The 1987 Crash

The 1987 Crash

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On October 19th, 1987 a date that  later became known as "Black Monday,"   the Dow Jones Industrial Average fell 508points or  22.6%. This was the largest one-day decline that   Wall Street had ever seen. That one-day price  drop was about the same in percentage terms   as the two-day drop that happened in October 1929  on back-to-back days.  There were fears in the  

wake of the crash that it would lead to another  Great Depression, but in fact not even a recession   occurred.  The unemployment rate was 6% at the  time of the crash and it continued declining after   the crash reaching 5.2% by the time the stock  market had fully recovered in 1989. No one-day   drop had ever come close to the magnitude of  the1987 crash in the 100 years before the event,   nor has there been a drop that severe since. The  crash marked the end of a five-year 'bull' market   that had seen the Dow rise from 776 in August 1982  to a high of 2,722 in August1987. The day after   the crash, many investors feared that the market  would topple again like it had in 1929, however,   the market rallied immediately after the crash,  posting a record one-day gain of over 100 points   the next day, a record that was quickly broken  on Thursday the 22nd when the Dow rose186.64   points. All in all, it took just under two years  for the Dow to recover completely. In today’s  

video, we’ll look at the events leading up to the  crash, the best explanations for why it happened,   and examine how the 1987crash changed both the way  market’s function and investor psychology. During   the years prior to the crash, equity markets had  been strong, so strong that price increases had   outpaced earnings growth meaning that price to  earnings multiples had expanded significantly.   Some of the market strength was down to the  favorable tax treatment that had been given to   the financing of corporate buyouts, like allowing  firms to deduct interest expenses associated with   debt issued during a buyout. This increased  the number of companies that were potential   takeover targets, pushing up their stock prices.  The market was off to a great start in 1987,   and by late August the Dow Jones was up 69% Year  to Date. In mid-October, some bad economic news   began to rattle investor confidence leading to  increased market volatility.  Let’s look at the  

days leading up to the crash. On Wednesday  October 14th two major pieces of news broke.   First, the US House Ways and Means Committee  filed legislation to eliminate the tax benefits   associated with financing mergers. The proposed  legislation would eliminate the tax deductions   for some interest expenses and would start  taxing “greenmail” payments made by companies   to corporate raiders to buy back their stock at  above-market prices. This news reduced the odds   that certain companies would be take-over  targets. Leveraged buyouts were a big part   of what was happening in markets at the time, and  this law was basically shutting Gordon Gekko down.   Second, the US Commerce Department announced that  the trade deficit for August was notably above   expectations. This caused the dollar to decline,  increased expectations that the Federal Reserve  

would tighten policy and pushed up interest  rates, putting further downward pressure on   equity prices. On Thursday October 15th, equity  markets continued to decline. The press at the   time attributed this to investor anxiety.  Friday October 16th the day before the crash   was what is known in markets as triple witching,  a day when stock options, stock index futures, and   stock index options all expire on the same day.   This happens four times a year and usually causes  

higher trading volume and unusual price action  in securities as traders rebalance their hedges.   Price declines over the prior two days had  eliminated many at-the-money options so investors   couldn’t easily roll their positions into new  contracts for hedging purposes. This pushed   more traders into the futures markets, where  they sold futures contracts as a hedge against   falling stock prices. By the end of the day on  Friday, the stock market had fallen considerably,  

the S&P was down over nine percent for the week.  This was one of the largest one-week declines   that had been seen in the last twenty years,  and it helped set the stage for the chaos that   erupted the following week. There were signs that  futures markets were already being overwhelmed by   heavier-than-usual volumes that Friday, as traders  on the CME had to meet up on Saturday to try   to settle positions and sort out holdings. The  weekend break didn’t offer much reprieve either   as on Saturday, Treasury Secretary James Baker  publicly threatened to de-value the US dollar   in order to narrow the nation’s widening trade  deficit. That brings us to the day of the crash,   but first I have to explain what is meant  by portfolio insurance and program trading,   as these two trading strategies are widely blamed  for the 1987 Crash. Portfolio insurance was a  

trading strategy that had grown in popularity in  the late 80’s and was supposed to limit the losses   investors might face from a declining stock  market. Broadly speaking, the strategy used   computer models that would add to your equity  exposure as markets rose and cut your equity   exposure as markets fell. Portfolio insurance  gave investors a payoff similar to being long   a call option in that it gave investors upside  exposure but limited downside risk – at a cost.  

