(& all over again.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Which Way Now? In the last six weeks the markets have seen the best of times and the worst of times: • From February 19 to March 23, the U.S. stock market saw the quickest meltdown in history, for a loss of 33.9% on the S&P 500. Then its 17.5% gain from Tuesday through Thursday of last week made for the best three-day stretch since the 1930s. • Of the 21 trading days between February 27 and March 27, a total of 18 days saw moves in the S&P 500 of more than 2%: eleven down and seven up. They included the biggest daily percentage gain since 1933 and the second-biggest percentage loss since 1940 (exceeded only by Black Monday in 1987). • From March 9 through March 20, issuing a new investment grade bond seemed inconceivable. Then, as our trader Justin Quaglia points out, last week’s news of the government’s rescue package enabled 49 companies to issue $107 billion of IG bonds. That made it the biggest week for issuance on record; part of the biggest month on record ($213 billion from 106 issuers); and part of the biggest quarter on record ($473 billion, up 40% from the first quarter of 2019). In fact, there was more issuance last week than in nine of the 12 months in 2019. • Finally, on March 26, Justin wrote, “It’s hard to believe I used the words ‘panic’ and ‘FOMO’ within two weeks of each other.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: matter of days. The speed with which COVID-19 events are unfolding is astonishing, but so is the speed of the Fed’s response to financial strains. The Fed is in “whatever it takes” mode. Fiscal authorities will likely follow suit (especially when next week’s unemployment claims reading is a multiple of the highest reading we have ever seen in the past). The ECB joined the parade tonight. All these are appropriate actions. Hopefully we’ll see benefits from them and more. The Fed and Treasury will do everything they think might help. Clearly there’s little interest in abstaining simply because expenditures will add to the national deficit and debt. However, it’s unfortunate that there was no appetite for refraining from stimulus and restocking the tool kit during the period of prosperity that prevailed in recent years. No one knows whether that failure will inhibit the monetary and fiscal response. But I wish (for example) that we were cutting short rates from 5.0%, not 1.5%. Market Behavior A few observations regarding the markets: It’s easy to say that something approaching panic is present in the markets. We’ve seen record percentage declines several times within the last month (exceeded since 1940 only by Black Monday – October 19, 1987 – when the S&P 500 declined by 20.4% in a day). This week and last included down days as follows: -7.6%, -9.5%, -12.0% and -5.2% yesterday. These are enormous losses.

Lynch's experience of the October 1987 crash is one of the most retold episodes in his public commentary, in part because he was on a golf course in Ireland when the market lost twenty-two percent in a single session. By the time he could reach a phone and understand what had happened to his portfolio, Magellan had dropped from roughly twelve billion dollars to roughly eight billion. The episode is often cited as a lesson in the futility of attempting to time the market — Lynch, despite being one of the most plugged-in investors in the world, did not see the crash coming and could not have acted on it if he had. Lynch's retrospective on the crash emphasised two lessons. First, the volatility of an equity portfolio is the cost of capturing the equity premium; the investor who cannot tolerate the cost cannot capture the premium. Magellan recovered from the 1987 crash within two years and went on to compound substantially through 1990. The investors who sold on October 19 or 20 of 1987 locked in their losses and missed the recovery. Second, the crash exposed which positions had been bought on leverage or on margin — those were the positions that had to be liquidated into the falling market, while the unleveraged positions could be held and ultimately recovered. The deeper methodological lesson Lynch drew was that the holder of unleveraged equity in fundamentally sound businesses does not need to forecast crashes. The investor whose positions are sized so that no single drawdown forces a sale, and whose businesses are sound enough to recover their earnings power after a macro shock, can sit through crashes by default. The 1987 crash was, in Lynch's framing, less a forecastable event than a stress test of portfolio construction. The portfolios that survived were the ones whose position sizes and balance sheets allowed them to do nothing — and doing nothing was, in 1987, the action that produced the best outcome.

