Black Monday looked like 1929 again

Where were you on Monday, 19 October 1987?

I recall exactly where I was—in graduate school, walking between classes, when I passed a television broadcasting the collapse.

For you youngsters, that is the day better known as Black Monday, when the stock market plunged 508 points in a single session. The Dow Jones Industrial Average lost 22.6%, the worst daily percentage loss on record.

The New York Times front page headline the next day asked, “Does 1987 Equal 1929?”

Anyone working on Wall Street today who is under 40 is unlikely to have any professional memories of the event. To you, I suggest reading Black Monday: The Stock Market Catastrophe of October 19, 1987 by Tim Metz. It is the definitive account of the crash, including the key players, personalities, decisions, news flows and first-hand accounts of what happened that day.

As in most complex matters, there were many forces that drove the events leading up to the crash. Here are two of the biggest:

Bull market froth: The Dow Industrials kissed 1,000 in 1966, then tumbled in the horrific bear market of the 1970s and didn’t surpass that number on a permanent basis until 16 years later in 1982. Then, between 1982 and 1986, the Standard & Poor’s 500 Index more than doubled. But things really heated up in 1987. In the first eight months, the index gained more than 38%. A correction was overdue. While many people were afraid that markets were overheated, no one had envisioned a one-day drop that would wipe out almost a quarter of the market capitalization of the major indexes. That had a different cause.

Portfolio insurance: The technique, invented by Hayne Leland and Mark Rubinstein in 1976, was an attempt to hedge volatility by shorting index futures to protect a long equity portfolio. As market prices fell, the index puts would be executed, locking in a small loss, and shifting the risk of more losses to the party on the other side of that trade. It was an academic concept, one that hadn’t been stress-tested yet. The working assumption was that a ready buyer would be there to take the other side of the trade, getting paid to assume additional risk. Not so much, as it turned out. Buyers eventually were willing, but at much lower prices. This created a selling spiral that got out of control. The lack of liquidity was also a problem, as index futures were a relatively new product with modest volume and not a very deep trading history.

There were other factors as well. Broader geopolitical concerns included Iran (it had attacked US merchant vessels) and collapsing oil prices (by 1986, crude oil prices had dropped by about 50%).

US treasury secretary James Baker disagreed with his European counterparts about the strong dollar and foreign-exchange rates. Some observers point to his comments as the spark in a room filled with gas vapours.

Of course, none of these individually was a cause, but collectively they contributed to trader anxiety. Once the market opened on Monday morning, the bloodbath began.

One last thing: US president Ronald Reagan downplayed the crash as a “correction”, causing many wags to scoff about his lack of financial acumen. Time proved Reagan right. The Dow finished the year up 1%, the S&P 500 with a 2% gain. The bull market that began in 1982 still had another dozen years to run.

In the grand scheme of things, Black Monday ended up looking like a modest setback. Even so, let’s hope it was an event that stands as a one-of-a-kind. Bloomberg

Barry Ritholtz is a Bloomberg View columnist.

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