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Black Monday: Could it happen again?

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On Oct. 19, 1987, exactly 25 years ago today, the stock market suffered its worst single-day loss of all time, on what quickly came to be known as Black Monday. The Standard & Poor’s 500 lost 20 percent of its value, by far its largest drop ever. The crash of 1929, the one that kicked off the Great Depression, comes in a distant second at 12.3 percent.

The circumstances leading up to that crash are an artifact of the times, with many conditions that were at their strongest in the 1980s. Investors today are still very wary of the equity markets — witness the more than $60 billion that has flowed out of domestic stock funds this year alone — but we still seem to be a long way from suffering another single-day collapse like that one.

It is a measure of how long ago the whole thing happened to note that the Dow Jones crossed 2000 for the first time on January 8, 1987. The first part of the year was very good for the market, with the Dow rising 44 percent before peaking that August. But there were concerns as well: The Ivan Boesky insider-trading scandal and the troubles encountered by the high-flying investment bank Drexel Burnham Lambert dampened the general public’s confidence in the trustworthiness of the markets.

The macroeconomy was going through some gyrations of its own as the market was rising. Although the legendary inflation of 1979-80 had dropped below 2 percent by much of 1986, it began to turn upward again in 1987, topping 4 percent. Concerned that hyperinflation might be returning, the Federal Reserve quickly raised interest rates, scaring away stock investors and driving long-term bond yields up toward 10 percent, which pushed many investors in the fixed-income market.

And then there was portfolio insurance, now considered a prime factor in the subsequent crash. Many trading firms began to use stock futures as a hedge against precipitous drops in stock prices. But after the Dow peaked in late August and prices dropped over the early autumn, traders found that there were fewer and fewer buyers on the other end of the insurance trades, leading to a massive backlog of sell orders waiting to be fulfilled.

On the week of October 12, the Dow began looking very precarious. On Wednesday the 14th, it suffered a record drop of 95 points; Friday the 16th beat that record, with a drop of 108 points on an all-time high in volume. The index had lost about 10 percent of its value in the course of a single week: about 5 percent of its value over the first four days, then another 5 percent on Friday.

Then there was another shock to the system: war. That Friday, Iranian missiles struck a U.S.-flagged tanker off the coast of Kuwait, and many feared we were headed to an armed conflict with Iran.

On the weekend before the crash, sell orders built up from all that portfolio insurance, as investment managers tried to sell off their futures and cover their insurance. Nervous individual investors also spent the weekend fretting about the market and deciding to get out.

On Monday morning, all those panicked investors had to compete with a tsunami of preprogrammed sales, with everyone trying to dump their stock. Then news came that two American warships had shelled an Iranian oil platform in the Persian Gulf. The Dow dropped 100 points by noon, and the plunge just accelerated from there. The day’s volume of more than 600 million shares traded was nearly twice the previous record, set the Friday before. When it was all over, the Dow had lost more than 500 points – 22 percent of its value in a single day.

Many expected the crash to kick off another Great Depression, but it didn’t happen. The Dow bounced back quickly and even finished 1987 up by 2.2 percent, fueled in large part by companies buying back their newly devalued stock. The Fed dropped interest rates, and a system of circuit breakers was put into place to stop trading when stocks began to plummet too quickly. Interestingly enough, the Black Monday crash was the end of a market decline, rather than signaling the beginning of one, as so many feared.

It was also the result of a perfect storm of events, many of which could not happen today, and others of which are unlikely to align so perfectly ever again. As we saw in the May 2010 Flash Crash, the market recovers from disasters much more quickly these days. While there will undoubtedly be sustained drops in market value taking place over weeks and months, it could well be that we never see another 20 percent drop in the S&P 500 in a single day.

For more from Tom Nawrocki, see:

The warning signs in earnings season

The tales of 9 stocks that doubled

The fallout from Europe


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