Warren Buffett believes that mechanics in the stock market can make prices unexpectedly swing due to their rare interaction.
The security price oscillates with the forces of demand. It can drastically drop or surprisingly go up making some sell their holdings but giving a window to others.
From Warren's perspective, the mechanics can be of two types: short and long term. The business buying opportunity falls into the latter. The short-term philosophy is the dominant force that determines the price of the stock. And this is when the buyer sees his opportunity in the long term.
Although the theory may show that this situation is easy to handle, there are cases when there is no consistency between the company's information and the forces that make price swing. And there are two events that can clearly demonstrate it: the Panic of 1901 and the Panic of 1987.
Both were characterized by a crisis in liquidity. Let's give a brief explanation of them.
The 1901 Panic: Although it lasted only one week, it really caused panic. It started as a par game between E. H. Harriman and James Hill (including their bankers, Kuhn, Loeb & Company and J. P. Morgan and Company) regarding Northern Pacific Railroad.
What did the giants of the railroad industry used to do at that time? They would go into the open market and discreetly start buying stock to gain control before the market became aware and started pushing the stock price up.
In early 1901, James Hill and J. P. Morgan and Company held large interests in Northern Pacific Railroad, but none of them held majority control. In April of that same year, E. H. Harriman began to buy stock in secret, making its price rise 25%. That was not a surprise. The market had been rising too. But there was no suspicion of a takeover. Traders just thought that the Northern Pacific's stock had gone up too fast. Thus, they started to short it.
Northern Pacific's stock drastically jumped. There was still no suspicion of what was going on. Some thought it was market manipulation and thus, shorts increased.
On May 7, 1901, it was felt something was wrong. It was rumored that Harriman was making his final offer to take control of the company. Hill and Morgan learned this and tried to stop him by buying as much stock as they could to prevent Harriman from taking absolute control.
The market was trapped. But it would not have had such an impact if it hadn't been for people who shorted stock and couldn't cover their positions.
Buyers pushed the price to the ceilings, but there was no sale. Those who shorted started to panic. They couldn't deliver the stock and thus started to offer it. The share price was $1000. What did they do? They started to sell other holdings to cover their short positions.
Leading stocks fell 60 points while one only went through the ceiling. Those who were short in Northern Pacific saw they didn't have enough cash to cover those positions and reacted by selling other positions. They needed liquidity.
The rest of the traders, who thought something similar might happen in other companies, started selling their holdings.
The market was in turmoil, but for others it was a chance to buy at very low prices knowing that the market would stabilize.
The 1987 Panic: Although the SEC began to control the purchase of stock (unlike 1901) a crisis still occurred. In this case, with the presence of two new investment strategies — index arbitrage and portfolio insurance — the interaction of which severely damaged the market.
The 1987 decline in the market was caused by a surprisingly high merchandise trade deficit that made interest rates reach high levels, and tax legislation that led to the collapse of stock of a number of takeover candidates.
However, this was not all. Selling by mutual funds and portfolio insurers triggered others sales. The strategy of portfolio insurance involved using computer-based models to figure out the best stock/cash ratio at several market price levels. According to this strategy, portfolio insurers sell when prices go down and buy when they go up. Unbelievable!
Later on, portfolio insurers noticed that it was cheaper to sell S&P 500 Index commodities contracts, which enabled them to sell millions of dollars' worth of stocks for a discount. The price of the contract was equal to that of the stocks comprising a specific index and changed each minute, also reflecting changes in the underlying stocks.
The problem with S&P contracts was that the delivery was the cash difference between the contract price and the price of the S&P contract on its execution date.
In 1987, portfolio insurers not only sold billions in stocks on the NYSE, they also sold thousands of S&P 500 contracts. This massive selling drove the price of the commodities contract below the price of S&P 500 stocks.
And what happened with market makers on the NYSE floor? They had to buy everything that was sold. After five consecutive days of heavy selling, the market makers ran out of cash.
It was then when NYSE government noticed that they had to turn the system off, and the Federal Reserve Bank said it could fund the bank's system through its open-market operations. Fortunately everything worked out.
What you can learn about this situation? The forces that buy and sell don’t care about the businesses' economic situation. But there are times when these forces bring about great buying opportunities, as the one Warren Buffett had in 1987 with this crisis.
Despite these drastic ups and downs, business perspective buyers may have the chance to buy at very low prices. All in all, the situation stabilizes.