Portfolio insurers at the time didn’t update their  models constantly, and there were a few reasons   for this. Firstly, because computers were a lots  lower and more expensive back then. And secondly,   they wanted to minimize their rebalancing as  transaction costs can really add up the more you   trade, cutting into returns. Instead, they updated  their models occasionally, often after large   market moves and then traded in batches. This  could add to market volatility as occasional large   orders hit the markets. Anyhow, that is portfolio  insurance is. The next trading strategy we need  

to understand is “index arbitrage,” which aims to  generate returns by exploiting differences between   the value of stocks in an index and the value of  stock index futures contracts. If the value of   the underlying stocks in an index was lower than  the value of a futures contract, then arbitrageurs   would buy the stocks and sell the futures  contracts short knowing that the prices would   have to converge before the expiration date. When  the value of stocks in the index was above that of   the futures, arbitrageurs could do the opposite.  That is how index arbitrage works. Ok, so on  

Monday October 19th, there was substantial selling  pressure when the New York Stock Exchange opened.   Due to buy/sell order imbalances, many specialists  didn’t open the stocks they covered for trading   during the first hour of the trading day. 11 of  the 30 stocks in the Dow opened more than an hour   late, and stocks representing one third of the  value of the S&P500 were still not open by 10AM.    Now, stock index futures did open on time,  but with so many stocks not trading, some of   the quotes used to construct the stock market  indices that these futures tracked were stale.  

The price of an index is calculated using the most  recent price quotes for the underlying stocks.    Because out of date stock prices – ones from last  Friday - were being used for over a third of the   value of the index, the Dow and the S&P didn’t  decline as much as they would have otherwise. The   index levels didn’t represent what was happening  in the market. So, the futures market was actually  

reflecting the heavy selling that was happening  and because the futures fell much more than the   cash market appeared to, a gap was created between  the value of stock indices in the cash market   and in the futures market. Index arbitrage traders  who used computer systems to take advantage   of divergences like this were buying futures  (which looked relatively cheap) and sending   sell-at-market orders to the New York Stock  Exchange – but for stocks that were often not yet   trading. When these stocks finally opened, prices  gapped down due to the accumulated sell orders and   the index arbitrageurs discovered they had sold  stocks at considerably lower prices than they   had expected.  When stocks gapped down like this,  portfolio insurers’ models prompted them to sell.   The record trading volumes hitting the exchanges  that day overwhelmed many automated systems.  

Fidelity was a major seller on the day of the  crash and many of their orders were entered using   a relatively new touch-tone phone order entry  system. Previously, a large institutional investor   would not have been able to place the same volume  of orders as were being pushed in that day,   but the order execution systems were overwhelmed  by the volume. On the New York Stock Exchange,   trade executions were being reported more than an  hour late, which caused confusion among traders.   Investors didn’t know whether their limit orders  had been executed or whether new limit orders   needed to be set. The automated portfolio  insurance driven selling was noticed by  

market participants, who feared that there  would be more and more automated selling.   This encouraged a number of aggressive  trading-oriented institutions to sell   in anticipation of further market declines. These  institutions included floor traders, hedge funds,   pension and endowment funds, money management  firms, and investment banking houses. As they   sold, the falling prices caused further  reactive selling by portfolio insurers.   A feedback loop was in effect. Now, not  everyone agrees that portfolio insurance   was to blame for the 87 crash, but most do  consider it an important contributing factor.  

The1988 SEC report on the crash says that  these strategies were not the 'sole cause'   of the crash," but were "a significant factor  in accelerating and exacerbating the declines.   "It’s been pointed out that other stock markets  around the world crashed at the same time as   the US market and most of them didn’t have any  program trading or portfolio insurance products.   Many international markets even had losses that  were more severe than those seen in the US.  

The Presidential task force on Market Mechanisms  estimated at the time that 6 billion dollars out   of the 31 billion dollars of sell orders executed  both on the stock exchange and in futures markets   were portfolio insurance trades.  That comes  to just over19% of sell volume on the day of   the crash, so there were many other big sellers.  Robert Shiller of Yale University pointed out in   a 1988paper on the crash that while the idea of  portfolio insurance - or using the Black Scholes   Model to create synthetic options positions was  somewhat new at the time, investors didn’t exactly   need computers to know that selling stocks would  cut their risk. Portfolio insurance just added   an additional level of precision to a style of  investing that had been around for a long time,   where investors added to winning trades and  cut their position sizes when facing losses.   Shiller argues that institutional investors who  adopted portfolio insurance would likely have done   something similar anyhow in the absence of these  new quantitative strategies. He points out that   a frequent theme in the popular press before the  crash was that the bull market had gone on for a   long time and that the market was overpriced. He  says that charts of stock prices were frequently  

