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Introducing an Important Book
on Stock Market Crashes
by Bruce I. Jacobs
Endorsements
Capital Ideas and Market Realities:
Option Replication,
Investor Behavior,
and Stock Market Crashes
By Bruce I. Jacobs,
co-founder and principal of Jacobs Levy Equity Management
With a Foreword by Harry M. Markowitz, Nobel Laureate
“Wall
Street’s equivalent of the movie Nightmare
on Elm Street – Part 10. Portfolio insurance/dynamic hedging, the Freddy
Krueger of the 1987 stock market crash, is back again with the recent growth of
options and swaps. Jacobs builds the case for how portfolio insurance and
dynamic hedging exacerbated the 1987 crash and points out that dynamic hedging
may have played a similar role in recent periods of market volatility. And he
draws unsettling parallels to the market turbulence surrounding the collapse of
Long-Term Capital Management: the forced selling of overleveraged arbitrage
positions, the ‘illusion’ of market liquidity, and the frontrunning by
competing traders.”
Robert Glauber, Executive Director, Brady Commission and
former Under Secretary of the Treasury; currently Chairman and CEO, NASD
“Bruce Jacobs, an investment manager who predicted before the
1987 crash that portfolio insurance would trigger chain-reaction selling,
recently forecast that option-strategies (‘the sons of portfolio insurance’)
would play a similar, though more muted, role in a future debacle. Monday
[October 27, 1997] provided damning evidence.”
Roger Lowenstein, in The Wall Street Journal, November 6,
1997
“Every fiduciary should read this book. Investors have too
often been taken in by promotions appealing to their basic human instincts of
fear and greed. Bruce Jacobs shows how supposedly low-risk, seemingly
infallible, investment strategies can backfire. His views on portfolio insurance helped steer our profit sharing
fund away from that craze in 1987.
Today, especially in light of the Long-Term Capital Management fiasco,
investors should know what Bruce has to say about derivatives trading
strategies and market crashes.”
John E. Stettler, Vice
President-Benefit Investments, Georgia-Pacific Corporation
“Bruce
Jacobs demonstrates effectively that trend-following strategies like portfolio
insurance are fair-weather techniques that may add to, rather than minimize,
troubles when a major crash occurs.”
Charles P. Kindleberger,
author of Manias, Panics, and Crashes: A
History of Financial Crises
“Bruce
Jacobs has created an instant classic. Capital
Ideas and Market Realities demonstrates how products that appeal to
investors’ fears of short-term losses often ignore prudence and long-term
value. These products can fail to
provide the riskless return their vendors promise, and they can actually create
risk for all investors, in the form of market instability. This book is a must read for every
investor.”
Brian Bruce, Editor-in-Chief, The Journal of Investing
“Jacobs'
book will be an education to the newcomers, a reminder to the veterans, and a
warning to all [pension fund and other investors] that the dangers of options
replication are not behind us. It should be read by all. And it is to be hoped
his warnings this time will be better heeded than his warnings [on portfolio
insurance] of 1983.”
Michael J. Clowes, Editorial Director, Pensions & Investments, July 12,
1999
“With
the U.S. stock market continuing to punch through record levels, pundits
occasionally trot out the usual suspects that might end the financial
exuberance. One money manager is warning about a very different and more
complicated scenario. You're not likely to hear about it at cocktail parties.
But Bruce Jacobs may have history on his side. Capital Ideas and Market Realities argues that recent market breaks
have been caused by new forms of derivatives-related trading. In 1987 a
then-popular form of [derivatives-related] hedging was blamed for at least
exacerbating if not causing the market crash. (Jacobs became an instant hero
for steering Prudential away from the technique.) Now Jacobs warns darkly that
a similar phenomenon has taken hold, through the use of options and dynamic
hedging.”
Alyssa A. Lappen, Institutional Investor, August 1999
“A
book for market professionals written by a consummate professional. I saw the
period leading up to the 1987 crash and the debate afterward through the eyes
of a technical analyst. Bruce Jacobs' book puts the whole era into a format we
can all understand. He looks at option-replication strategies in 1987 and
dynamic hedging today and gives us a hard look at the risks these programs
present.”
Bruce M. Kamich, Director, Market
Technicians Association
“Understanding the limitation of certain trading
strategies is critical to making an informed investment decision. This book is
therefore relevant to all investors, traders, arbitrageurs, trustees of pension
funds, consultants and private client managers.”
Shanta
Acharya, The Times Higher Education
Supplement, November 19, 1999
“The book mounts a powerful
argument against the notion that somehow risk can be disconnected from reward
if enough professors of finance work at it. It should resonate especially with
investors who hold the long-term view.”
Porus
P. Cooper, Global Investment,
December 1999
“Will
sophisticated financial theory ultimately eliminate the risks from investment?
Bruce Jacobs argues all too plausibly that growth in over-the-counter equity
derivatives markets will cause increasing market turbulence. The effect of
complex derivatives strategies like those of LTCM has, after all, been to
encourage the illusion of liquidity and destabilise markets.”
John Plender, Financial Times,
January 3, 2000
“The
most fascinating account concerns the recent collapse of the hedge fund
Long-Term Capital Management. Once again there was the illusion that with the
aid of modern financial theory, and its quantitative practitioners, risk could
be avoided.”
