“Black Monday” Revisited

With the stock market at or near all-time highs, and with traditional measures suggesting it is overvalued, I’ve been seeing a number of articles about today’s anniversary of the crash of October 19, 1987, when the Dow crashed 22 percent in a single day—still the largest one-day decline in history. A lot of the articles I’m seeing now say “we still don’t know exactly why it happened,” but I think this is not correct. Here’s my narrative of the events leading up to and immediately following the crash.

Looking back afterwards, the harbingers of a stock market breakdown become easier to make out. The stock market could not maintain its level in the face of rising interest rates and extreme valuations; the Standard and Poor’s 500 Index was trading at 22 times trailing earnings at the market top in August, far out of line from its historic range.  A study in the Harvard Business Review would later conclude that the market was 17 percent overvalued at its peak.  Market volatility started noticeably increasing, with 40 and 50 point swings in the course of a trading day—the equivalent of 200 points nowadays.  At the market peak in August, big institutional buyers—mutual and pension funds—were net buyers of about 2.8 million shares a day. But by mid-September, the funds had become net sellers, shedding 300,000 shares a day. By mid-October institutional funds were dumping shares, with daily net sales accelerating to 4.4 million shares.

Right after Labor Day, the New York Stock Exchange’s president Gerald Corrigan said, “the storm clouds were visibly gathering.” A few prescient observers at the time saw the clouds forming and sounded the alarm in real time.  Commodities trader Paul Tudor Jones had been saying since late 1986, “There will be some type of decline in the next 10, 20 months, and it will be earth-shaking; it will be saber-rattling.” Robert Prechter, an advocate of the esoteric Elliott Wave hypothesis of market behavior, said on October 5 that “The overvaluation of stocks is more extreme than the 1929 high.” The legendary investor Philip Fisher—Fisher had gone through the Great Crash of ’29, after having famously predicted that stock prices would go still higher—told Forbes magazine that the stock market looked to him like 1927 or 1929.  The advance cover date of the Forbes issue where his remarks appeared was October 19.  A little known stock adviser named Elaine Garzarelli advised her clients to sell everything a week before October 19; she would be little known no longer.  But as the signs of a market meltdown accumulated, the market would stage robust rallies that lulled investors; on September 22, the Dow rallied for 75 points, a record rise at the time.

During the week of October 5, the Dow fell 150 points, starting off a roller-coaster that set the stage for Black Monday.  Volatility increased the following week.  On Monday October 11, the Dow fell 11 points, but it rallied Tuesday by 37 points.  Kidder, Peabody reassured its clients: “The long-term bull market remains intact. On an intermediate-term basis, early 1988 should still witness 2900 on the Dow Jones Industrial Average.” On Wednesday, October 13, the trade deficit figure for the previous month was released; it was $1.5 billion higher than expected. Bond yields spiked above 10 percent for the first time in two years. The Dow fell 95 points, at that time the largest one-day drop ever. On Thursday, the market seemed steady until the last half-hour, when a wave of heavy selling drive the Dow down another 57 points. It was the 4th busiest day in market history. The Dow had now declined in eight of the past nine trading days.

Reacting to the trade deficit numbers, Treasury Secretary James Baker had said, late in the day on Thursday, that the U.S. could “accommodate further adjustments” in the value of the dollar, meaning that the U.S. was willing to let the dollar’s value fall further.  Baker’s comments reinforced market suspicions that further weakening of the dollar was the unofficial policy of the Reagan administration; a falling dollar would put more upward pressure on interest rates. Friday was another debacle on Wall Street. After trading evenly for most of the morning, at lunchtime the bottom fell out. The Dow fell 108 points—another new record—dropping the last 50 points in the final half hour of trading.  338 million shares had traded hands—also another new record.

The market turmoil got the attention of the White House. Late in the day Reagan met with Greenspan, Baker, Treasury Undersecretary Beryl Sprinkel and others to take stock.  Reagan expressed his concern that the money supply was too tight.  As he recorded in his diary, “Alan [Greenspan] doesn’t agree & believes this is only an overdue correction.”  Over the weekend, Baker returned to his dollar-bashing theme, telling “Meet The Press,” “We will not sit back in this country and watch [trade] surplus countries jack up their interest rates and squeeze growth worldwide on the expectation that the United States somehow will follow by raising its interest rates.” On Sunday the 18th the New York Times ran a story quoting a “senior administration official” (Baker adamantly denied being the source for the story) saying the U.S. would allow the dollar to decline against the West German mark.  Unrest in the Persian Gulf added further to Wall Street jitters.  Late in the week Iran had fired on an American oil tanker.  Over the weekend the U.S. Navy destroyed two Iranian oil platforms in retaliation (the platforms had been used a staging areas for the Iranian attacks on Gulf shipping).

Many individual investors who had flocked to the market during its bull phase panicked and jammed the phone lines at mutual fund companies. Fidelity received 80,000 calls.  Joseph Nocera wrote: ‘The people who ran the likes of Fidelity and Schwab and Vanguard knew—absolutely knew—what was going to happen next.”