being discussed and interpreted in the press  before the crash as showing a continuing bull   market since 1982 with the question "When will  it end?" Shiller points out that a book called   “The Crash of 1990” by Ravi Batra was on the  best seller lists in advance of the crash in 87,   and that the Atlantic magazine cover story on  display on newsstands at the time of the crash,   had the headline: "America is about to Wake Up  To a Painful New Economic Reality, Following   the Biggest Binge of Borrowing and Spending  in the History of the Nation."  He doesn’t   argue that these people predicted the crash, but  instead he argues that after a long bull market,   there was a general awareness that there could  be a crash. He says that the big price declines   in the preceding week left people wondering: Is  this "it"? and because of this unusual mind set,   many reacted to price declines on the day by  assuming "it" (meaning the crash) was happening.   George Soros makes a similar argument.  He puts  forth that it is a mistake to think of the stock   market as being a passive reflection of investor  expectations as is often done in academia.   He claims that it works the other way around and  market prices instead shape investor expectations.  

He argues that this happens because it’s  impossible for people to be truly rational   in the face of real uncertainty and  that the greater the uncertainty,   the more investors are likely to take their  cue from the stock market’s recent behavior.   A rising stock market gives investors the  urge to buy stocks, and when investors see   others panicking, they panic too. OK, so what  are the other explanations for the crash?    Well, one explanation is that margin calls, and  the way they were implemented on the day were   likely a significant contributor to the severity  of the crash. Derivatives traders, and traders who  

use leverage are required to post a portion of the  value of their position in an account with their   broker, which is known as margin. If the value of  their trading position declines due to changes in   market prices, they are then required to post  more margin. This is known as a margin call.   The funds that are taken from the accounts  of investors whose positions have fallen   in value are then used to credit the accounts of  investors whose positions have increased in value.   At the time, the way margin accounts worked  was that the exchanges first made margin calls   against all of the positions that lost value and  only later credited the accounts of investors   whose positions had gained in value(so even if  an investor had offsetting positions, they would   have had to post margin on the position that  lost money and would only later receive credit   for the offsetting position that had made money.)  Margin calls could be made throughout the day and   were always done at the end of the day. For  intraday margin calls, investors needed to post  

additional margin within the hour; for end-of-day  margin calls, additional margin was required to be   posted before the exchange opened the next day.  The sharp price movements in futures markets on   the day of the crash resulted in record intra-  and end-of-day margin calls for firms that were   members of the CME clearinghouse; these margin  calls were about ten times the typical size.   Because of the lag between collecting margin and  paying it out, these margin calls strained market   participants significantly as many traders who  hadn’t even lost money on their overall positions   had to arrange loans to bridge this time gap.  Lenders were obviously less willing to make   these kinds of loans seeing the chaos in the  markets, and this meant that many traders had to   liquidate positions that they would not normally  have done. These forced liquidations would have  

added to the chaos. Another big problem on the  day was that trading volume was so high that the   computer and communications systems in place at  the time were overwhelmed, often leaving orders   unfilled for an hour or more. Large funds  transfers were delayed for hours, and the Fedwire   and NYSE SuperDot systems shut down for extended  periods, further compounding investor confusion.   Two economists who worked at the SEC, Mitchell and  Netter, published an analysis in 1989 that argued   that the anti-takeover legislation that had been  moving through congress triggered the crash. They   noted that the announcement of the legislation  caused the selloff in the days before the crash,   and that the stocks that led the market downward  were precisely the ones most affected by the   proposed legislation. Ultimately, the new law  was stripped of the provisions that concerned  

the stock market before it was passed. A number  of analysts argue that the stock market was   overvalued in the lead up to the crash. The index  P/E which had typically traded at around 15,   had reached 20 by October 1987. Does this  mean that overvaluation caused the crash?   Well, while these ratios were higher than normal  in the lead up to the crash, similar P/E ratios   had been seen between 1960 and 1972 and no crash  had happened in that period. Another argument we   can consider is that attractive long-term bond  yields might have contributed to the crash.  

Bond yields started 1987 at7.6% but had climbed  to approximately 10% the summer before the crash.   This offered investors an attractive alternative  to stocks. Before the opening of financial   markets on Tuesday October20th, the Federal  Reserve issued a short statement that read:   “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.” This statement reportedly contributed  significantly toward supporting market sentiment.  