Edward M. Miller, Research Professor of
Economics and Finance, University of New Orleans, The Journal of Social, Political and Economic Studies, Spring 2000
“Dr. Bruce I. Jacobs is on a crusade. He
wants to educate investors about the pitfalls of some modern investment
strategies—before it’s too late. He believes that option replication, dynamic
hedging, and other ‘mechanistic’ trading systems based on option pricing
models, are the heirs apparent to a failed strategy called ‘portfolio
insurance,’ which was first developed the early 1980s.”
New York Society of Security Analysts’
Newsletter, April 2000
“One
who issued early warnings about portfolio insurance was Bruce Jacobs, a finance
professor who later formed his own money management firm, Jacobs Levy Equity
Management. Jacobs warned that the
strategy was unstable and not equivalent to a true insurance policy, and that
it could destabilize the market…Jacobs…would be proven right.”
Michael
J. Clowes, The Money Flood, John Wiley, 2000
“Let us get one issue out of the way quickly--buy the book. If
nothing else, it is a great read…just seeing the names of some of your
colleagues and peers is worth the price of admission. More important, the book reminds us that every investment
strategy has trading implications that are often not fully explored by the
investor or explained (or even understood) by the seller.”
Thomas Schneeweis, Editor, The Journal of Alternative
Investments, Fall 2000
“Jacobs demonstrates that
portfolio insurance amplified significantly both the previous market rise and
the downturn [in
October 1987]. Only intervention
by the Fed prevented an even larger disaster. Jacobs argues that…synthetic puts [also] aggravated
selling into the market downturn of the mini-crash of 1989. Only the small amount of puts at the time
prevented a larger effect. Ten years
later, OTC puts on stocks and stock indexes amount to over US $1300 billion,
rendering the stock markets infinitely more exposed to the danger of a brutal
crash landing.”
Alfred Steinherr, Derivatives:
The Wild Beast of Finance, John Wiley, 2000
“Public interest in the stock market, stock price levels, and
stock market volatility all seem to be at an all-time high. Talk of speculative bubbles and of major
'corrections' abound. Is a stock market
crash inevitable? Are there destabilizing forces that exacerbate stock market
moves? Jacobs has written a book with
the intent of providing some insight into these questions. He provides a detailed analysis of the 1987
stock market crash, as well as some more recent events, such as the near
collapse of Long-Term Capital Management.
Although 1987 seems far away now, the volume is both fascinating and
timely, because understanding this bit of finance history can be important in
providing some perspective on today's markets and on what might come.”
Anat R. Admati, Professor of Finance and Economics, Stanford
University, Journal of Economic Literature, December 2000
“In his excellent 1999 book Capital
Ideas and Market Realities, Bruce Jacobs argues that the portfolio insurers
were primarily responsible for the crash of 1987 and played the central role in
the ‘cascade scenario’ driven by the confluence of index arbitrage and
synthetic portfolio insurance. [He]
argues that there are certain similarities between the intrinsic dynamics of [the]...mini-crashes
[in 1989, 1991, 1997] and Black Monday, with the portfolio insurers substituted
by the OTC put writers, [and also provides] an interesting account of the LTCM
story.”
Kirill Ilinski, Physics of
Finance, John Wiley, 2001
“Dr. Jacobs adeptly makes the important point that the availability of portfolio insurance during the mid-1980s played a significant role in fostering speculation that led to the stock market bubble and the crash that followed in October 1987... Dr. Jacobs’ wonderful effort explains not only the intricacies of portfolio insurance and dynamic hedging strategies, but also elucidates brilliantly how ‘the story of portfolio insurance is one of sophisticated marketing winning out over common sense...”
Doug Noland, “The Credit Bubble Bulletin: The Son of Portfolio Insurance,” www.PrudentBear.com, May 25, 2001
“Bruce Jacobs’ Capital Ideas and Market Realities is an important contribution to a fundamental debate concerning the workings of financial markets. Jacobs’ polemical but scholarly critique of orthodoxy is endorsed enthusiastically by Markowitz...Orthodoxy is taken by Jacobs and Markowitz to be the view that the efficient market hypothesis is a good guide to the workings of financial markets, and that in consequence they are benign in their impact on society. In particular financial innovation is likely to generate both private gains and social benefits through improving informational efficiency.”
David Gowland, University of Derby, The Economic Journal, June 2001
“Jacobs chronicles the path from investment theory into investment products...it is instructive how a product based on an incorrect interpretation of theory was oversold, and contributed to marketwide destabilization.”
Robert G. Snigaroff and Michael Munson, “The Late Twentieth Century Great Growth Bubble,” Journal of Investing, Fall 2001
“An excellent book, Capital Ideas and Market Realities, where the discussion on tactical asset allocation vs. hedging portfolios was insightful.”
Chetan J. Parikh, “Predicting Market Moves,” www.CapitalIdeasOnline.com, January 25, 2003
“In a remarkable piece of work dealing with the impact of options on market crises, Jacobs shows that the various strategies through which the sellers of options or the investors themselves strive to hedge their risks has a boomerang effect on the stock market and provokes the very sort of panic attacks they were meant to avert.”
Michel Fleuriet, Finance, A Fine Art, John Wiley, 2003
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