The ‘Black Monday’ crash of 1987 refers to the date of October 19th, 1987, when the Dow Jones Industrial Average (DJIA) tumbled over 22%. It was a loss that, to this day, remains the biggest ever single-day drop in stock market history. For context, during the infamous 1929 crash that preceded the Great Depression, the stock market recorded its biggest-ever single-day drop of just over 12%. The crash highlighted the financial risks of modern-day technologies and globalisation; because, unlike numerous other crashes, it was not triggered by any banking crisis. The ‘Black Monday’ crash brought about many reforms that continue to prevent or limit damages during crisis periods. The Federal Reserve took up the role of using liquidity to perform damage-control during crashes. Also, numerous stock exchanges implemented ‘circuit breakers’ that temporarily halt trading activity after a pre-set percentage drop is achieved during a rapid market selloff.
The Background
In the five years leading up to the 1987 crash, the DJIA had enjoyed a period of massive bullish momentum. The index printed a peak of just above 2700 in August 1987, more than three times higher than five years earlier. In the first seven months of 1987 alone, the DJIA had climbed over 44%, and there were already concerns that the market was ripe for a correction.
The bull run itself was powered by some positive fundamentals, but there were looming dangers that largely remained ignored. The Federal Reserve had earlier been involved, together with other G5 nations, in an agreement that would be dubbed the ‘Plaza Accord’. The agreement was meant to address trade imbalances between the US and other G5 nations, and its implementation saw the US dollar purposefully devalued. A cheaper US dollar helped address some of the objectives of the Plaza Accord and additionally drove finance to the stock market. By 1987, trading volumes at the NYSE were in excess of $181 million, compared to the average of just around $65 million in 1982. In 1987, the US was largely comfortable with the achievements of the Plaza Accord and sought a new agreement.
In February 1987, the Louvre Accord replaced the Plaza Accord. The new Accord sought to stabilise exchange rates as well as limit the slide of the US dollar. The Federal Reserve, during this period, also started to aggressively hike interest rates. This new monetary environment tightened the money supply in the US, and in the final quarter of 1987, stocks started to drift lower.
How the Crash Unfolded
The market was already in full sell mode in the previous week leading up to the crash. On Wednesday, October 14th, the markets recorded a loss of about 3.8% and then another loss of about 2.5% the following day. Then on Friday, October 16th, another major loss of about 4.6% was recorded. A market innovation at the time allowed participants to sell their shares during the weekend using closing prices of the prior week. But there were numerous requests that brokers and other financial institutions supporting this scheme could not service.
Even before the US market opening on October 19th, 1987 (Black Monday), equity markets around the world had started tumbling hard and fast. Asian markets were the first to open, and in particular, New Zealand stocks were the worst hit, tumbling over 60%. European markets also plunged heavily and, in the US, the DJIA would on that day shed off over 500 points, closing 22.6% lower and recording the worst ever single-day drop in history.
The Markets after Black Monday
Although devastating, the Black Monday crash of 1987 went down as one of the most short-lived stock market crashes. The very next day, the DJIA gained about 102 points; and by the end of the second day, the market had cumulatively recovered over 288 points, which represented about 57% of its Black Monday losses. It would then take about two years (by September 1989) for all losses to be recovered. The markets then went on to experience a prosperous decade that saw the DJIA cross above 10,000 points in early 1999.
What Caused the Black Monday Crash of 1987?
It is generally agreed that the Black Monday crash was caused by a variety of factors. To start with, the market was on a 5-year bull run by 1987, and in the first seven months of that year alone, the markets were up over 44%. The markets had benefitted from a period of low-interest rates and a huge money supply in the US economy. But since the start of 1987, it was a market ripe for a correction. The Federal Reserve had started a period of hiking interest rates aggressively and abandoned an accord that was designed to keep the US dollar weak. Inflation started rising, and the economy stagnated, yet the markets continued to rise. By all means, it was just a matter of ‘when’, and not ‘if’ the markets would dip, or at least correct.
Another major catalyst of the Black Monday crash was the use of automated trading programs. They were still relatively new in the markets in the 1980s, and most of them were programmed to trade off momentum. This meant that during bullish periods, the programs would aggressively execute buy orders in the market, and during bearish periods, they would execute aggressive sell orders. On the day of Black Monday, aggressive sell orders were executed in the market and the chain reaction accelerated the collapse of the markets to new lows. These programs executed sell orders when a certain price threshold was achieved, and new rounds of selling then resurfaced as new lows continued to be created.
There was also a strategy dubbed Portfolio Insurance that further hastened the market decline. Portfolio insurance was an investment product designed to preserve gains during a bull run but limit losses when prices start to fall. It was invented in the late 1970s but became very popular with institutional traders in the 1980s when concerns about an overvalued market arose. They were essentially a dynamic hedging facility, primarily computerised, and involved selling futures and options contracts against an underlying stock portfolio. The problem is that they were sold as absolute protection of any portfolio, and consequently, this brewed overconfidence as market participants did not fear higher valuations. Most portfolio insurance programs initiated the selling of derivatives when the markets fell by a certain percentage. Thus, while portfolio insurance did not kick start the selloff, they effectively ensured that it got out of control.
The Aftermath of Black Monday
In the aftermath of the crisis, the important role of the Federal Reserve was highlighted, something that was not witnessed during the 1929 crash, which eventually turned into the Great Depression. The central bank quickly moved to act as a source of market liquidity and helped stem a looming crisis. The bank intervened to participate in the open market directly and even encouraged lenders (who were increasingly becoming nervous) to continue lending so as to prevent a liquidity crisis. This two-pronged intervention helped prevent the collapse of major institutions as well as the spread of the crisis into other sectors.
Another major consequence of the Black Monday crash of 1987 was the introduction of ‘circuit breakers’. A circuit breaker is a regulatory emergency measure that halts trading when a certain level of volatility is reached in the markets. It basically helps to prevent panic in the market from getting out of control. Circuit breakers are governed by the SEC (Securities and Exchange Commission), and when triggered, they will halt trading for a specified amount of time to give market participants time to reflect on how to objectively react in the market when trading resumes.
In the US, the S&P 500 index is used as a reference for circuit breakers to be triggered. There are 3 levels that will trigger a circuit breaker: Level 1 will be triggered if the S&P 500 falls by 7% from the previous market close and trading will be halted for 15 minutes; Level 2 will be triggered if the index falls by 13% from previous market close and trading will be halted for 15 minutes; while Level 3 will be triggered if the index falls by 20% from the previous close and trading will be halted for the remainder of the trading session.
These are market-wide circuit breakers, but the SEC also provides ‘circuit breaking’ guidelines for different classes of individual stocks. Typically, trading for an individual stock will be halted if its price makes a 10% move within a 5-minute time period. Circuit breakers help market participants to literally take a breather, but critics believe it helps create artificial disruption and goes against the spirit of true pricing in a free market. A recent application of circuit breakers was witnessed twice in March 2020 when investors were concerned about the business and economic consequences of the global coronavirus pandemic.
Evidently, the Black Monday crash brought about many reforms which have helped to limit or prevent major damage during crisis periods.