The Wisdom of Crowds – The Story of The Stock Market’s Reaction to the Challenger Explosion

“If the efficient market hypothesis is true – and the Challenger explosion example certainly implies it is – The wisdom of crowds has enormously far reaching consequences.”

-Andrew Lo, from his book Adaptive Markets: Financial Evolution at the Speed of Thought

As we build out our ‘This Day in Stock Market History‘ archives, I like to go into more detail on events that I believe offer important lessons for investors, had significant historical impact, or events that are just simply interesting.

This week in history, on January 28th, 1986, an event occurred that meets all three of these criteria – The stock market’s behavior after the explosion of the Challenger space shuttle.

Space Flight and the Stock Market

An entire book could be written on the importance of the space program to the stock market. Our  ‘This Day in Stock Market History’ series has briefly covered a few important early events, and their impact on the stock market:

•  October 4th, 1957 – Soviet Union launches Sputnik into space
• December 6th, 1957 – America’s (failed) first attempt to get into space
• February 1st, 1958 – America’s first successful satellite launch
• June 2nd, 1964 – The “IPO of the Century” Comsat, allowing American’s to invest in space satellites

But here, we are just going to look at one event in the space program’s history, its impact on the stock market, and lessons investors should take from it.

Besides The Challenger program’s broader significance to the development and deployment of communication satellites and scientific research, the Challenger program was responsible for billions of dollars in government contracts.

In 1986, many publicly traded companies derived a significant portion of their revenues from the Challenger program:

Being awarded a large NASA contract meant hundreds of millions, or even billions of dollars in revenue. It meant tens of millions in profits, years of dividends to shareholders, and the ability for a company to monopolize market share.

Being able to help NASA successfully launch into space meant billions to some of these companies.

Needless to say, on January 28th, 1986, as the Challenger was set to take off its 10th mission, billions were at stake.

Over the previous 5 years, the Challenger mission had 9 successful launches. But on the 10th mission, the unthinkable happened:

At that instant, no one knew what went wrong. The most technologically advanced piece of machinery ever built, designed to abort the mission at the slightest out of spec reading in temperatures, pressures, or valve movements, never even flashed a warning signal:

6 days after the Challenger explosion, President Reagan signed executive order #12546, creating the Rogers Commission, to investigate the cause of the failed launch. The Commission included Nobel Prize physicist Richard Feynman, former Secretary of State William Rogers, and astronauts Neil Armstrong and Sally Ride – Some of the world’s most brilliant minds on analysis, physics, and space travel.

It was take this group 5 months to come to a formal conclusion. On June 9^th, 1986 the commission released their final report:

The findings of the study determined that the cold temperatures impacted the performance of O-Rings manufactured by Morton-Thiokol.

To reach that conclusion, over the course of the 5 months the committee spoke with thousands of engineers, tested hundreds of parts, watched hours of footage of the launch from every available angle, and even began to reconstruct the shuttle from the debris that was recovered, in search of clues.

The government’s investigation was thorough, but stock market investors are not a patient bunch. Being at fault would likely cost a company hundreds of millions, or even billions of dollars. So for investors, the race was on to determine not only who was a at fault in the explosion, but the projected financial fallout as well.

What took the Rogers Commission 5 months to determine, and the U.S. legal system years to work out, would take the stock market just minutes.

Stock Market Reaction to Challenger Explosion

There were 4 main contractors for the U.S. space program in 1986; Lockheed, Martin Marietta, Morton Thiokol, and Rockwell International. Each of these companies had significant revenue from government contracts, contracts that would be in jeopardy if their parts were found at fault for the explosion.

Not surprisingly, the shares in all 4 companies sold off abruptly in the first few minutes after the challenger explosion.

By 11:52, just 13 minutes after the explosion, the stocks of each of those 4 companies were all down between 4 and 6 percent:

But then, something interesting happened.

At 11:52, while debris from Challenger was still falling from the sky, volume in one of the four companies increased dramatically.

Before the failed Challenger launch, Morton-Thiokol averaged 100,500 shares traded per day. In the 13 minutes after the Challenger explosion, 52,200 shares traded before a wave of even heavier selling orders forced the New York Stock Exchange to halt trading in Morton-Thiokol for approximately 50 minutes.

Neither Rockwell, Lockeed, or Martin Marietta were halted on the day. Although volume was heavy, trading remained orderly.

