Tuesday, May 23, 2006

Black Monday 1987 0 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
In the wake of two local "Black Mondays" I thought it would be a good time to outline one of the original Black Mondays.

How much has the STI dropped in each of the last two Mondays which witnessed the largest drops compared to other subsequent days of the week? About 3% on each day. Compared to Black Monday in the US on Oct 19 1987, this was small fry: on that day, the Dow Jones Industrial Average (DJIA) fell by 23% in the course of one day. Statistically, it is not hard to conclude that many stocks probably fell by 50% or more in one day alone.

What is it about Mondays? In the other major collapse of the 20th century, 1929, it was also a 13% collapse on a Monday (October 28) that triggered a secular bear and the Great Depression; the greatest point loss in DJIA history was also on a Monday(17 September 2001, 685 points). Someone (think it's Peter Lynch) has suggested a possible reason: people have plenty of time to think over things over the weekend, and the sensation-seeking press will always make sure that they have plenty of things to worry about: trade deficits, budget deficits, rising inflation etc. So come Monday people will have made up their minds to sell off some assets and revert to cash. When enough people worry in this way, the result is a market sell-off that if uncontrolled could feed on its own momentum.

The cause of the dramatic collapse on that fateful day in 1987 are still debated by academics to this day but suffice to say that it cannot have been due to long-term fundamental factors. The best evidence was that the market recovered to its previous level within a year, and then proceeded on another decade of bull run --- the longest sustained secular bull in history.

The Black Monday market collapse in the US was probably triggered by earlier market collapses in overseas markets earlier (the US market lags Asia by ~12 hours, as seasoned investors may well know). Markets in Asia and parts of Europe had already posted heavy losses before the New York markets opened, which drew its lead from there.

Program trading has been the most-oft quoted single reason for creating and sustaining the market panic of Black Monday, so I'll discuss it although one should be aware that in post-mortems it is always easier to blame a system or institutional structure (in this case, computerised trading) than the humans involved. There are two main types of program trading being blamed here: index arbitrage and portfolio insurance. Index arbitrage takes advantage of discrepancies between markets by simultaneously buying in one and offsetting that purchase with a short position of the same size in another closely linked market. Portfolio insurance involves the sale of stock index futures to protect the value of a falling stock portfolio. These strategies are supposed to hedge against losses in fund managers' portfolios by adopting offsetting futures positions to underlying index/stock positions (compare this to the "convergence trades" practised by Long-Term Capital Management; however in a market panic what happens of course is that falling stock prices triggers fall in futures prices (as the latter are being sold to hedge) and which in turn feeds back to further falling stock prices. What might have been a self-stabilising situation under normal market conditions turned into a destabilising system. This explains the swiftness and extent of the market collapse, and also underlines the close linkages between the stock and futures markets that had developed by then.

As mentioned above, market players also had plenty to worry about. The thing about the markets is that it can be similar to marriage life: issues can be simmering below the surface while the market chugs along, but on a bad day all these can suddenly come into public consciousness and create continuous waves of psychological panic. Those who have experienced the SGX market correction these few days can testify to this: one moment everybody (including, if not especially, the analysts) were calling for a smoothly-rising economy and stock market in 2006, the next moment issues like high oil prices, rising interest rates, a weak US dollar, political instabilities (in the Middle East and South America), a slowing China, a commodities collapse suddenly float to the surface. In 1987 the issues were as follows: Iran-US spat, declining US dollar, high interest rates, high trade deficit. I suppose you can draw exact parallels between the macroeconomic concerns then and now (with the exception of the China issue). History works in mysterious ways.

At the same time, some also quoted the possible reason of US market overvaluation. The S&P was trading at 19X PE in 1987, an above-average valuation that might have formed a fundamental basis for selling down, in the minds of investors and fund managers on Black Monday. However, subsequent strong corporate earnings through the rest of the decade and beyond might have judtified this valuation.

All these factors probably contributed to creating and extending a crisis of confidence on the big day, and then accentuated (instead of nullified) by the emotionless computers through program trading. They also accentuated the problems of academicians, hitherto the preachers of the "rational investor" theory and Efficient Market Hypothesis. How could a 23% single-day drop justify their assumption that investors were rational or that the market was efficiently priced (fundamentals couldn't have declined 23% in one day)? That's why it was convenient to blame structural weaknesses (ie. program trading) for the collapse.

In the wake of the crash, markets around the world were put on restricted trading primarily because sorting out the orders that had come in was beyond the computer technology of the time. This also gave the Federal Reserve and other central banks time to pump liquidity into the system, as well as lowering short-term rates, to prevent a further downdraft. Market suspensions in the wake of drastic collapses are still practised to this day (eg. the Sensex market suspension just yesterday) to allow liquidity injections and for investors to come to their senses. Some call the Black Monday of 1987 a selling climax, where the excess value was squeezed out of the system. It reinforced the market collapses in international markets, such that by the end of October, stock markets in Australia had fallen 42%, Canada 23%, Hong Kong a whopping 46%, and the UK 26%. As mentioned earlier, the rebound from Black Monday was swift as well, and ultimately the US market recovery in 1988 onwards led the way out of the blue for world markets.

(1) Wikipedia entry: Black Monday 1987
(2) Stock Market Crash Net: Black Monday- the Stock Market Crash of 1987
(3) Sniper.net: Stock market crash - Black Monday - October 1987
(4) Lope Markets: The 1987 Stock Market Crash




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