They will be hearing overwhelmingly compelling reasons why stock prices should go higher, why the bull market should last considerably longer than any other in history, why this boom will not be followed by a 1929-like crash and why “this time it’s different.” Many of these arguments will be tempting because they will have some element of truth to them. Even Mr. Templeton concedes that when people say things are different, 20 percent of the time they are right. But the danger lies in thinking that the different factor – like the recent investment in United States stocks by the Japanese – will be uninterrupted. Wallace’s essential message is that investors must take heed when the four words are in widespread use. Why? Look back at the paragraph introducing the above quote: when you first read it, did you happen to notice the date of publication? It was just eight days before Black Monday (October 19, 1987), the worst day in stock market history. We know how bad it feels when the market falls 20% in a year. Try 22% in a day!! Wallace’s warning was particularly important at the time the article was published, but for me it’s always important. * * * © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Lynch's response to recession worries in the post-1987 period was, characteristically, to ignore them. The 1988 Barron's Roundtable produced a list of twenty-one picks that Lynch had selected on bottom-up analysis, without taking a view on whether the U.S. economy was entering recession. His argument was that recessions are visible only in retrospect, that the equity market had already discounted the recession if it was coming, and that the investor who waited for the recession to be confirmed would miss the recovery. The Magellan portfolio was, in the post-crash period, a portfolio of businesses whose earnings would survive a recession and whose prices had been marked down to levels that already reflected recession risk. Lynch's argument against recession-timing was arithmetic. The U.S. economy had been in recession roughly one year in five over the post-war period. An investor who moved to cash ahead of every feared recession would have been right about one in three of those fears and would have sat out two-thirds of the recoveries. The arithmetic of being out of the market during recoveries — which tend to be concentrated in the first months after the recession ends — overwhelms the arithmetic of avoiding the recession itself. Lynch's view was that the recession-forecaster has to be right about both the timing of the recession and the timing of the recovery, and that the compound probability of being right on both is too low to justify the strategy. The 1988 picks list was, in retrospect, a reasonable portfolio of consumer and industrial names that compounded through the late-1980s expansion. Lynch's framing of the picks was that the businesses were growing earnings at rates that would carry the share prices higher over a three-to-five-year horizon, and that the macroeconomic path over that horizon was not the variable that determined the return. The discipline of looking through the macro noise to the underlying business is the discipline that the 1988 list illustrated, and the discipline that Lynch believed had produced the bulk of Magellan's outperformance over the prior decade.

Consider some of the extremes. At their peak in 1972, equity-oriented funds comprised 93% of fund industry assets. By 1974, a 50% stock market decline and net liquidations of fund shares had reduced total industry assets from $60 billion to $36 billion, a cool 40% decline. Then came the rise of money market funds, bailing out our shaken industry and producing a remarkable $270 billion of assets by 1982. At that point, money funds constituted an amazing 80% of industry assets, leaving equity funds with a residual share of 14%. Then, as long term interest rates moved well ahead of short-term money market rates, it was the bond fund segment that was the industry’s fastest-growing component. At the close of 1986, Bond fund assets of $240 billion actually exceeded equity fund assets of $180 billion. The 33% stock market crash of September-October 1987 contributed to the dimunition in equity fund share. But despite the fact that the full year 1987 saw the market rise, equity flows were negative in 1988, and didn’t return to 1986 levels until 1991, five years in which stocks were at bargain-basement levels. But with each acceleration in the great bull market, the equity fund share of industry assets increased apace—from 30% in 1991 to 40% in 1993, to 50% in 1995. As the cash began to roll in, the equity fund share leaped to 67% in 1998, and by the time March 2000 rolled around, equity-oriented funds laid claim to 72% of the assets of this then-$7 trillion dollar industry.

Despite the hysterical headlines this, in my opinion, falls well short of turmoil — a word frequently used to describe these events. October has been a notoriously bad month for stock markets in recent decades and an example of what might reasonably be described as market turmoil was so-called Black Monday 19th October 1987 when the Dow Jones Industrial Average Index (‘Dow Jones’ or ‘Dow’) fell 22.6% in a single day. That felt dramatic. I should know as I was in work that day on the trading floor of the investment bank BZW and when I went home I received a slew of sell orders from a large US client who rang me.had

not been restored from the hurricane, which struck on the previous Friday, adding to the dramatic effect. I can only imagine with some amusement how some of the commentators, ‘investors’ and market participants who are reeling from the events of this October and December would have performed in October 1987. A December 2018 Financial Times headline referred to ‘Wild market swings’ and whilst the author might like to blame the headline writers for hyperbole — they are trying to sell papers/pixels after all — the article described a recent one day fall in the Dow of 3.1% as ‘eye-popping’. The fall of seven times that scale in 1987 would surely have led to them to exhaust the lexicon of hyperbole. Who knows what might have popped then? Tumultuous, turmoiled or turbulent Black Monday may have been, but did it really matter? Take a look at the chart below of the Dow Jones and see if you can spot Black Monday. You will need good eyesight or reading glasses to do so. In the long term, it did not matter. However, this does not stop advisers and commentators predicting crashes and bear markets and suggesting you take preventative action which ranges from reducing your equity holdings, buying or ‘rotating’ into lowly rated so-called ‘value’ stocks, through to selling everything and holding cash to safeguard the value of your assets or buying Bitcoin (down 80% in 2018).

