Up, Up, then Doooown

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Of the many Americans who were hurt in the Crash of '87, few feel as let down as the millions who invested in stock mutual funds. Their money, after all, was in the hands of savvy professionals who, if they saw a disaster coming, would take the necessary precautions to ease the blow.

Wrong. More than 1 million households in Boston's Fidelity Magellan, the biggest and most celebrated mutual fund, watched the price of their shares plunge by nearly 23% in three days of trading. In an unusually candid and revealing series of interviews with TIME, Peter Lynch, Magellan's manager, offers no excuses. "I was caught in a trap," he says. "I should have paid more attention to the red flags out there."

On the morning of Black Monday, Oct. 19, when financial markets everywhere suddenly seemed to disintegrate, Lynch was playing golf on a windswept course in Killarney, Ireland. He tried to concentrate on keeping his shots straight, but his mind kept veering back to the gathering Wall Street storm that threatened to destroy everything he had worked to achieve over the past decade. By the time Black Monday was over and Lynch realized the full magnitude of what had happened, he knew his Irish vacation would have to be cut short. By 6 a.m. the next morning Lynch was on his way to Shannon Airport, pondering the stunning news that in the two business days he had been away, Fidelity Magellan's assets had plunged by 28%, from $10.7 billion to $7.7 billion.

More than a vacation was wrecked. So was Lynch's aura of invincibility. For ten years, Lynch, 43, had been the wunderkind of the investment world, the man who could do no wrong. Magellan was the brightest star in the galaxy of mutual funds offered by Fidelity Investments, which manages more than $75 billion for investors. Between 1977, when Lynch took over Fidelity Magellan, and the beginning of last October, the value of the fund's shares grew by more than 2000%. A $1,000 investment made ten years ago was worth $21,437.70. No other mutual fund came close to that performance.

But when the market started to fall sharply on Oct. 14, customers began bailing out of Fidelity's 75 stock funds. Caught off guard with not enough cash on hand to meet the flood of redemptions, Fidelity was forced to sell shares heavily. On Oct. 19 alone, it sold nearly $1 billion worth of stock and thus helped to intensify the crash. Because Lynch is an aggressive fund manager who is usually light on conservative stocks, the Magellan Fund was especially hard hit by the collapse. An investment of $1,000 made on Sept. 30 is now worth $782.

Since the crash, Lynch has gone over the year's events in his mind many times. Interviewed in the relaxed surroundings of his seaside home on a promontory north of Boston, he admitted to having qualms as early as January, when the Dow Jones industrial average broke 2000 and stood more than 157% above its 1982 low point. What bothered him was that the market seemed to bear no relationship to the performance of the companies whose stocks were being traded. Corporate earnings for 1986 had been no larger than they were in 1982 and 1983, and yet stock prices were more than twice as high.

That was worrisome for a fundamentalist like Lynch. Unlike the market timers and technicians, who rely on esoteric theories and elaborate charts of trading data to tell them when to jump in and out of the market, Lynch looks at bricks and mortar: output and sales, productivity and profit potential. He probes companies the way doctors used to examine patients, by making house calls. Magellan's boss visits at least 20 companies a month and speaks with executives of dozens more every week. "I don't like blind dates," he says. "I have to get my own picture."

Early in the year he got a disturbing picture: stock prices could not justifiably go higher without a substantial rise in corporate profits. He had a premonition that 1987 would be Magellan's first down year since he took over the fund. And yet the market surged, as the fever of speculation rose. For the first time in years, large numbers of individual investors joined the frenzy. "The public missed the rally in 1985 and 1986," says Lynch, "so they started investing heavily in 1987." At the same time, Japanese investors invaded the U.S. market in force. American stocks may have been expensive, but not when compared with the shares being traded on the overheated Tokyo exchange.

Lynch sensed that things were getting out of control and that he should be conservative. Describing the Dow's incredible surge, he said, "We went over 2100 on Jan. 19, then 2200 a month later. Then 2300 in March, 2400 in April, 2500 in July. Then you get 2600 in August and 2700 a week later. Bang! Bang! Bang! These were scary numbers." But he was by nature venturesome, like the * Portuguese navigator for whom his fund was named. He told himself that he and his clients were investing for the long haul and should not worry about short- term blips and dips in the Dow. Besides, eight times his fund had declined by 10% to 30%, and each time it had bounced back.

