Market Crash: Black Monday (19 October, 1987)

On 19 October, 1987, the stock markets around the world collapsed by huge percentage points resulting in huge losses in a very few hours. This day came to be known as “Black Monday” (or “Black Tuesday” in Australia and New Zealand). This day resulted in the largest drop in the history of major indices around the globe including DJIA, S&P 500 and FTSE indices. While the economic situation had worsened in the days leading to Black Monday, there was no single factor that could have pointed to what was to come about. Yet, a confluence of factors eventually lead to the outcome of this day. And then a number of actions taken/events that happened during this day and the day following, perhaps resulted in the limiting the losses and eventually making a turnaround in the index prices.

This crash is a very difficult one to understand - because, thing happened so fast, because no single factor played an overwhelming role, because how fast the recovery happened. Yet, to have a better understanding of markets and how they function we need to have a better understanding of this crucial day, the lead-up to it, as well as some changes that happened as a result of it. Though it must have been a painful day for those who lived through those moments, our markets are definitely better as a result of this crash (or the actions taken from the learnings of it).

Timeline

As usual we’ll examine this market crash by the means of a review of the timeline of key events.

Historical Context

1976

Invention of Portfolio Insurance
- Leland O'Brien Rubinstein Associates, Inc (LOR)
  - Key people:
    - Hayne Leland
    - Mark Rubinstein
  - Introduced Dynamic Hedging to the investment world

1980’s

The arrival of the Corporate Raiders

1981

Starting in mid-1981, Interest rates continue to drop as inflation begins to cool.

1982

Gibson Greetings sale
April 21, 1982: S&P 500 futures contracts were first introduced by the Chicago Mercantile Exchange (CME).
August 12, 1982: S&P 500 Index bottoms at $102.39 and continues an upward ride through the 1980’s. This date would mark the market’s acceptance of the defeat of inflation at the hands of the Federal Reserve and a projection of the end of the recession of the early 1980’s.

1983

1 July, 1983: SPX call options start trading on CBOE.

With the historical context set, we can now get into 1987.

1987

Jaruary

January 5, 1987: Treasury Yields close to the bottom since 1981 - 3 month at 5.42% | 10 year at 7.32% | 30 year at 7.45%

March

March 25, 1987: US Interest rates start rising
- US Dollar starts to drop
- US Trade deficit starts to balloon

August

August 11, 1987: Alan Greenspan appointed as the Chairman of the Federal Reserve
August 25, 1987: S&P 500 hits intraday high of $337.89 and closes at $336.77

September

September 4, 1987: Federal Reserve hikes interest rate by 0.5% to 6.0% in order to stamp out inflation.

October - BEFORE BLACK MONDAY

October 4, 1987 (Sun): Greenspan makes announcement on potential upcoming interest rate hike.
- Chairman of the Federal Reserve Allan Greenspan’s announcement of potential upcoming hike in interest rate.
October 6, 1987 (Tue): Stock market drop
- Elliot Wave Theory article published
October 7, 1987 (Tue):
October 8, 1987 (Thu): Stock market continues to drop
October 9, 1987 (Fri): Stock market continues to drop
October 12, 1987 (Mon): Stock market continues to drop
- Garcia report on Portfolio Insurance-driven selling
- WSJ reports on interest rate pressures
- Third loosing day in a row
October 13, 1987 (Tue): Stock market gains a bit
- Dollar gains
- Interest rates ticked down
- US House Ways and Means Committee Meeting: The US House Committee on Ways and Means introduced a tax bill that would reduce the tax benefits associated with financing mergers and leveraged buyouts. This would effectively raise tax on Corporate Raiders and Private Equity.
October 14, 1987 (Wed): Stock market gains a bit
- Early morning: News released on House Ways and Means Committee Meeting. Proposals included:
  - Eliminating deductibility of interest payments on debt including junk bonds
  - Corporate raider tax
- 8:30 am: Trade deficit announcement of over $15B (way more than expected)
- Late day afternoon: Late day selling
October 15, 1987 (Thu): Stock market gains a bit
- DJIA drops another 19 points
October 16, 1987 (Fri): Stock market gains a bit
- Stocks continue to go lower, slowly initially and then picking pace
- DJIA was down 4.6% on the day
- Interest rates picked up to higher levels - 3 month at 6.93% | 10 year at 10.23% | 30 year at 10.24%
- Post-close:
  - DJIA was down more than 10.4% on the week
  - Portfolio Insurance models dictated more selling to be done on Monday - $8.0 billion of futures to be sold
  - Iranian missiles hit a U.S.-flagged tanker off of the coast of Kuwait.