My guiding principles for dealing with such events and predictions are as follows: 1. No one can predict market downturns with any useful level of reliability. Forecasts of what may happen in the market are about as reliable as Michael Fish’s infamous denial that there would be a hurricane in the BBC weather forecast on 15th October 1987. 2. However, when one of the repeated warnings proves to be accurate the forecasters will ignore the fact that if you had followed their advice you would have forgone gains which far outweigh your losses in the downturn. I can now trace back six years of market commentary that has warned that shares of the sort we invest in and our strategy would underperform. During that time the Fundsmith Equity Fund has risen in value by over 185%. The fact that you would have forgone this gain if you had followed their advice will, of course, be forgotten by them if, or when, their predictions pay off for a period. I suggest you don’t forget it. 3. Bull markets do not die of old age so ignore warnings which are based on a phrase such as ‘This bull market has gone on for a long time.’ They usually die from some event, often but not always rising interest rates. 4. Bull markets climb a wall of worry. The troubling events you can readily see unfolding are rarely the cause of a bear market. Alan Greenspan had already described the market as irrationally exuberant in 1996, so we were in a worryingly well- developed bull market.

Competition for Enough.? LOTS OF BOOKS, YES, BUT ALSO LOTS OF PAPERS . . . Journal Papers by John C. Bogle Forthcoming The Index Mutual Fund— 40 Years of Growth, Change, and Challenge Jan/Feb 2014 The Arithmetic of "All-In" Investment Expenses Mar/Apr 2009 The End of "Soft Dollars"? Jan/Feb 2009 Markets in Crisis (Interview w/ Rodney Sullivan) Mar/Apr 2008 Black Monday and Black Swans Nov/Dec 2005 The Relentless Rules of Humble Arithmetic Jan/Feb 2005 The Mutual Fund Industry 60 Years Later: For Better or Worse? Jan/Feb 1980 Institutional Investment Performance Compared… (with Jan M. Twardowski) Nov/Dec 1970 Mutual Fund Performance Evaluation: Conventional vs. Unconventional May/June 1960 The Case for Mutual Fund Management (as John B. Armstrong) Financial Analysts Journal (10 papers) * * * *Graham and Dodd award winners AND THE JPM. . .

The extremeness of the bull-market upswing – just like the downswing of its bear-market counterpart – gives investors what should be an important signal. The Sure Thing Investors may profess confidence in their ability to grapple with the future, but deep down many sense their own limitations and feel at sea. Thus they’re prime targets for the newly minted “silver bullet” that’s touted as sure to deliver return without commensurate risk. They develop outsized confidence in it, especially if at first it provides the hoped-for results. The most attractive of these are often mechanical, since their perfection stems from a dependable machine rather than a mysterious swami.  In 1987, investors fell for “portfolio insurance,” under which they could take on disproportionately large equity allocations, secure in the knowledge that if the market started down, the technique would automatically enter sell orders. But when the Dow Jones Industrial Average fell 22.6% on Black Monday (October 19), many brokerage firms refused to answer their phones, the sell orders weren’t executed, and the “sure thing” turned out not to be.  In the early 2000s, “portable alpha” promised high returns by overlaying hedge funds with equity futures. But when stocks fell, it became clear that the previous high returns © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

That changed with the spread of the argument – associated primarily with Michael Milken – that incremental credit risk could responsibly be borne if offset by more-than-commensurate yield spreads.  Around 1980, debt securitization began to occur, with packages of mortgages sliced into securities of varying risk and return, with the highest-priority tranche carrying the lowest yield, and so forth. This process was an example of disintermediation, in which the making of loans moved out of the banks; 25 years later, this would be called the shadow banking system.  One of the first “quant” miracles came along in the 1980s: portfolio insurance. Under this automated strategy, investors could ride stocks up but avoid losses by entering stop-loss orders if they fell. It looked good on paper, but it failed on Black Monday in 1987 when brokers didn’t answer their phones.  In the mid- to late 1980s, the ability to borrow large amounts of money through high yield bond offerings made it possible for minor players to effect buyouts of large, iconic companies, and “leverage” became part of investors’ everyday vocabulary.  When many of those buyouts proved too highly levered to get through the 1990 recession and went bust, investing in distressed debt gained currency.  Real estate had boomed because of excessive tax incentives and the admission of real estate to the portfolios of S&Ls, but it collapsed in 1991-92.

