Among the most eventful days in the history of financial markets, Black Monday occurred on October 19, 1987, when markets around the world collapsed. The Dow Jones Industrial Average (DJIA) lost a whopping 22 percent and the S&P 500 shed 20.4 percent on that day alone, thus creating the largest single-day drop in US stocks on record up until that point—easily surpassing the previous record of 12.8 percent set during the Wall Street Crash of 1929. By the end of the month, most major stock markets had lost more than 20 percent.
Unlike that famous 1929 crash, moreover, there were few warning signs that such a spectacular collapse was in the offing in October 1987. Indeed, perhaps most astonishing about the events of Black Monday was just how unexpected they were; when the crash occurred, stock markets had been on a bull run of five straight years, the economy was experiencing buoyant growth, and bullish sentiment pervaded markets all around the world—or so it seemed.
Alan Greenspan had only been Senate confirmed as chairman of the Board of Governors of the Federal Reserve on August 11, 1987, just two months before Black Monday.
Indeed, there remains to this day no clear consensus over what specifically caused the global market rout on that fateful day. Nevertheless, a number of key factors seemed to have underpinned the remarkable events of those 24 hours. Here are some of the most commonly cited ones:
- Rumours of a US interest-rate hike: The weeks prior to Black Monday saw a marked depreciation in the US dollar, particularly following news of the widening trade deficit. The Federal Reserve had already raised interest rates in September under its new chairman, Alan Greenspan, and yet the greenback continued weakening as the Deutsche Bundesbank responded by hiking its own rates, which kept the downward pressure on the dollar. With a potential currency war looming, and with stocks already historically expensive at the time—the S&P 500’s trailing price-to-earnings ratio leading into the selloff was at a significantly high 22—investors opted to move out of stocks en masse and into bonds, where long-dated yields were in double-digits. A weaker dollar also prompted a move out of dollar-denominated assets, which further contributed to the bearish sentiment for US stocks. Indeed, the trading before Black Monday—Friday, October 16—saw the Dow lose 4.6 percent, a precursor to the events that followed.
The widening trade deficit may also have concerned investors. Burgeoning trade-deficit issues (which continue to be a priority for US political leaders today) were perhaps the biggest warning sign that the financial markets were at risk. Efforts to limit trade advantages by Asian countries stoked controversy, as larger investors worried that Pacific Rim countries would respond to anti-trade policies by shunning US government bonds.
- Portfolio insurance: This type of investment tool involved trading risky derivatives and options, which were used as hedging tools to insulate investors against pronounced stock market declines. Given that the stock market had rallied consistently over the previous five years, more institutional investors were keen to use such portfolio insurance to protect themselves against a market correction. They mainly decided to sell short S&P 500 futures if the stock market declined significantly, which would allow them to offset any losses the underlying market rout would have on portfolios.
“This was a very new idea. Before 1987, if investors began selling aggressively ‘into a falling market,’ it’s because they had no choice. They were getting margin calls and they had to sell,” recalled Matt Maley on CNBC, days before Black Monday’s 30th anniversary in 2017; Maley was on the Salomon Brothers trading desk at the time of the 1987 crash. “With portfolio insurance, these people did not have to ‘sell’ to raise money. They were simply contractually obligated to ‘sell into a falling market’ due to their portfolio insurance agreements…. If the market continued to fall, they would short more futures as the S&P index broke below other certain levels. The problem came when investors from several other different areas ‘had to sell’ at the same time, with each obligation further exacerbating the situation.”
- Digital trading: Computerised trading had become popular by October 1987. Also known as program trading, this was mainly used by large institutional investors to automatically execute large orders once specific market conditions had been met. Once stocks began being sold off on Black Monday, many of these orders were executed as sell orders, meaning that the downward price pressure already in the market was further exacerbated by program-trading mechanisms.
- Global media: Black Monday represented arguably the first major market crash that could be captured by television. As such, viewers globally could see markets plummet in real-time, along with images of panicking traders desperately acting to contain their losses. Such powerful visual evidence would have undoubtedly influenced more investors globally to unload their positions than would otherwise have been the case in the absence of this media coverage.
- Tax proposal: A tax bill proposal that was making its way through the U.S. House of Representatives Ways and Means Committee a week before Black Monday is seen by many as the spark that finally lit the firestorm of panic that swept across markets on October 19. The proposal would have made certain US corporate takeovers considerably more expensive to execute. As such, it fuelled speculation that corporate profits could be severely dented should this bill be approved.
As Salomon’s Maley remembered, “In fact, it was that committee’s ‘trial balloon’ regarding a takeover-tax bill, sent around several days before the crash to see how the measure would be received, that was a main catalyst—or at least the straw that broke the camel’s back—in an environment that was already appearing to be a perfect storm for some kind of tumble for months, if not years.” During a 1988 speech, the U.S. Securities and Exchange Commission (SEC) also cited this tax proposal as a chief cause of the market collapse.
Again, comparing the 1929 crash to Black Monday reveals key differences between the two crashes, perhaps the most notable being just how much more damage the former did to the wider economy than the latter, with the Great Depression taking hold and stock markets taking decades to recover fully. In contrast, the Dow surged by 288 points within three trading days following Black Monday, while the October 1987 crash failed to register even a blip on US economic growth.
Computerised trading, also known as program trading, had become popular by October 1987.
By September of the following year, US stock markets had recovered all of Black Monday’s losses. The strong rebound was also aided by the Federal Reserve, which intervened quickly to cut interest rates. It also encouraged banks to continue lending without risk of default to prevent a crunch on credit and liquidity and made clear to banks that it was able to provide them with capital. “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system,” Greenspan announced the day after the crash, which went a long way towards quashing the panic.
And over the longer term, markets recovered well, with the ensuing five years seeing US stock prices grow on average by 14.7 percent per year, European markets by 7.6 percent, the UK market by 8 percent and global stock markets as a whole by 6.3 percent. Japan was the only major country to suffer market losses during this period, as initial gains in the Nikkei 225 benchmark gave way to a spectacular crash by 1990. As such, Japan’s stock prices declined by a hefty 7.2 percent on average over the same five-year period.
Although Black Monday seemed to catch many by surprise, what seems certain is that the world’s major stock markets experienced a collective panic. And it came at a time when those markets had experienced gains over several years that had taken valuations to record highs. Nonetheless, regulators were able to learn some crucial lessons from what happened. For one, circuit breakers were soon implemented that were designed to slow trading down for a few minutes, thus giving market participants some time to gauge what was happening in the market and respond more rationally. Greater regulatory scrutiny was also applied to program-trading mechanisms and portfolio-insurance programs involving derivative contracts.
Further viewing
A documentary on Black Monday containing interviews with the market makers of the time can be found here.