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Black Monday: What Happened?


On Oct. 19, 1987 - "Black Monday" - the Dow Jones Industrial Average plunged 508.32 points, or about 22.6%, and closed at 1,738.40.

On Oct. 19, 1987 – "Black Monday" – the Dow Jones Industrial Average plunged 508.32 points, or about 22.6%, and closed at 1,738.40. The decline almost doubled the 12.8% loss in the 1929 crash.

By mid-1988, the market had recovered and, in general, the U.S. economy had shrugged off the sharp downturn. In contrast, the U.S. economy nose-dived after the 1929 crash and didn't revive until the nation rearmed to fight World War II.

The difference: Quick action by the Federal Reserve.

"Black Monday was the result of a 'perfect storm' of diverse factors," says Irv DeGraw, a finance professor at St. Petersburg College in Florida. "The market had enjoyed a big run, but was getting shaky, interest rates were rising, new anti-takeover legislation was pending in Congress and there was a large amount of margin buying. In addition, there were two relatively new computerized trading strategies – portfolio insurance and program trading – and both were widespread."

Looking Back

Congress passed the Federal Reserve Act in 1913 in an effort to provide the nation with a safer, more flexible and more stable monetary and financial system. Prior to the creation of the Fed, private banks typically handled panics themselves through consortiums called "clearinghouses." In response to a run on a local bank, the clearinghouse made it impossible for customers to convert their deposits into cash. Larger banks then determined that the bank under attack was solvent and made loans needed to cover withdrawals. This halted localized panics and prevented them from spreading, but imposed a major hardship on customers who didn't have immediate access to their money.

In late 1928 and 1929, the Fed tightened monetary policy and set out to lower what it saw as stock prices inflated by speculative use of credit. Banks failed and the private sector shriveled after the October crash. The Smoot-Hawley Act, adopted in 1930, raised U.S. tariffs to historically high levels, cutting world trade about 66% between 1929 and 1934 and creating what some have called the "great contraction."

Some economists argue that much of the pain inflicted by the Great Depression could have been avoided if Benjamin Strong, governor of the Federal Reserve Bank of New York and the de facto equivalent of today's Fed chairman, hadn't died prematurely in 1928. Strong's policies during the 1920s were sound, many historians say, and his successor, George Harrison, lacked Strong's experience and forceful personality. Power diffused and those in authority lacked Strong's understanding of what a central banker should do at home and internationally during an economic crisis.

However, in 1987, the Fed pumped up liquidity to bolster the market. In addition, the Fed eased short-term credit, issued public statements underscoring its commitment to providing liquidity and temporarily eased the rules covering the lending of Treasury securities from its portfolio.

Unlike the 1930s, the U.S. has generally backed free trade through the General Agreement on Tariffs and Trade, the North American Free Trade Agreement and the World Trade Organization. Overall, this has benefited the economy.

"While investors tend to make similar psychological mistakes over and over again – always have and probably always will – dramatic events tend to stick in our consciousness," says Jason Goepfert, a Minyanville professor and founder of Sundial Capital Research. "Just look at how many references there have been to the crash of 1987. An event of that magnitude is easily remembered and isn't likely to be repeated, at least to the same degree. Regulations and the structure of the market have changed and individuals have learned what to do – and not do – during a panic."

On a much smaller scale, the Fed recently reprised its role of liquidity warrior in response to the credit crunch created by the collapse of the sub-prime mortgage sector. The result: so far, so good, including a market rebound and strong employment numbers.

Technical Difficulties

Program trading is perhaps the best-known factor contributing to the 1987 crash. Computer-generated sell orders acted as positive feedback creating a cascade of additional sell orders until the system was overwhelmed, making it impossible to get a price on some stocks and knocking the ticker about two hours behind the market.

Program trading included two computer-assisted variations: index arbitrage, or taking advantage of discrepancies between markets and buying in one while offsetting the purchase with a short position in another market, and portfolio insurance, or the sale of stock index futures to protect the value of a declining portfolio.

At the time of the 1987 crash, many fund managers purchased insurance from portfolio insurers. The insurers would sell futures on behalf of fund managers if the market headed south. The system worked well for minor events, but was overwhelmed on Black Monday when sell orders triggered more computer-generated sell orders and many prospective buyers couldn't get a price.

Many stocks were overvalued on Black Monday. The price/earnings ratio of the S&P 500 had increased to about 19 by the week of the crash, up from 10 in 1985. Prices had outstripped earnings, making stocks pricey and suggesting there was no place for the market to go but down.

Leveraged buyouts, hostile takeovers and merger mania contributed to the bull market of the day. Companies scrambled to raise capital to expand. Junk bonds – high-risk deals that paid a premium to investors – were widely used. Anti-takeover legislation moved through Congress just prior to the crash, shaving about 10% from stock prices and giving some a case of the jitters.

Be Prepared

Individual investors can spread portfolio risk by diversifying within equities – large-cap, mid-cap and small-cap domestic and international stocks – as well as across asset classes, including bonds and certificates of deposit. Exchange Traded Funds, or ETFs, represent a basket of stocks and offer diversification few investors can match on their own.

For more on these types of alternate investments, see: "ETFs Explained", "Play It Safe With CDs and Bonds" and "CDARS: Seeing the Forest For the Trees".

The market is near its record high and while some analysts routinely get the jitters, few expect a repeat of 1987.

"We will have another bear market at some point, but I think the chances of a 20% single-day decline are more remote now than they were 20 years ago because we've already experienced it and have learned something from it," Goepfert says.

Here's hoping.

For further reading about the 1987 crash, please see the following: How Confident Are 1987 Comparisons?, Why Did the Crash of '87 Occur?, and What Happened in 1987, Could It Happen Again?

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