© Oaktree Capital Management, L.P. All Rights Reserved  Most of the time, the end of the world doesn’t happen. The rumored collapses due to Black Monday in 1987 and Long-Term Capital Management in 1998 turned out to be just that. * -- Money has to be someplace; where would you put yours? If you put it in T-bills, what purchasing power would be accorded the dollars in which they’re denominated? If the government’s finances collapsed, what good would your dollars be, anyway? What depository wouldn’t be in danger? If you and many others decided to put billions into gold, what price would you have to pay for it? Where would you store it, and how would you pay for the truck to move it? How would you spend it to buy the things you need? What would people pay you for your gold, and what would they pay you with? And what if you bought credit insurance on all of your holdings: who would be able to make good on your claims? No, I don’t see any viable way to plan for the end of the world. I don’t know any more than anyone else about its probability, but I see no use in panicking. I think the outlook has to be viewed as binary: will the world end or won’t it? If you can’t say yes, you have to say no and act accordingly. In particular, saying it will end would lead to inaction, while saying it’s not going to will permit us to do the things that always have worked in the past.

But any misdeeds are likely to be symptomatic of a lax environment, not causes of the problem, and punishing them is unlikely to be an effective part of the solution. UEliminating the Fear of Loss A couple of weeks ago, I had a great talk with Tom Petruno, an insightful business reporter for the Los Angeles Times. Calling on our shared experience as Californians, he presented what I consider a very apt analogy. It went like this: We’ve all heard about the connection between the Fed’s actions and moral hazard. There’ve been many incidents and scares over the last couple of decades: Black Monday, the meltdown of Long-Term Capital Management, Y2K, the bursting of the tech bubble, 9/11, and a recession here and there. Each time, the Fed rushed in with interest rate cuts and increases in liquidity designed to prevent or offset their depressing effects. A few times, it was said, these actions averted a collapse of the world financial system. But the cost was moral hazard: a growing expectation that the Fed would bail out imprudent risk takers. By behaving in ways that cause people to think they’ll always come to the rescue, authorities encourage risky behavior. And we all share the cost of rescuing the risk takers, whether we participated or not. In this way, the risk taking encouraged by the Fed’s policy of protecting participants caused the risks to grow ever- higher.

 But while the quants’ predictions usually center on the high probability that events will fall within the normal range, the last nine months have given all of us the opportunity to witness events at the extreme. This started last summer, when “once-in-a-lifetime events” became common. David Viniar, CFO of Goldman Sachs, may be remembered for saying in August that “we were seeing things that were 25- standard deviation moves, several days in a row.” It’s unusual for 100-year floods to become daily occurrences, but sometimes they do.  Finally, I’ve reminded readers about past bull market innovations that promised miracles but often failed when tested in bear markets. One of the most easily recognized of these is “portfolio insurance.” PI was a statistically derived technique that would enable equity exposure to be increased without a commensurate increase in risk. This was made possible by a process through which computer-generated sell orders would be implemented automatically in the event of a market decline, instantaneously scaling back portfolio risk. PI had its heyday in the period just before “Black Monday.” But then, on October 19, 1987, the U.S. stock market declined 20%; beleaguered brokers didn’t answer their phones; the sell orders weren’t implemented; and PI ceased to be heard of. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

A few months ago, the twentieth anniversary of Black Monday gave me the opportunity to reflect on the short life of portfolio insurance. I began to think – and now I’m convinced – that PI didn’t fail because Black Monday just happened to occur. Rather, it contributed to Black Monday’s occurrence, and thus to its own demise. In my December memo “No Different This Time” I listed twelve lessons of 2007. Number four said that “widespread disregard for risk creates great risk.” In that way, in 1987 the widespread belief that equity exposure could be increased without similarly increasing risk led to an unjustified – and unsustainable – expansion of equity allocations. And the carefree buying this generated led to elevated stock prices from which a retreat was increasingly likely. When the S&P 500 fell 10% on the Wednesday-Friday leading up to Black Monday and users of PI had the weekend to think things over, it seems they concluded that they had accepted too much risk; that they couldn’t depend on PI to save them; and that they had to dump stocks en masse. Thus, this innovation was not undone by a chance event. Its undoing was brought about by an event which it had, at least in part, caused. Innovation generally requires bullish assumptions, and thus it’s easily accomplished in bullish times. Those optimistic assumptions add to the risk in the environment, and when eventually proved to be too rosy, they contribute to losses and to the products’ failure.

