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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Stock Market Crash of 1987

What it is:

The stock market crash of 1987, also called Black Monday, refers to the 509-point fall in the Dow Jones Industrial Average on October 19, 1987, one of the worst days in the average's history.
 

How it works (Example):

Black Monday is perhaps the most famous trading day in Wall Street history. In one day, the companies in the Dow Jones Industrial Average lost 22% of their value, or about $500 billion.

Put simply, the reason for the market crash, as with any crash, was that the supply of stock suddenly far exceeded the demand for stock, and investors, fearing that prices would continue to fall, panicked. However, the specific causes of Black Monday are controversial and numerous. Although many still blame program trading and portfolio insurance for the crash, no one event is solely responsible -- each factor that affected the crash was only part of a larger web of influences. For example:

  • The bond market, especially the junk bond market, was especially popular in 1987, and Treasury yields hit record highs (about 10%). Many investors questioned the wisdom of being in the stock market when they could receive similar or better returns from bonds. Rising crude oil prices also created inflation worries, which further increased bond yields. However, many considered bond yields too high, blaming out-of-control fears about inflation, which was about 4%. Regardless, the stock market was seeing record highs, record trading volume and high P/Es, demonstrating that many investors were still optimistic in 1987.
  • A steadily falling market showed that institutional investors' heavy dependence on program trading and portfolio insurance actually did more harm than good. Investors originally used derivatives to prevent losses, and many accomplished this by selling index futures. However, in a rapidly declining market, this desire to sell only exacerbated the downward pressure on the market. Further, the institutional investors' program trading mechanisms hastened the downward spiral by automatically placing stop-loss orders after the market crossed certain thresholds. On Black Monday, the heavy sell volume overwhelmed the NYSE's automated order system and many traders simply gave up trying to execute trades for a time. These events created serious information gaps and delays, which further inflamed the panic selling.
  • The United States trade deficit was relatively high, and the House of Representatives passed an amendment aimed at reducing the trade surpluses of many Asian countries, which made Wall Street worry that there would be less Asian demand for U.S. Treasuries. Wall Street also worried about the weakening dollar.
  • Events in the Middle East were creating concerns about military action or war. A few days before the crash, Iranian missiles hit a U.S. tanker near Kuwait, five months after an Iraqi missile hit a U.S. frigate. This drove the Dow Jones Industrial Average down on October 16. On October 19, Black Monday, two U.S. warships shelled an Iranian oil factory.
  • A series of corruption and insider trading investigations continued to get headlines in 1987. Most major investment banks came under SEC scrutiny, including Drexel Burnham Lambert; Goldman Sachs; Merrill Lynch; Paine Webber; and Kidder, Peabody. Some of the Wall Street's most famous names also were caught in a variety of legal troubles, including Ivan Boesky, Michael Milken and Carl Icahn. As a result, many investment banks struggled with major layoffs, disenchanted clients and bitter investors.

Why it Matters:

The stock market crash of 1987 was a reminder of the power of the markets. It became an example of the power of investor confidence and the interrelation of global financial markets and economic factors. It also exposed the weaknesses of new portfolio strategies (namely portfolio insurance and program trading) and created opportunities for new technologies (namely circuit breakers and increased trading capacity) that help prevent or mitigate selling panic. For individual investors, it became a prime example of the risks of short-term investing and of the temporary nature of trends.

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