Happy 30th anniversary, Black Monday!
With U.S. stocks trading at all-time highs, it might be easy to forget that 30 years ago this week Wall Street had its worst single-day loss ever.
On Oct. 19, 1987, the Dow Jones industrial average lost 22.6 percent of its value. Never before, nor since, has it experienced a loss that great, in percentage terms.
Between Jan. 1 and Aug. 25, 1987, the Dow rose an impressive 43.24 percent. And, while a rapid rise could be viewed as the precursor to a pullback, no one at the time was sounding the alarm bell. The Dow’s close at 2,722 that day would be its zenith for more than two years. The headlines in the evening paper that day spoke of nothing looming that would signal the more than 17 percent decline the Dow would suffer before the crash.
But, there were things happening in the economy that may have foreshadowed the decline. The trade deficit was growing. The dollar was declining. Interest rates were rising.
See photos from the day no one saw coming:
The crash. The week before the crash a couple of events occurred that set the stage for the looming fall. The first was a report that the country’s August trade deficit was larger than expected. This led to more weakness in the dollar, prompting fears that the Federal Reserve would continue raising interest rates to protect the greenback. The second was a report that the House Ways and Means Committee had introduced a bill that would eliminate the tax-deductibility of interest paid on bonds used to finance mergers.
The news rattled the market, and by the end of the week the Dow had declined 9.39 percent. This set into motion the structural components that would be blamed for the bloodbath the next Monday.
Historians point to three factors that led to the massive 508 point Dow loss on Oct. 19, 1987: portfolio insurance, program trading and a lack of liquidity.
Portfolio insurance is a hedge used by big institutions to protect long stock positions. It comes from buying or selling index futures to capture the difference in price between the cash market and the futures market. While this worked great in an orderly market, it didn’t work so well on that fateful Monday.
When the market opened for business on Oct. 19, there were more sellers than buyers for many stocks. This delayed the opening for a number of securities. That meant these stocks’ prices weren’t accurately reflected in the price of the index.
When these stocks finally opened for trading, they opened lower. So, traders who bought index futures, believing that they had profitably captured the difference between cash and future prices, actually saw the value of their futures positions plummet. To limit losses, they sold off shares of stock. This deepened losses in the futures market, which prompted more selling. This fed on itself all day long, and was exacerbated by program trading.
Program trading computer instructions that send buy or sell orders to an exchange based on a given set of price parameters. The flood of program trades that day overwhelmed the system, added to the confusion and fed the panic selling.
The final culprit blamed for the crash was the mismatch in liquidity between the stock market, the options market and the futures market.
In 1987, stock trades settled in three business days, but futures and options trades settled in one.
As a result of that disparity, cash proceeds from the sale of stock couldn’t be used to satisfy the purchase of either a futures or options contract. Since traders who sold stocks couldn’t use those proceeds to buy futures or options, they had to borrow against their stock holdings to cover those other trades. But, as stock prices declined, the value of that collateral deteriorated. And, when that happened, those traders had to sell even more stock to cover their margin calls. And, the whole process was repeated throughout the day.
What happened the next day was pretty remarkable. Before the opening bell, the Federal Reserve announced that it would “serve as a source of liquidity to support the economic and financial system.” It lowered the Fed funds rate from 7.5 percent to 7 percent (numbers that seem exhorbitantly high by today’s standards) and flooded the financial system with cash. It then told banks to loan out that money to support trading and provide the liquidity needed to keep stocks trading.
As a result, the financial markets steadied and ultimately regained much of value lost in the previous day’s session. At the end of 1987, the Dow Jones industrial average closed at 1,938.83, more than 11.5 percent higher than its closing price on Oct. 19.
What’s different today? Since then a number of structural changes have been put into place to help safeguard against similar huge one-day losses. Just this year, the Securities and Exchange Commission required brokerages to settle stock and bond trades in two days rather than three. The move was designed to help reduce market risk.
Meanwhile, the New York Stock Exchange instituted trading restrictions to address extraordinary market volatility and has installed systematic “circuit breakers” to halt trading when market volatility reaches predetermined triggers. And, the Fed has solidified its position as the lender of last resort and steward of the financial system.
Heaven only knows what the next financial shock might be. But, it’s safe to say that there will be one. If the lesson of Black Monday has taught us anything it is that moments of financial panic come and go. This doesn’t happen quickly or easily, but eventually they fade from memory. And, over time, a well thought out investment plan that stays the course even in time of doubt is the correct long-term strategy.
Let’s not forget that the crash of 1987 occurred when the Dow was trading around the 2,000 level. It’s around 23,000 today, a testament to equity markets as a long-term engine of growth.
Copyright 2017 U.S. News & World Report