When I was a kid, there were a lot of cartoons showing men carrying sandwich boards (who remembers what they were?) that said, “The end of the world is at hand.” So far, though, they’ve been wrong. Likewise, people said we had approached the end of the financial system around Black Monday in 1987, and when LTCM melted down in 1998. But we’re still here. It seems we muddle through, despite all attempts to screw things up. It’s my guess we always will. It’s tempting for worriers like me to consider apocalyptic possibilities. But it’s not productive, so I’ve quit. I can come up with “China Syndrome” theories, but (a) I can’t give them a high probability of coming to pass, and (b) there’s little I can do. The things one would do to gird for the demise of the financial system will turn out to be huge mistakes if the outcome is anything else . . . and chances are high that it will be. * * * Fortunately, one of the most valuable lessons of my career came in the early 1970s, when I learned about the three stages of a bull market:  the first, when a few forward-looking people begin to believe things will get better,  the second, when most investors realize improvement is actually underway, and  the third, when everyone’s sure things will get better forever. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Black Monday and Black Swans Remarks by John C. Bogle Founder and former chief executive, The Vanguard Group before the Risk Management Association Boca Raton, Florida October 11, 2007 Just a week from tomorrow, we’ll mark the twentieth anniversary of what came to be known as “Black Monday,” October 19, 1987. On that single day, the Dow Jones Industrial Average dropped from 2246 to 1738, an astonishing decline of 508 points or almost 25 percent. The drop was nearly twice the largest previous daily decline of 13 percent, which took place on October 24, 1929 (which became known as “Black Thursday”), a distant early warning that the Great Depression lay ahead.1 From its earlier high until the stock market at last closed on that fateful Black Monday of 1987, some one trillion dollars had been erased from the total value of U.S. stocks. The stunning decline seemed to shock nearly all market participants. But there were some veterans whom it didn’t surprise. Ace Greenberg, former chairman of Bear Stearns, was quoted in the newspapers as saying, “So markets fluctuate. What else is new?” And only a year before Black Monday, I observed to the Vanguard crew that even a 100-point decline in the Dow—something that had never before occurred—was possible. Why? Because, as I observed, “in the stock market, anything can happen.” That truism remains, but I’d argue the point even more strongly today.

Black Monday, then, was a Black Swan. Unlike its 1929 antecedent, however, Black Monday was not a warning of dire days ahead. If anything, it was, totally counterintuitively, a harbinger of the greatest bull market in recorded history. The Black Swan, as most of you are likely aware, is also the title of a new book by Nassim Nicholas Taleb. Here is his definition of the characteristics of a black swan, in our markets, and, for that matter, in our lives: 1. An outlier beyond the realm of our regular expectations. (Rarity) 2. An event that carries an extreme impact (Extremeness) 3. A happening that, after the fact, our human nature enables us to accept by concocting explanations that make it seem predictable (Retrospective Predictability) So there it is: Rarity; extremeness; and retrospective predictability. Together they define the occurrence of an event that is regarded as impossible, or at least highly improbable. What’s more, as Taleb notes, a Black Swan is also the reverse of this definition: The non-occurrence of an event that is regarded as highly probable. Life is full of them! Today I observe little concern about the ever-present possibility that what will occur in our financial markets in the coming months (or years) might in fact prove to be a non-occurrence of what we expect. Indeed, despite the recent wild disturbances in both the stock market and the bond market, most market participants seem confident that future returns will resemble those of the past.