Although Rockwell, Lockeed, and Martin Marietta experienced volume 2-3 times greater than average on January 28^th 1986, volume in Morton Thiokol jumped more than 17x its daily average (despite being halted for nearly an hour!).

(All volume information in the chart above is in thousands.)

Besides the volume of shares traded, something else interesting was going on.

At 12:44 shares in Morton-Thiokol resumed trading. At that time, 3 of the companies would begin to see their share prices recover, while one company – Morton-Thiokol – would see its share price continue to fall.

By 1 pm, shares of Lockeed, Martin Marietta, and Rockwell were all down between 4 and 5 percent, while shares of Morton-Thiokol were down 9%.

By the end of the day, less than 6 hours after the Challenger exploded, shares of Morton-Thiokol would close down 12%, significantly worse than Rockwell, Martin Marietta, or Lockheed.

The decline of Morton-Thiokol would take the company’s share price from 36 7/8 to 32 ½:

Based on 47.7 million shares outstanding at the time, Morton Thiokol saw its market cap drop $209 million on January 28^th, 1986.

$209 million – Remember that number.

The Cost to Morton-Thiokol Due to Challenger

The Rogers Commission report found not only faulty Morton-Thiokol products, but gross mismanagement from the executives at Morton-Thiokol. This resulted in many additional costs, penalties, and loss of future income for Morton-Thiokol.

First, the families of the astronauts who died aboard Challenger filed a lawsuit against Morton-Thiokol and the U.S. government. The lawsuit was settled for $7.7 million, 60% of which was to be paid by Morton-Thiokol. In total, the company would pay $4.641 million to the families in the form of tax-free annuities.

In addition to the money Morton-Thiokol had to pay to the families, the company would also pay back $10 million in incentives provided by NASA, and perform $409 million in work at cost.

For fiscal year 1986, Morton-Thiokol had a net income of $96 million, on $933 million in revenue – a net margin of 10.2%.

Based on this net income margin, the work that Morton-Thiokol performed cost the company $41.7 million in lost profits.

Then came the real pain. Because of their loss of reputation, and the likelihood of losing the contract anyway, Morton-Thiokol would drop out of consideration for the renewal of the $1.5 billion solid fuel rocket booster contract that NASA was offering for the next round of space travel. At the time, Morton-Thiokol had a near monopoly on solid fuel rocket boosters. If Challenger had not happened, it is very unlikely that they would have lost this contract.

Based on their 10.2% net margins, this loss of $1.5 billion in revenue resulted in a loss of future profits of $153 million.

To total the costs and profit loss to Morton-Thiokol:

• $4.641 million legal settlement
• $10 million in incentive paybacks
• $41.7 million in free labor
• $153 million in lost future profit.

In total – $209.341 million, almost exactly what the stock market deducted from Morton-Thiokol’s market cap within hours of the Challenger exploding on January 28^th, 1986.

Lessons For Investors From Challenger

“…the Challenger case is also pertinent to the information theory of Hayek [who] notes  that ‘‘there is beyond question a body of very important but unorganized knowledge … the knowledge of the particular circumstances of time and place.’’  What the Challenger episode adds to Hayek’s insights is that securities markets are a vehicle for amalgamating unorganized knowledge.”

-Maloney and Mulherin (2003)

Even without the aid of today’s high frequency, algorithmic based trading systems, the collective forces that made up the stock market in 1986 were able to not only determine fault for the Challenger disaster, but also very accurately project the future cost to Morton-Thiokol in minutes.

Investors today collectively spend billions of dollars per year with a hope to outsmart and outperform the stock market through active managers, whose fees come from high fund expense ratios, expensive research, and an army of stock analysts.

We spend billions in an attempt to outguess the stock market – The world’s best fortune teller. I think we should have the lessons of the Challenger explosion in mind and ask ourselves – is it even possible?

Before making your next investment, keep the lesson of the stock market’s reaction to Challenger in mind and ask yourself – “Do I really know more than the stock market?”

Further Reading

There are 3 primary sources used for this post:

First, a paper by economists Michael Maloney and J. Harold Mulherin, “The complexity of price discovery in an efficient market: the stock market reaction to the Challenger crash“

Next, “Catastrophic Events, Contagion, and Stock Market Efficiency: The Case of the Space Shuttle Challenger” by Laurence Blose, et al.

And, I was originally introduced to the stock market’s reaction to the Challenger explosion in Andrew Lo’s book, Adaptive Markets: Financial Evolution at the Speed of Thought