As Lynch put it in a Fidelity Magellan brochure sent to potential customers, "If all you care about is what the fund's going to be in six months or three months, you probably should be in Atlantic City or in Las Vegas at the casino." While some fund managers were hedging by building up cash reserves, Lynch could not bring himself to sit on money. "If the public puts the money in, even when I'm negative on the market," he thought, "I'm just not going to take all the money they're giving me and put it into cash."

Resisting the temptation to invest more money in recession-resistant utility and food-company stocks, Lynch continued to hunt for securities that had lagged the market and still had the potential to rise. He bought shares of telephone, paper, chemical and media companies. One part of his portfolio that he reduced was his stock in savings and loan associations. He figured that they would be squeezed by rising interest rates and increasing competition from commercial banks.

By the summer Lynch was less nervous. In fact, he once again became a true believer in the bull. Reason: the healthier corporate profits he had been looking for had started to arrive. "Here I had this lurking fear that there were no longer any values in the stock market, and, lo and behold, what was starting to unfold was that earnings were coming back." Behind the rise were a determined cost-reduction campaign by American business and the long decline of the dollar, which encouraged U.S. exports and made imports less competitive. Says Lynch: "The popular opinion is that America is no longer competitive. But I was getting the feeling that from a combination of cost cutting and the weaker dollar America was creating a world-class competitive environment."

In retrospect, Lynch kicks himself for not paying more attention to some ominous signs that were flashing in September. Despite the weak dollar, the trade deficit did not improve as hoped. The July figure, released in September, set a new record. Meanwhile, the prime rate that banks charge on commercial loans kept creeping up, from 7.5% in March to 9.25% in early October.

On Wednesday, Oct. 14, the stock market, shocked by disappointing trade figures, suffered its first big quake -- a record 95.46 drop in the Dow. That posed a dilemma for Lynch and his wife Carolyn, 41, a physical therapist. They had long been planning to leave on Oct. 15 for a trip to Ireland. "Should we do this?" they asked each other. But Lynch rarely took long vacations, and he was especially reluctant to cancel this one. Though his roots are as Irish as homespun Donegal tweed, he had never been to the home of his ancestors. Besides, could an avid golfer who shoots in the low 70s pass up a chance to visit the country that, in his estimation, boasts six of the 25 best courses outside the U.S.? So Lynch packed his bags and left his deputies with a list of 100 stocks to sell, if necessary, and 100 stocks worth buying if their prices went lower.

As the couple toured the scenic mountains of West Ireland on Friday, Oct. 16, they stopped at Blarney Castle, where Lynch kissed the legendary stone. "All I could think of was the market," he recalls, "as I swung backward, head down, into space, holding onto a steel bar for dear life." He hoped that the stone would give him luck rather than eloquence. But when he called the office that night, he learned that the Dow had plunged another 108.36 points. Worse, Magellan customers besieged Fidelity's 1,500 telephone operators with orders to redeem shares. Net withdrawals on Friday amounted to $265 million, or about 2.5% of the fund. "I told Carolyn that if this continued, we would have to go back," says Lynch.

When he finished playing 18 holes at Killarney on the morning of Black Monday, it was two hours prior to the opening of the New York Stock Exchange because of the five-hour transatlantic time difference. Lynch called up his traders with sell orders, since the wave of redemption requests had swelled over the weekend. On his list of stocks to be dropped: Abbott Laboratories, Amoco, Capital Cities/ABC and many more. Then Lynch traveled to the small coastal town of Dingle and checked in at the Sceilig Hotel just before 2:30 p.m., as the 9:30 a.m. starting bell at the Big Board was about to ring. Lynch got on the phone and stayed riveted to the receiver as his colleagues at Fidelity described the sickening free fall of stock prices. He took a break for dinner with Irish friends at Doyle's, one of the country's best-known seafood restaurants, but he cannot remember what he ate. As the Dow plummeted a record 508 points, 500,000 calls jammed Fidelity's toll-free number. Many customers were buying, but many more were selling, and the fund lost an additional $150 million, or 2%.

Between 10 p.m. and 2 a.m., as Carolyn repacked to go home, Lynch plotted his strategy for the next day. Realizing that he would have to sell a huge bundle of stocks to meet redemptions, he decided to concentrate on unloading issues that were down only 10% or so, rather than take heavy losses on shares that had taken a worse beating. In particular, he chose to sell many of the British stocks in the Magellan portfolio, since the London Exchange had not fared as badly as Wall Street. But even as Lynch was deciding what to sell, he was overcome by a bold urge to buy. "I was expecting a major rally the next day," he says. Prominent on his shopping list were Merck, Eastman Kodak and Pacific Telesis.