October 19 - BLACK MONDAY

Summary - This is the day of the crash
Early morning
- Geo-Politics: Operation Nimble-archer (US retaliation for Iran missile strike) - Two U.S. warships shell an Iranian oil platform in the Persian Gulf
Pre-Open:
- NYSE opened DOT an hour early (expecting a huge flow of orders)
9:30 am - Open:
- DOT had $500 million of stocks to sell
- Many stocks failed to open due to overwhelming sell orders and barely any buy orders. These stocks still reporting Friday’s closing price.
- 187 failed to open at market open
- $475 million sell orders loaded into DOT
10:00 am:
- $140 million futures were already sold
- 95 of S&P 500 stocks were still not trading
10:45 am: Stocks start trading
- Many blue-chips including IBM starts trading.
11:00 am: As more stocks start to trade the extent of the damage starts to become visible.
- DJIA had fallen 104 points in the first hour
- DJIA falls another 104 points in the next 30 mins
11:30 am: Pretty much all stocks are trading and the indices start to recover.
- SEC chairman (David S. Ruder) talks about the possibility of trading halt (without the knowledge of the recent recovery in stock prices)
11:45 am: News about SEC chairman’s discussion of possibility of trading halt hits the market
12:55 pm: DJIA at 2053 (194 points down, 8.6% down) since open
1:09 pm: Repeat story of SEC chairman’s trading halt proposal hits the market.
2:05 pm: DJIA drops 1969 - 278 points (12.4%)
4:00 pm: NYSE closes
Post-close:
- John J. Phelan Jr. (President of NYSE) news conference
- Allan Greenspan asks Leo Melamed - “Will you open tomorrow?”
  - Leo responds - “I do not know”
Conclusion of the Day:
- The DJIA Index declined by 508 points (22.6%)
- The S&P 500 Index declined by 57.64 points (20.4%)
- It was the worst day that the US stock markets had ever seen
- Leo Melamed (Chairman of CME) works on settlement

October 20 - DAY AFTER BLACK MONDAY

Summary - This was a day of extreme volatility and eventually became the day of the turnaround.
8:30 am:
- Continental Illinois bank advances money to CME clearing house
8:41 am: Federal Reserve Chairman Alan Greenspan issued a brief statement:

"The Federal Reserve, consistent with its responsibilities as the Nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system"

9:00 am:
- NYSE DOT was closed to ensure
- NYSE specialists given extended leeway to set prices
9:30 am:
- Specialist use the provided flexibility to raise prices or delay trading open until higher prices - this results in an artificially created higher price for the market, providing an impression of a strong open
- S&P 500 futures continued to put on downward pressure
11:00 am: Stocks continue a precipitous drops
11:45 am: CBOE suspends trading
12:15 pm: CME suspends trading
12:40 pm: MMI futures (CBOT) start to rally
- Buy orders start to trickle in to NYSE
- Buyback orders start to come in
1:00 pm: Stocks post a strong rally
1:04 pm: CME & CBOE starts trading
1:00 pm to 2:00 pm: Many stocks reopen (mostly higher)
Conclusion of the Day:
- DJIA had 102.27 points gain

S&P 500 index prices through most of 1987 and early 1988 with the dramatic drop of Black Monday clearly visible - Yahoo Finance

REST of 1987 - AFTER BLACK MONDAY/TUESDAY

The market would continue its bottoming process through December 4, 1987, before making a long recovery. On that day (December 4), S&P 500 would close at $223.92, below the closing price of October 19, 1987 ($224.84), but it never crossed the intraday low of October 20 (of $216.46) ever again.

In the days that followed, circut-breakers would become a common-thing in stock exchanges, that would solve for the liquidity risk that is inherent in fast-moving markets that may be thinly traded due to a variety of reasons.

Instruments & Technologies

Every crash tends to involve some technology (or instrument) that fails in some way or another. Below are some of the ones involved in this crash:

Portfolio Insurance - Algorithmic decision-making/manual execution hedging tool that became common-place in the lead-up to the crash.
DOT (Designated Order Turnaround) - Designated order turnaround is an order routing system formerly used by the New York Stock Exchange (NYSE) in which orders are sent directly to a specialist on the trading floor, thus bypassing the broker.

News Media Reports

The day following Black Monday there were many reports in news media with catchy headlines drawing people’s attention to this important event. Below are some examples:

The New York Times reports on top of the front page:

Stocks Plunge 508 Points, a drop of 22.6%; 604 Million volume nearly doubles record

The Wall Street Journal reports on the front page:

The Crash of '87 - Stocks Plunge 508 Amid Panicky Selling

Financial Times reports on 20 October, 1987:

Rout on Wall Street leads stocks to record falls

Conclusion

After Black Monday, regulators overhauled trade-clearing protocols to bring uniformity to all prominent market products.

They also developed new rules, known as "trading curbs" or colloquially as circuit breakers, allowing exchanges to temporarily halt trading in instances of exceptionally large price declines in some indexes; for instance, the DJIA.

These trading curbs were first used multiple times during the 2020 stock market crash.

The day would come to be known for many things including:

The largest drop in DJIA and S&P 500 indices in history (even beyond the drop on the days of the great stock market crash of 1929).
How the extended use of a somewhat less-understood instrument (Portfolio Insurance), specifically when used in not-so normal circumstances could lead to dramatic outcomes.
How severe drop in liquidity results in exponential high volatility
How the wrong tone & timing in communication by a key regulator (in this case the Chairman of SEC) could dramatically change the market’s tone.
How well measured assurance by key regulator (Chairman of Federal Reserve) and (President of NYSE) could help calm the nerves.