Black Monday - 1987 on Monday, October

Black Monday - 1987 On Monday, October 19, 1987, the Dow Jones Industrial fell 508 points -- which meant that it lost 22.6% of its value -- which was an unprecedented fiscal calamity at that time. This paper delves into that frightening dive, into the reasons why it happened, and looks into the possibility that it could happen again. Why did it happen? In January, 1987, the Dow Jones Industrials gained 13.8%, according to NBC's Consumer News and Business Channel (CNBC).

Through the month of March the Dow was up 21.6% and through July the Dow was up 37.7% (CNBC). In August of 1987 the Dow peaked at 2,722, a remarkable gain of 43.6% on the year. Then in October (between the 2nd and 16th) the Dow lost 15%, which was a kind of warning shot to investors that something was wrong. Then on the 19th of October, the market crashed and the Dow lost about 23%, according to CNBC. The year ended with a 2.3% gain overall (CNBC).

Bruce Bartlett, a senior fellow with the National Center for Policy Analysis explains that the blame for the 1987 crash can be traced to the "…interplay between stock markets and index options and future markets" (Itskevich, 2002, p. 1). In the stock market component, investors actually purchase shares of stock, Bartlett explains.

But in the futures market, investors are only "purchasing rights to buy or sell stocks at particular prices"; hence, the value of options and futures -- which are called derivatives -- is driven by changes in actual stock prices albeit "no shares are owned" (Itskevich, 1). Bartlett puts the blame on the fact that the derivatives markets and stock markets failed to work "in sync"; this was a "major factor" leading to the crash (Itskevich, 1).

Another source Itskevich references is an economics website in the University of Melbourne; this source claims that the enormous budget and trade deficits that built up during the third quarter of 1987 "…might have led investors into thinking that these deficits would cause a fall of the U.S. stocks…" in comparison to foreign securities at that moment (Itskevich, 2). The University of Melbourne website questions whether the U.S.

budget deficit really was part of the problem, because if it was then why didn't stock markets in other countries crash as well? Meanwhile, according to Forbes staffer Robert Lenzner, the dive in the Dow was "…triggered by the use of dangerous leveraged stock index futures in Chicago" (Lenzner, 2012, p. 1). That in turn caused many investors and other firms to lose control of their "sell orders" and it turned into a "chaotic mess" that was not regulated and not "transparent" (Lenzner, 1).

From that problem there resulted a "wholesale short dumping of S & P. index futures" which caused "massive selling of the underlying shares" in the NYSE (Lenzner, 1). The author suggests that the computerized programming in the world of investments helped create the mess. And interestingly, Lenzner asserts that the crash on Monday, October 19, 1987, had nothing whatsoever to do with the American economy. In fact the market was going through the "first whirlwind tornado of the Age of Derivatives" (Lenzner, 1).

The Forbes journalist references a comment by financial icon Warren Buffett, who fully understood that "…allowing investment banks and hedge funds and other investors to buy or sell index futures with only a 5% down-payment was an invitation to disaster" (Lenzner, 2). The Federal Reserve explains that the crash in 1987 showed "…the weaknesses of the trading systems themselves"; the crash also showed how the trading systems can be "strained and come close to breaking" when conditions are "extreme" (Carlson, 2006).

A major problem that contributed to the lightning-fast decline was the great difficulty in "…gathering information in the rapidly changing and chaotic environment," Carlson explains. The existing systems were simply not able to process so many transactions at the same time and the "uncertainty about information" very likely contributed to a "pull back by investors from the market" (Carlson, p. 2).

One more factor that Carlson -- who is on the Board of Governors of the Federal Reserve -- mentions is the "record margin calls that accompanied the large price changes" that day (2). The size of the margin calls and the "timing of payments" contributed to the reduction in market liquidity, Carson continued (2).

As additional background, Carson notes that the financial markets had witnessed a big increase in "program trading strategies," which involved high-speed computers set up to "quickly trade particular amounts of a large number of stocks" when conditions were just right (4). He references a problem due to "portfolio insurance," which is a program designed to limit the losses that any investor might have to deal with in a "declining market" (4).

In other words, an investor could buy stocks in a market that was going up and he could sell them in a falling.