The turmoil and declines of the previous week left the markets deeply shaken at the open on Monday morning. The Dow fell 68 points in the first half hour of trading; 11 of the Dow 30 stocks were unable to open because of severe imbalances between sell and buy orders.  With no buyers, over 200 stocks—one-twelfth of the NYSE’s listings—could not open for trading.  At 11 am the market appeared to have stabilized, down “only” 200 points. Then the new chairman of the Securities and Exchange Commission, David Ruder, blundered.  At the completion of a speech in Washington, Ruder, besieged by reporters wanting comment on the market turmoil, mused aloud about halting trading on the NYSE.  His comments hit the trading floor shortly after 1 pm.  Ruder claimed later to have been misunderstood, and even though the SEC quickly issued a statement saying it was not going to close the markets, the psychological damage was done.  (This was not a new idea for Ruder; he had mentioned the idea of a trading halt to combat volatility in a speech on October 6.)  The afternoon was a one-way rout.  The system for handling large orders seized up under the huge volume, and computer screens on the trading floor went blank.  Many trades cleared at prices far from the price in effect when the orders were placed.  Orders for sales of more than 100 million shares were never completed at all, and the trading tape, which can handle 900 trades a minute, ran two-and-a-half hours behind.

Some evidence suggests that selling by individual investors drove the magnitude of the crash; the volume of large trades (25,000 shares or more) by institutions was only 2 percent higher in October 19 than the average of the preceding 50 trading days. But a larger factor in driving the market over the cliff was an innovation that was supposed to protect investors against this very risk—“portfolio insurance” in the form of index futures options. Starting in 1982 the Chicago Mercantile Exchange began selling a new financial product—futures options on the price of various stock indexes.  Index options were thought to be a perfect hedge against losses. Owners of large stock positions with big paper gains could hedge against the prospect of large decline in price by selling a futures contract on the price level of one of the major stock indexes, such as the S & P 500, and thereby lock in gains. Index option prices would rise and fall with the level of the index itself, naturally. These index option contracts were highly leveraged, and there quickly developed a thriving index arbitrage practice whereby traders would exploit differences implicit in the index option price and the prices of the underlying stocks in the index.  Movements in the options index price or the price of the stocks themselves put reciprocal pressure on the other, resulting in increased volatility, especially on what became known as “triple-witching day,” when index options expired and had to be settled.  This dynamic was the origin of computerized program trading; computers would shift massive amounts of money from index futures to the underlying stocks, depending on which was cheaper at the moment.

While in theory index options should have helped to smooth the market during ordinary conditions, their highly leveraged nature meant they increased risk of a market meltdown in any episode of extraordinary volatility or market panic. On October 19 automatic computer trading programs flooded the market with billions of dollars in index option sell orders, but with no buyers the prices collapsed and pulled down the prices of underlying stocks. It was the financial equivalent of a runaway nuclear war by computer rather than human decision. Reflecting later on the problem of computerized trading, Greenspan would later say: “The market plunge was an accident waiting to happen.” One of the market reforms enacted after the October 19 crash was limits and halts on computer trading in conditions of extraordinary volatility.

When the dust settled at the end of the day the Dow finished down 508 points on 604 million shares of volume, closing at 1739, down from 2516 just 11 days earlier. It was a 22 percent loss in one day, representing a half-trillion dollars in market capitalization.  Forty stocks declined for every one that rose; normally a three-to-one ratio is considered a rout.  The one-day figure understated the damage: along with the previous Thursday and Friday, the Dow had lost 769 points—a third of its value—in three days. By contrast, the Great Crash of 1929 had taken the market down 13 percent. And the crash was global. As the market closed in New York, the contagion spread to the markets opening in the Far East.  In Hong Kong the main stock index dropped 45 percent, and the stock market closed for the rest of the week. Japan’s stock market dropped 15 percent; Australia’s market plunged 20 percent, and the London stock market fell 12 percent. Many investors fled to Treasury bonds, but gold jumped $10 an ounce to a five-year high.

Blue-chips became black-and-blue chips: Westinghouse lost one-third of its value; Exxon one-quarter; IBM one-quarter. The value of Sam Walton’s share of the company he founded, WalMart, fell $1.1 billion.George Soros lost $800 million. Securities firms feared a classic run on the bank from panicky account holders. Donaldson, Lufkin & Jenrette posted uniformed security guards outside its New York office, fearing violence from customers. Alan Greenspan was on a commercial airline flight to Dallas during trading hours; when he deplaned he was relieved the hear that that market had fallen “five-oh-eight,” assuming it meant 5.08 on the Dow. “Some people are talking of panic,” Reagan wrote in his diary that night. He was slow in paying attention to the market’s action as it had been a busy day elsewhere. He spent the late afternoon with Nancy at Bethesda Naval Hospital, where she was recovering from breast cancer surgery two days before.

