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and accordingly bid up the price of the stock. This was the case with the Northern Pacific.
In the beginning of 1901, James Hill and J. P. Morgan and Company had large interests in the Northern Pacific Railroad, but they did not control a majority of the stock. In
April of 1901, E. H. Harriman started secretly buying the stock, and during the month of April the price of the stock rose 25%. This didn't cause any alarm, because the
overall level of the market had been rising. Since it wasn't apparent that a takeover was in the works, some traders thought that Northern Pacific's stock had risen too fast and
started shorting it.
When one shorts a stock, he is in fact borrowing the security from someone and then selling it. If the price of the security then goes down, the person who shorted the stock
can go into the market, buy the stock back, and tender the stock back to the person he borrowed it from, thus repaying the loan. One makes a profit if he shorts a stock and can
later buy it back at a lower price. One loses money if he shorts a stock and has to buy it back later at a higher price.
On Monday, May 6, 1901, Northern Pacific's stock made a sudden and dramatic jump upward. No one seemed to know the cause of the stock's rise. The directors of the
Northern Pacific didn't know, and their bankers were in the dark as well. Many thought it was a mere market manipulation, and accordingly the shorts increased their
position they shorted more of the stock.
On Tuesday, May 7, the stock continued to climb, from $117 a share to $143. By late afternoon it became apparent to all what was happening. Word got out that Harriman
was making his final bid to take control of the company. Hill and Morgan heard this news and tried to stop him by putting in bids to buy as much of the stock as they could to
keep it out of Harriman's hands.
By Wednesday, May 8, it became obvious to all concerned that the warring parties, Harriman versus Hill and Morgan, in their struggle for control, had cornered the market
for the stock of Northern Pacific. This really wouldn't have had any effect on the overall stock market except for one thing: the people who had shorted the stock were still
short they hadn't covered their positions.
No one was selling, and big buyers were forcing the price through the ceiling. This meant the shorts were caught, and as the price of the stock rose, they started to panic.
Understand that back in those days, people who sold short a stock had to deliver it the next day. If they didn't own it, they had to go borrow it. If they couldn't deliver it, the
party they sold it to could go into the market and pay the market price for the stock and stick the bill to the person who shorted it but couldn't deliver.
On May 8 there were few if any sellers, and the shorts trying to cover their positions started to bid wildly for the stock. By the end of the day the stock was trading at $180 a
share.
When the gong kicked off trading on Thursday morning, the ninth, the shorts had reached an intense state of fear, and panic swept like wildfire through their ranks. By noon
the shorts had bid the stock to $1000 a share. When you have to have it, you have to have it.
At the same time a most interesting thing was occurring to the rest of the market. It started to nosedive. The shorts, caught in a very dangerous situation, began panic selling of
their other holdings to raise money to cover their short positions. Dozens of large trading firms were caught with their pants down and now were scrambling to cover their
butts.
Bernard Baruch was on the floor of the exchange that fateful day and later wrote, "On the Exchange floor fear had completely taken the place of reason. Stocks were being
dumped wildly, dropping from ten to twenty points. There were rumors of corners in other stocks."
Before Harriman reached a truce the next day with Hill and Morgan, leading stocks fell as much as sixty points; and banks, who were charging 4% for money they loaned to
traders, got scared and pushed their loan rates to as high as 60%. One stock goes through the ceiling and rest of the market gets tanked.
Here is the lesson. The drop in price of the other stocks was not caused by a recession or a lull in the business cycle, or by companies reporting lower earnings, or by a
changing macroeconomic picture. It wasn't even because of a shift in the interpretation of the information available on these businesses.
What happened was that the investors who were short Northern Pacific stock were caught in a squeeze and were losing their shirts. This pushed them into a liquidity crisis, to
which they responded by selling their other stock positions. They did this to generate cash to cover the losses they experienced because they were caught in a short position in
Northern Pacific.
The rest of the traders, fearing similar situations in other companies, began freaking out and started a wave of panic selling.
Bernard Baruch realized what was going on. He knew that great companies were being sold at ridiculous prices and saw an opportunity to do some buying.
Thus the market mechanism that allowed someone to sell what he didn't own, combined with a sudden price rise in the stock of Northern Pacific, created an explosive
situation, which led to a massive and irrational sell-off of the entire stock market. This strange bit of market dynamics in turn created a buying opportunity for Baruch. The
market soon recovered and Baruch made his initial fortune.
Market mechanisms through unexpected interaction can cause wild price swings that have nothing to do with processing economic information.
THE PANIC OF 1987
You may be wondering what all this has to do with the market today. Didn't the SEC in the 1930s enact rules to prevent the kind of panic that occurred in 1901? The answer is
yes. But things change and government bodies tend to legislate regulation after the fact. In the late 1980s, a new set of facts developed.
During the Panic of 1987, two new investment strategies, index arbitrage and portfolio insurance, came into play and started to dominate the stock market. Their interaction
set into play dynamics that from October 13 to October 19, 1987, ripped the market apart.
The Presidential Task Force on Market Mechanisms, in what is popularly known as the "Brady Report," said:
From the close of trading on Tuesday, October 13, 1987, to the close of trading on October 19, 1987, the Dow Jones Industrial Average "Dow" fell 769 points or 31 percent.
In those four days of trading, the value of all outstanding US stocks decreased by almost $1 trillion [THAT'S $1 TRILLION!!!]. On October 19, 1987, alone, the Dow fell by
508 points or 22.6 percent. Since the early 1920's, only the drop of 12.8 percent in the Dow on October 28, 1929 and the fall of 11.7 percent the following day, which together
constituted the Crash of 1929, have approached the October 19, (1987) decline in magnitude ("Brady Report," p. 1).
The precipitous market decline of mid-October 1987 was triggered by specific events: an unexpectedly high merchandise trade deficit, which pushed interest rates to new high
levels, and proposed tax legislation, which led to the collapse of the stocks of a number of takeover candidates.
This initial decline ignited mechanical, value-insensitive selling by a number of mutual fund groups reacting to price reductions. Selling by these investors and the prospect of
further selling by them encouraged a number of aggressive trading-oriented institutions to sell in anticipation of further market declines. These institutions included, in
addition to hedge funds, a small number of pension and endowment funds, money management firms, and investment banking houses. This selling, in turn, stimulated further
reactive selling by portfolio insurers and mutual funds.
To understand the madness of that October it is necessary to understand the buying and selling strategy of mutual and pension funds that use portfolio insurance. Portfolio
insurance is a strategy that uses computer-based models to determine an optimal stock-cash ratio at various market price levels. This usually calls for selling as stock prices

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