Thursday marks the 30th anniversary of Black Monday, the infamous day when the US stock market fell almost 23 per cent – by far the biggest one-day crash in history.
Concerned commentators often caution it could happen again, warning that the apparent drivers of the crash – negative fundamentals triggering an about-turn in sentiment in an over-valued, ageing bull market, with error-ridden computerised trading magnifying the downturn – are eerily evident today. Should investors be spooked by the prospect of another Black Monday? Or are commentators drawing the wrong lessons from this important but misunderstood episode in market history? Black Monday was a unique event. In terms of economic significance, it cannot remotely compare to the 1929 crash or the 2008 global financial crash, both of which ushered in protracted recessions. But the speed of the market collapse was shocking. Stock losses were almost twice as bad as the worst day of the 1929 crash and roughly three times worse than anything seen during the 2008-09 meltdown. Market sentiment had become decidedly nervy in the days leading up to the crash, stocks suffering especially heavy falls on the preceding Friday.
Monday morning began with heavy falls in Far Eastern markets and the declines accelerated when UK markets opened for trading.
The Dow Jones fell 9 per cent within 90 minutes of opening and the panic snowballed. Soon, "the market was falling into history", writes Diana Henriques in A First-Class Catastrophe, a new book which dissects "the worst day in Wall Street history".
By the end of the trading day, the US market had fallen 22.6 per cent. It was "pure pandemonium", said Gluskin Sheff strategist David Rosenberg, best known for his time at Merrill Lynch and his warnings of financial chaos in the run-up to the global financial crash.
Rosenberg had “been though” many market crises, including the 2000-02 “tech wreck” and the aforementioned 2008-09 banking crash, but “the palpable fear, there was nothing like October 19th, 1987”, he said. “People actually thought that the world was going to come to an end.”
The question is: why? Markets are meant to price in bad news over time, not lose almost a quarter of their value in a single day.
Even today, the causes of the crash are hotly debated. Geopolitical concerns in Iran, rapidly falling oil prices, poor US trade figures and reports of growing economic tensions between the US and Germany are all cited as contributory factors in a market that had run up too far, too fast. Stocks had gained almost 150 per cent between 1982 and 1986 before soaring another 40 per cent or so in the first eight months of 1987. Others point to the growth in computerised trading and new financial instruments such as portfolio insurance and index arbitrage. Markets were becoming increasingly dominated by institutional investors, writes Diana Henriques, who is sharply critical of these "titans and their trading toys". The road from Black Monday, she says, "could have led to a different outcome, to broader, deeper, more coherent markets operated for the public good. Instead, it led us here – to a global market that is a fragile machine with a million moving parts but few levers to govern its size or its speed". This argument is rejected by influential economist and writer Prof Burton Malkiel. New trading instruments may have magnified the US decline, but he notes that non-US markets characterised by traditional trading vehicles suffered similarly brutal declines. Similarly, the role played by bad financial news is hotly debated. According to Nobel economist Eugene Fama, Black Monday represented "an adjustment to a change in fundamental values"; markets "moved with breathtaking quickness to its new equilibrium, and its performance during this period of hyperactive trading is to be applauded".
However, evidence from fellow Nobel economist Robert Shiller indicates Fama's devotion to the idea of efficient markets may have skewed his perspective.
At the time of the crash, Shiller sent out questionnaires to individual and institutional investors inquiring about their behaviour during the event. The responses of nearly 1,000 investors showed no news story or rumour was responsible for investor behaviour; recent news “showed only a slight relation to decisions to buy or sell”; two-thirds of investors interpreted the crash as “due to the psychology of other investors”, with investors also influenced by “technical analysis considerations”.
Asked what news stories they were reacting to on the day of the crash, investors largely referred to the actual price declines as opposed to fundamental news. The importance of market psychology was confirmed in a later Shiller study. There was increased chatter regarding apparent similarities between the 1929 market and the 1987 market, so much so that more than half of institutional investors were talking about the 1929 crash on the days leading up to Black Monday. These “memories” of 1929 were “integral”, said Shiller, in creating the 1987 crash.
Indeed, markets went on to suffer a mini-crash on Friday, October 13th, 1989, with stocks falling 6.9 per cent. The fact it was just shy of the second anniversary of Black Monday, Shiller said, influenced proceedings.
“It may be a silly notion, but silly thoughts may have come to the minds of people trying to decide whether to sell as prices plummeted in the last hour of trading. They did not then have all of the reassuring commentary that came later, and they had to act then or risk having to sell on the following Monday”. Three decades later, the memory of Black Monday continues to fascinate. Permabears and excitable commentators habitually warn another Black Monday-style crash is possible.But would this be so bad?
It tends to be forgotten the S&P 500 actually made small gains in 1987. Stocks then gained 16 per cent in 1988 and 31 per cent in 1989. The brief nature of the declines mean the 1987 crash should not be considered a real bear market, says Rosenberg.
He sees Black Monday as a liquidity event, whereas a fundamental bear market is protracted and largely recession-driven (such as, for example, the largely unremembered 1990-91 bear market). It is, he says, “a comment on human nature that in the fall of 1987, many pundits believed the equity-market devastation would lead to recession”.
That sentiment is echoed by Ben Carlson of Ritholtz Wealth Management. Stocks more than doubled from the start of 1987 through the end of 1992, but "crash, crash, crash is all anyone remembers", a "classic case" of short-term loss aversion "overwhelming long-term market gains." This loss aversion means fearful investors overestimate both the damage caused by crashes and their likelihood. Shiller has been surveying institutional and ordinary investors over the last three decades, with one question asking respondents to estimate the probability of a "catastrophic" crash over the following six months, one resembling those seen in October 1929 or October 1987. On average, they estimate the odds to be around 19 per cent; in reality, such crashes have occurred in just 1 per cent of all six-month periods. Anything is possible, but the stats suggest investors shouldn't lose sleep over another Black Monday occurring. Investors would do well to remember the gains that followed as well as the losses seen on the day itself. In that sense, Black Monday is, as Rosenberg has said, testimony to the wisdom of Rudyard Kipling's advice to keep your head when everyone else is losing theirs.