Not surprisingly the first order of business at the White House the next morning was another meeting between Reagan and his economic advisers. Greenspan was still in Dallas, where he issued a short statement first thing Tuesday morning to reassure the market of the Fed’s “readiness to serve as a source of liquidity to support the economic and financial system.” He then cancelled his morning speech and returned to Washington on the first available plane.

The panic Reagan worried about nearly came to pass on Wall Street the following day.  History—and Reagan’s diary for October 20—records that the markets settled down and the Dow rose 102 points, providing some measure of relief to Washington and a nervous public. Neither the White House nor the public learned until later that, in fact, October 20 was more unsettling than the 19th had been, as the stock market came within a hair’s breadth of collapsing and shutting down. Financier Felix Rohatyn told the Wall Street Journal that “Tuesday was the most dangerous day we had in 50 years; I think we came within an hour” of the disintegration of the market.

The immediate problem at the end of the day Monday and at the market open on Tuesday is that many securities firms and specialists (the firms on the trading floor who perform the all-important function of making a market for individual stocks by buying and selling from their own inventory) were facing margin calls on account of the fallen value of their now-swollen holdings, and, according to market rules, needed to settle their accounts within five business days. Many firms lacked sufficient cash to do so. But banks that normally extended credit to brokers and specialists were reluctant to step into the breach.  Specialists and brokers were stunned when their banks said Monday night and early Tuesday morning that they wouldn’t make new loans. Some specialist firms faced immediate insolvency; as a result, a few were forced into “shotgun” mergers with larger firms. One small specialist firm that faced immediate insolvency, A.B. Tompane, merged overnight with Merrill Lynch; the deal was completed at 3 a.m. Tuesday morning.

Despite the Fed’s promise of liquidity, the market opened slowly, with many leading blue chip stocks taking an hour or more to begin trading. Initially the Dow Jones average was up an encouraging 200 points, but this gain quickly evaporated as specialists and securities firms tried to unload the large unwanted positions built up the day before.  As buy orders dried up, blue chip stocks ceased trading one by one like a row of falling dominoes.  Merck stopped trading at 9:52 am; Sears at 11:12; Eastman Kodak at 11:28; Philip Morris at 11:30; Dow Chemical at 11:43. Some blue chips had not opened at all.  Stocks that remained open were trading sporadically and in small volumes. With so many stocks closed, the American Stock Exchange and the Chicago Mercantile Exchange halted options trading. By noon the Dow was off 100 points and market watchers feared it was about to drop over the cliff and fall another 200 points.

Rumors swept trading floors nationwide during the lunch hour that the New York Stock Exchange was going to close. In fact the NYSE’s president and senior executives were meeting to decide whether to take such a dramatic step. Behind the scenes, several securities firms—Goldman Sachs and Salomon Brothers were said to be among them—were calling the SEC in Washington and urging the SEC to close the exchange (the SEC does not have the power to do this, but could presumably ask the president, who does).  White House chief of staff Howard Baker encouraged the markets to stay open. The NYSE’s president, John Phelan, recoiled from the thought of closing the market: “If we close it, we would never open it.”

At about 20 minutes before 1 pm a sudden turnabout occurred that traders later described to the Wall Street Journal as “a miracle.” At the Chicago Board of Trade, buy orders started flooding in for the MMI (Major Markets Index), the only major index option still trading. Within five minutes the prices of the MMI swung from an implicit 60-point discount to the underlying value of the stocks in its index to a 12-point premium. The Wall Street Journal described it as “the equivalent of a lightning-like 360-point rise in the Dow.” As with many market events, where this flood of buy orders came from is not fully known, but circumstantial evidence pointed to a small number of sophisticated buyers acting deliberately to force the market back into positive territory. News of the surge in the MMI reached the trading floors in New York at the same time several major corporations announced major share buybacks. Several banks reversed their earlier position and now agreed to extend credit to specialists and brokers. Shortly after 1 pm, most blue chips stocks reopened for trading; the crisis was over. The Dow ended the day up 102.2 points—a record move at the time, once more on record volume of 608 million shares.  Gainers outnumbered decliners 1,398 to 537. Wednesday October 21 was even better: the Dow rose 186 points; 1,749 stocks posted gains.

It was the end of the panic. Instead of a prolonged bear market, stocks resumed their slow upward march, and the economy continued to grow rather than stalling out.  GDP grew by 3.4 percent for 1987 as a whole, and a robust 6.1 percent in the 4thquarter).  The economy then grew 4.1 percent in 1988, and corporate profits were up more than one-quarter.  Consumer confidence surveys rebounded quickly, and there was no apparent impact on consumer spending. Within a few months USA Today noted “a host of signs that recession worries are overblown,” and National Review taunted the naysayers: “What if the press threw a recession and nobody showed up?” A year later, the Financial Times looked back: “The prophets of doom have been confounded. Far from being pitched into recession, the world economy is approaching the anniversary of the crash with the fastest growth since 1984.” Anyone who bought stocks the day after the crash made out handsomely. By the end of 1988, the Dow Jones Industrial Average was 25 percent higher than at the close of Black Monday.

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