As soon as Lynch reached the Shannon Airport on Tuesday at 10 a.m., he called one of his traders, Barry Lyden, who had arrived at Fidelity's main office in Boston before dawn. Twice the call went dead, until Lynch pleaded with the Irish operator to stay on the line because "we're talking about hundreds of millions of dollars here."

Boarding the plane, Lynch felt "like a prizefighter who knows that in six hours he will walk into the ring." Despite his confidence that the market would bounce back, he was troubled by fears and doubts, just like every other investor, large or small, during the historic crash. He thought about his mother, who lived through 1929 and "always said you should never own stocks." He wondered, "Maybe this is the start of the real thing." Most of all, he thought of the people who had bet on him, though he had always told them up front that in any downturn, Magellan would do worse than the market. Then Lynch, who had been earning between $2 million and $3 million a year, began thinking about his own finances. He felt relieved that the money for his three daughters' college educations had been set aside in money-market funds, saving accounts and a few selected stocks. But he decided that maybe he should pay down the mortgage on his house.

Back in Boston, he was whisked in a Fidelity limousine to his office, where he worked on what is now known as Terrible Tuesday until just before midnight. Though the blue-chip stocks in the Dow staged a rally, the rest of the market took a drubbing again. The price of a Magellan share fell by another 2%. Says Lynch: "Tuesday was the worst day of my career."

% Fortunately, the worst was over. The market kept gyrating during the next few weeks, but there were no more crashes. Lately, the inflow of new investments has started to outpace redemptions, and Lynch is pleased that only 50,000 out of the 1 million-plus Magellan customers have abandoned the fund completely. Even after the crash, Magellan investors are 2% ahead for 1987 as a whole. According to an independent study by Lipper Analytical Services, investors who have been in Magellan for three years have earned 68% on their money as of the end of November. Over the same period the Standard & Poor's Index of 500 stocks has gone up only 56.7%, and the average stock fund has risen 38.6%.

Lynch's peers in the money-management business think that he came through the crash remarkably well, considering the enormous size of the fund he had to handle. Says Barton Biggs, a global strategist for Morgan Stanley: "Lynch is still the most consistent mutual-fund manager in the country, even if he does not outperform the market every time. None of us are supermen in a prolonged bear market." Agrees Anthony Thatcher, a portfolio manager at Scudder Stevens & Clark: "Lynch's reputation, though somewhat tarnished, is not obliterated."

Lynch did learn some lessons though. For one thing, he never intends to be caught again without enough cash on hand. From now on, he will keep 3% to 5% of Magellan in money-market instruments or other cash equivalents, at least three times as much as in the past. Says he: "If $300 million wants to go out in a day now, I want to be ready." That way, if the market falls and redemptions suddenly run high, he will not be forced to sell stocks that he expects will rebound later.

Sobered by the crash, Lynch is wary about what will happen to the market. He does not foresee a recession yet, but is fearful of the plunging dollar. "If the dollar declines from here," he says, "it will probably accelerate our inflation and persuade the Europeans and Japanese to stay out of the U.S. stock market." Lynch also frets that the market is at the mercy of sophisticated, new computerized trading techniques that sometimes run out of control. Says he: "Program trading, portfolio insurance, stock options and index trading accelerated the crash. Without them, instead of an 508-point decline, we might have had 150 to 250 points."

Yet Lynch does not waste much time agonizing about what could happen next week. He has been too busy snapping up stocks that he considered well worth buying at their depressed postcrash prices: Goodyear, Chrysler, Intel, Texas Instruments, Carnival Cruise Lines and Toys "R" Us, along with companies that most people have not yet heard of, such as Metro Mobile CTS, a cellular phone system, and Comcast, a cable-TV operator.

Lynch remains convinced that America is returning to competitive shape. To abandon the stock market now would be to lose faith in those bustling factories, offices and stores he inspects every week. He believed in the long- term value of U.S. companies before the crash. He still does.


CREDIT: TIME Chart by Cynthia Davis


DESCRIPTION: Total net assets from January, 1987, to December 21, 1987. Color illustration: Yellow triangle and sunburst.