On this day in economic and business history ...
Shell-shocked investors swarmed the streets in front of the New York Stock Exchange (UNKNOWN:UNKNOWN) after the close of trading on Oct. 19, 1987. Some cracked jokes. Some cursed the fickle gods, or their own bad luck. Some stood silently, trying to come to grips with what had happened that day -- the single worst day in the history of American stock markets. That day, the Dow Jones Industrial Average (DJINDICES:^DJI) lost 508 points, 23% of its value, in a single trading session. Over $500 billion in market value -- equal to 10% of American GDP at the time -- was destroyed in the carnage.
By 11 a.m., the Dow had already lost 250 points. Half an hour later, a ray of hope flickered across trading screens. The index climbed fast, reclaiming 150 points of its initial decline by noon. But it was all downhill from there. At 12:30 p.m., the Dow fell back to a 175-point loss. By 2:05 it had hit new lows, nearly 300 points below the prior day's closing value. For a while, the index held at this new depth, but in the final hour all semblance of stability was blasted apart by a rapid plunge. Shortly after 3:00, the Dow crashed past a loss of 350 points, continued downward past 400, then 450, before finally settling at a 508-point loss that left Wall Street dumbstruck.
Nothing so violent had ever occurred in the market before, and nothing has yet matched it in all the trading days that have come afterwards. The Dow had closed out a chaotic Friday at 2,246.74 points, 17% below its late-August high. It ended Black Monday at 1,738.74 points, a level last seen 14 months earlier, and one that slashed the dramatic bull market gains of the 1980s neatly in half. More than 600 million shares, nearly twice as many as the record set just one trading day earlier, exchanged hands on Black Monday. A third of the Dow's components were not accessible to traders for nearly an hour after the opening bell, and the "tape " -- updated to a digital system capable of tracking 900 trades a minute -- fell more than two hours behind.
What caused this staggering loss? Many blamed computerized trading. Others simply attributed it to a widespread panic over inflated stock valuations. Innovative new investment strategies also received some scrutiny. Japanese investors, then surging toward the giddiest heights of their bubble-of-a-lifetime, were suspected of worsening the damage by retreating from American markets en masse on Black Monday. A flurry of excuses dashed across Wall Street, but no one seemed to have any immediate answers. Most investors were too busy worrying about the imminent recession supposedly heralded by Black Monday.
Later analyses placed most of the blame squarely on trading systems not designed to handle the strain of a sudden break. In Wall Street's rush to computerize their trading platforms and strategies, basic fail-safes were overlooked and widespread algorithmic deficiencies created that turned a crash into a cascade reaction. Mark Carlson of the Federal Reserve studied the crash two decades later and concluded:
There were two program trading [computer or high-frequency trading] strategies that have often been tied to the crash. The first was "portfolio insurance," which was supposed to limit the losses investors might face from a declining market. ... In practice, many portfolio insurers conducted their operations in the futures market rather than the cash market. ... There were concerns that the use of portfolio insurance could lead many investors to sell stocks and futures simultaneously; there was an article in The Wall Street Journal on October 12 citing concerns that during a declining stock market "could snowball into a stunning rout for stocks."
The second program trading strategy was "index arbitrage," which was designed to produce profits by exploiting discrepancies between the value of stocks in an index and the value of the stock-index futures contracts. ...
By the end of the day on Friday [before Oct. 19], markets had fallen considerably. ... This decrease was one of the largest one-week declines of the preceding couple of decades, and it helped set the stage for the turmoil the following week. Portfolio insurers were left with an "overhang" as their models suggested that they should sell more stocks or futures contracts.
Extreme selling pressure at the open, which caused a discrepancy between futures contracts and the underlying prices of stocks on a delayed tape, induced portfolio insurers' trading programs to sell shares to exploit the difference. Once the true price of these devastated stocks became known, it became apparent that shares had been sold at lower-than-expected prices, causing a brief flurry of buying to compensate -- the aforementioned pre-lunch surge from 250 points down to only 150 points down. However, this was not enough to prevent other trading programs from tripping into sell mode once the lower share prices came across the tape. Forbes writer Robert Lenzer has called it "the first whirlwind tornado of the Age of Derivatives" because of the added leverage index futures contracts heaped onto the market.
Market managers moved quickly to ensure that such a cascade would never happen again. Circuit breakers, now commonly used to arrest extreme fluctuations in individual stocks, were put in place shortly after the crash on a marketwide basis. Marketwide circuit breakers have been used only three times since their implementation changed to a percentage basis: once in 1997, once in 2008, and once in 2010, the latter of which became the modern-day equivalent of 1987's collapse despite causing far less damage to portfolios. But other efforts proved more dangerous -- new Federal Reserve Chairman Alan Greenspan stepped forward the very next day with a pledge of liquidity, introducing what soon became known as the "Greenspan put," an implied government-supported floor to the market. This introduced greater degrees of moral hazard into the actions of market makers, who now believed that they would be bailed out -- as would later be the case -- if they went too far.
The Dow quickly shrugged off the damage of Black Monday, which proved to be the low point of the short, sharp, and shocking Crash of 1987. Markets immediately resumed a march toward dot-com-fueled record highs with a 6% pop the following day as a result of Greenspan's statements, and no recession occurred until a brief downturn in 1990. Despite the shallow bear market caused by that recession, the Dow advanced to an early 2000 peak 575% higher than its closing value at the end of Black Monday.
Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter, @TMFBiggles, for more insight into markets, history, and technology.
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