1,000 A Fibonacci Sequence 1b. A Fibonacci Sequence 1a. ancestors called “the Golden Mean,” appearing all through civilization, notably in nature, in architecture, and, more mundanely, in the size of book covers and playing cards. Mandelbrot applies this concept to the daily price movements of the Dow Jones Industrial Average. Nearly always (since 1915), the standard deviation (Sigma) of the daily change in the Dow has been about 0.89 percent. (Chart 2) That is, two-thirds of the fluctuations were within 0.89 percentage points (plus or minus) of the average daily change of 0.74 percent. Nonetheless there are frequent occasions with standard deviations of 3 or 4, infrequent occasions when it exceeds 10, and just one 20- Sigma event. (The odds against such a happening are about 10 to the 50 th power.) Black Monday, of course, was that 20 and Black Thursday was that 10-Sigma event. (The possible 100-point decline that I contemplated back in 1986 would have been a 6-Sigma event.) While our markets are periodically defined by fractals and power laws (although we never know when), there are many areas in which they do not apply. The classic example is in the height of men, or the extremes of temperature, or the flipping of coins. (Chart 3) These patterns lend themselves to Gaussian (standard-frequency) distribution curves, familiarly known as bell curves.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Returns, Absolute Returns and Risk U What’s In a Name? My memos often touch on the subject of investors’ foibles, one of the worst of which consists of their tendency to pay too much attention to labels (and too little to substance).  Enthusiasm for “growth stock investing” carried investors to the ridiculous conclusion that for the stocks of the fastest-growing companies, no price is too high. That was just before the “nifty-fifty” stocks of America’s best companies lost up to 90% of their value in 1973-74.  “Portfolio insurance” assured investors they could participate fully in stock market gains with protection against declines if they would simply commit to automatically enter sell orders pursuant to an algorithm. But in the crash of October 1987, investors found themselves unable to make those sales, and the ineffectiveness of the “insurance” (combined with the outsized positions it had encouraged) cost them dearly. And at any rate, portfolio insurance, like any mechanical risk-limiting device, should have been expected to limit long-term return as well as risk. After all, there rarely is a free lunch.  “Market neutral” funds were supposed to be insensitive to market fluctuations, but the so- described Granite Fund of mortgage-backed securities melted down in just a few weeks when it turned out not to be insulated from the rapid rise of interest rates in 1994.

© Oaktree Capital Management, L.P. All Rights Reserved * * * The most noteworthy feature of the recent correction may be the role of some prominent hedge fund managers. It was reported on February 25 that George Soros's Quantum Fund had lost $600 million on its yen position in one day. On April 1, we read that Michael Steinhardt had lost $1 billion of his $5 billion under management, due largely to the drop in bond prices, and that in the last two months, investors in Askin Capital Management's Granite Funds may have lost 100% of their $600 million capital in mortgage backed securities. Hedge funds occupied a meaningful part of our February 17 memo because they were felt to exemplify (to a power of ten) the risk-tolerant behavior of investors in general. Thus their subsequent experience can offer us some valuable and highly magnified insights. The important observations, applicable to all investment behavior, are as follows: - Words alone mean very little. Just as "portfolio insurance" turned out in the 1987 Crash not to insure much, today's startling losses indicate that many "hedge funds" don't really hedge enough to make a difference, and that the Granite Fund, which described itself as "market neutral," was anything but. - Following from the above, we are reinforced in the belief that some investors don't know what their managers are doing, or how much risk they're taking.

Yet investors, normally quick to snap up anything offering better yields than CDs and money-market funds are staying away. Assets of convertible funds stood at $2.36 billion on June 30, up just $ 100 million since the start of the year, and way below their peak of $5.3 billion just before the 1987 crash. Reaction was negative, and convertible mutual fund assets dropped to $3.2 billion at year-end 1989 and only $2.2 billion today, down 62% from the 1987 level. If strong inflows are, as I believe, a precursor of poor performance (and vice versa), then the outlook today should be excellent. Convertibles are getting no respect and attracting no inflows. That leaves bargains for those willing to act as contrarians. We hope you will consider convertibles an attractive way to hold an increased portion of your commitment to equities. October 8, 1992 Between 1977 and 1984, the number of convertible mutual funds was constant at seven, and at the end of that period their total assets stood at the princely sum of $452 million. By the end of 1987 there were thirty funds with assets of $5.8 billion, for a thirteen-fold increase. It can clearly be seen in retrospect that the strong flow of capital into convertibles in 1985-87 “poisoned the well” and led to a loss of price discipline, to purchases of over-priced securities, and to poor performance.

After the October 1987 crash, Philip Fisher made the rare decision to liquidate nearly all his personal stock holdings in a matter of days, concluding that the systemic backdrop had changed too much to trust the market's structure. The episode became one of the most discussed departures from his own buy-and-hold doctrine, showing that his rules were rooted in conditions rather than dogma — when the plumbing of the market itself looked broken, he chose survival over consistency.

Members of Fisher's family later recalled that his 1987 sale was not a valuation call but a recognition of what portfolio insurance and program trading were doing to market behavior. The lesson his son Kenneth drew from it was about humility under regime change: a framework built in one market structure may need to be suspended when the structure itself mutates.

Fisher's grandson Ken Fisher has written that Philip regretted aspects of the timing but never the logic of reassessing everything after a structural break. The incident is usually cited as a counterpoint to the caricature of growth investors as permanent holders, and as evidence that Fisher treated his fifteen points as tools of judgment, not a religion.