Trading on the day after the crash was disorderly  with stocks frequently being closed for trading by   the NYSE specialists as order imbalances made  maintaining orderly markets very difficult.   Bid ask spreads were very wide reflecting floor  traders’ reluctance to step in. Due to the huge   volume of trades that had happened the prior day,  two CME members had not received margin payments   due to them by noon – as was usual. This kicked  off rumors about the solvency of the exchange   and its ability to make these payments. These  rumors turned out to be unfounded but nonetheless  

allegedly deterred some investors from trading on  the CME that day. Trading on the CME and CBOE were   closed early that day due to the disorderly  trading. Later in the afternoon, there was a   sustained rise in financial markets as companies  announced stock buyback programs to support demand   for their stocks.  The market posted a record  one day gain of over 100 points that day.  

The Federal Reserve was active in the wake of  the crash providing liquidity, easing short-term   credit conditions, and issuing public statements  affirming its commitment to providing liquidity.   The liquidity support was important on its  own, but the public nature of the central   banks activities likely helped support market  confidence. The Federal Reserve also encouraged   the commercial banking system to extend liquidity  support to other financial market participants,   this was seen as important in helping financial  markets return to more normal functioning.   The 1987 crash didn’t just affect American  markets. London’s stock exchange turned out to   be more vulnerable than New York’s, and the Swiss  market was shaken even more. The worst hit was the  

Hong Kong market where a group of futures traders  managed to persuade the colony’s government   to suspend stock trading for the rest of the  week in an effort to settle futures contracts at   an artificial, pre-crash level. This ploy failed  and the speculators were wiped out. The Hong Kong   futures market had to be rescued by government  intervention. While the Hong Kong market was   suspended, selling from Hong Kong radiated to  other markets in Asia, Australia, and Britain. The  

selling pressure persisted for the better part of  2 weeks after Black Monday. Although other stock   markets hit new lows, the New York market did not  exceed the lows set in the initial selling climax.   Only Japan’s stock market appeared to escape  collapse. A one-day panic followed Black Monday,   when prices on October 20th, fell the legal  limit of fifteen percent on low volume. When the   Japanese market reopened on Wednesday and there  was some selling pressure, the Ministry of Finance   made a few telephone calls and the sell orders  disappeared. Large financial institutions began  

aggressively buying stocks. The market recovered  a large part of the prior day’s losses. The crash   of the New Zealand stock market was particularly  severe as the market continued to fall long after   other global markets had recovered. New Zealand's  stock market fell nearly 15% on the first day of   the crash. But then the market continued  to decline, bottoming in February 1988,   after losing 60% of its value. Over time, markets  recovered, with the following five years seeing   US stock prices rise an average of 14.7 percent  per year, European markets by 7.6 percent a year,  

the UK market by 8 percent a year and global stock  markets (as a whole) by 6.3 percent per year.   Japan – the country that had appeared to avoid the  worst of the crash was the only major country to   suffer market losses in the years afterwards,  as initial gains in the Nikkei gave way to a   spectacular decline by 1990. All in, Japan’s stock  prices declined by 7.2 percent a year on average   over the next five-year period. Regulators learned  some crucial lessons from the events of October   1987. For one, circuit breakers were introduced  that were designed to temporarily halt trading in   instances of exceptionally large price declines,  thus giving market participants some time to   gauge what was happening in the market and respond  more rationally. Greater regulatory scrutiny was  

also applied to trade-clearing protocols to bring  uniformity to all prominent market products.   Traders and risk managers learned a lot from  the 87 crash too, lessons learned from the crash   changed patterns in implied volatility which  is used in the pricing of financial options.   Equity options didn’t show a volatility smile  before the crash but began showing one afterwards.  

The 1987 crash had a huge effect on the psyche  of traders and investors, where they learned how   violent market moves can be.  The crash provided  a career for Nicholas Nassim Taleb who was a   derivatives trader at the time and went on to  write 7 – 10 books on the idea that markets can   move much more than many people realize. So how  much was the market down in 1987?  Well, it wasn’t   down.  The S&P500 finished the year up a bit over  two percent. If you enjoyed this video, you should   watch my video on the top ten craziest fat finger  mistakes next where we look at some of the biggest   trading mistakes in recent market history.  That’s all for now, see you again soon.  Bye.

2022-08-30 17:40

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