The security price oscillates with the forces of demand. It can drastically drop or surprisingly go up making some sell their holdings but giving a window to others.
From Warren's perspective, the mechanics can be of two types: short and long term. The business buying opportunity falls into the latter. The short-term philosophy is the dominant force that determines the price of the stock. And this is when the buyer sees his opportunity in the long term.
Although the theory may show that this situation is easy to handle, there are cases when there is no consistency between the company's information and the forces that make price swing. And there are two events that can clearly demonstrate it: the Panic of 1901 and the Panic of 1987.
Both were characterized by a crisis in liquidity. Let's give a brief explanation of them.
The 1901 Panic: Although it lasted only one week, it really caused panic. It started as a par game between E. H. Harriman and James Hill (including their bankers, Kuhn, Loeb & Company and J. P. Morgan and Company) regarding Northern Pacific Railroad.
What did the giants of the railroad industry used to do at that time? They would go into the open market and discreetly start buying stock to gain control before the market became aware and started pushing the stock price up.
In early 1901, James Hill and J. P. Morgan and Company held large interests in Northern Pacific Railroad, but none of them held majority control. In April of that same year, E. H. Harriman began to buy stock in secret, making its price rise 25%. That was not a surprise. The market had been rising too. But there was no suspicion of a takeover. Traders just thought that the Northern Pacific's stock had gone up too fast. Thus, they started to short it.
Northern Pacific's stock drastically jumped. There was still no suspicion of what was going on. Some thought it was market manipulation and thus, shorts increased.
On May 7, 1901, it was felt something was wrong. It was rumored that Harriman was making his final offer to take control of the company. Hill and Morgan learned this and tried to stop him by buying as much stock as they could to prevent Harriman from taking absolute control.
The market was trapped. But it would not have had such an impact if it hadn't been for people who shorted stock and couldn't cover their positions.
Buyers pushed the price to the ceilings, but there was no sale. Those who shorted started to panic. They couldn't deliver the stock and thus started to offer it. The share price was $1000. What did they do? They started to sell other holdings to cover their short positions.
Leading stocks fell 60 points while one only went through the ceiling. Those who were short in Northern Pacific saw they didn't have enough cash to cover those positions and reacted by selling other positions. They needed liquidity.
The rest of the traders, who thought something similar might happen in other companies, started selling their holdings.
The market was in turmoil, but for others it was a chance to buy at very low prices knowing that the market would stabilize.
The 1987 Panic: Although the SEC began to control the purchase of stock (unlike 1901) a crisis still occurred. In this case, with the presence of two new investment strategies — index arbitrage and portfolio insurance — the interaction of which severely damaged the market.
The 1987 decline in the market was caused by a surprisingly high merchandise trade deficit that made interest rates reach high levels, and tax legislation that led to the collapse of stock of a number of takeover candidates.
However, this was not all. Selling by mutual funds and portfolio insurers triggered others sales. The strategy of portfolio insurance involved using computer-based models to figure out the best stock/cash ratio at several market price levels. According to this strategy, portfolio insurers sell when prices go down and buy when they go up. Unbelievable!
Later on, portfolio insurers noticed that it was cheaper to sell S&P 500 Index commodities contracts, which enabled them to sell millions of dollars' worth of stocks for a discount. The price of the contract was equal to that of the stocks comprising a specific index and changed each minute, also reflecting changes in the underlying stocks.
The problem with S&P contracts was that the delivery was the cash difference between the contract price and the price of the S&P contract on its execution date.
In 1987, portfolio insurers not only sold billions in stocks on the NYSE, they also sold thousands of S&P 500 contracts. This massive selling drove the price of the commodities contract below the price of S&P 500 stocks.
And what happened with market makers on the NYSE floor? They had to buy everything that was sold. After five consecutive days of heavy selling, the market makers ran out of cash.
It was then when NYSE government noticed that they had to turn the system off, and the Federal Reserve Bank said it could fund the bank's system through its open-market operations. Fortunately everything worked out.
What you can learn about this situation? The forces that buy and sell don’t care about the businesses' economic situation. But there are times when these forces bring about great buying opportunities, as the one Warren Buffett had in 1987 with this crisis.
Despite these drastic ups and downs, business perspective buyers may have the chance to buy at very low prices. All in all, the situation stabilizes.
