30 years ago today: lessons from Black Monday 1987

The world's biggest financial markets crash in living memory took place on 19 October 1987. In the US, the Dow Jones fell 22.6%. This destroyed the previous record one-day fall of 12.8% set during the Wall Street Crash of 28 October, 1929.

This information features in a detailed and fascinating account of the event and its surrounding context provided by global investment firm Schroders. In a recent extended note it set out to relive what immediately became known as Black Monday of 1987 and to consider lessons relevant to investors today.

Younger readers should begin here. In October 1987 stock markets were in the midst of a five-year bull-run, Schroders recalls. The global economy had recovered from the recession and stagnation that had blighted the 1970s.

October 19 1987

Credit was expanding, house prices were rising and investors were in bullish mood. But things were about to turn sour. In the space of 24 hours on 19 October, global stock markets went into freefall. Yet few could put their finger on the exact reasons why.

In the years since, investors have blamed worries surrounding a turn in the fortunes of the global economy and rising inflation. Others have pointed to rumours of an interest rise in the US and political tensions between the US and Iran that were threatening to spill over.

What can’t be argued with is the fact that there was a collective panic across markets. Losses were exacerbated by new computerised trading floors that were ill equipped, at the time, to prevent the collapse from spreading.

Tales of the financial markets crash

There are almost as many tales of the time as there are different perspectives. D Keith Ross Jr is today executive chairman of Illinois-based US equity trading platform PDQ Enterprises. At the time of Black Monday he was running a small trading group.

It managed its own funds and actively traded in stocks, stock options and futures. He too focuses on technical matters, pointing in particular to solutions that in fact exacerbated the problems. “We were members of the various options exchanges and electronic members of the NYSE,” he says.

“Black Monday was the headline event, but I would say the critical moment was Tuesday morning after Black Monday when the market almost didn’t open. The technical reason was more futures selling for portfolio insurance than the market could handle.

“There were estimates shortly after the fact that that the amount of futures that needed to be sold for portfolio insurance needs were approximately three times the size of the total open interest of the S&P 500 futures market."

D Keith Ross, courtesy of PDQ Enterprises

There was money to be made

With the benefit of 20/20 hindsight Ross believes that there was money to be made. Investors who were either short the market or long puts should have made money, he says. “But when that much market value evaporates so quickly you have to be very nimble to be a winner.

“We were able to keep trading through the storm - reacting quickly each day trying to keep up with the market - and although we lost a lot of money from some takeover deals that we were involved in we were able to make it all back by the end of the month and have a breakeven performance for October."

Black Monday came after a period of sustained gains, resumes Schroders. Most stock markets in developed countries had been growing at more than 30% a year in the five years up to 19 October 1987. These gains - not repeated since - took valuations to record highs.

Central banks to the rescue

As stock markets plunged and investors panicked, central bankers took action: interest rates were cut and the Federal Reserve “encouraged” banks to continue lending to ensure the flow of money wouldn’t dry up. Those policies worked. In the five years following the crash, stock markets made a strong recovery.

• US stock prices grew by 14.7% a year
• UK and European stock markets rose at rates of 8% and 7.6%, respectively
• Global stock markets as a whole posted annual gains of 6.3%
• The Japanese stock market was a notable exception - a banking crisis left investors facing annual average falls of 7.2%

High valuations not necessarily a catalyst

While high stock valuations can contribute to a fall they are not necessarily the catalyst, argues Schroders. Valuations in the US, UK and Europe are higher now than they were in 1987, yet stock markets continue to hit record highs.

Though "for how much longer?" ask the doomsayers who feel another financial market crash is long overdue.

Andrew Rose, an equities fund manager at the Schroders, describes as surreal the atmosphere in London that surrounded Black Monday. “It was an exceptional time for the stock market. We hadn’t seen anything like the performance in stock prices before and we haven’t seen anything like it since.

Andrew Rose, courtesy of Schroders

Perfect story

“And it coincided with one of the greatest storms the UK has ever seen.” This storm, which BBC weather forecaster Michael Fish notoriously reassured the nation was not happening, even as it began to develop on the Thursday night before Black Monday, bizarrely ended up contributing to market falls.

It barely registered elsewhere but became a metaphor for the chaos in the UK in general, and the City of London in particular.

“There was hardly anyone in the Schroders’ London office on the Friday or anywhere in the City,” recounts Andrew Rose. “Matthew Dobbs (an equities fund manager in London at the time of Black Monday and today its head of global small cap at investment) and I were in work because our Tube line was running.

“Anyone coming in on overland trains had no hope. Fallen trees were strewn across roads and rail lines. “With markets closed it meant that investors had to carry their positions throughout the weekend because they couldn’t square them on the Friday.”

Matthew Dobbs, courtesy of Schroders

Solution caused the problem

“But traders had bought portfolio insurance – a mechanism that automatically sold investments into a market when the price hit a certain level. Investors thought it was a free lunch and losses would be limited. But everyone was a seller and no one was a buyer when markets went into freefall on Monday morning.”

The automated mechanism of selling at a certain price failed. In fact, it exacerbated the issue. Ironically, if traders hadn’t taken out this sort of insurance then markets might never have fallen as much as they did, he observes. Procedures are now in place to prevent stock markets falling so far, so fast, he adds.

Ross adds that portfolio insurance was thus discredited and money managers use different techniques today to hedge portfolios. “The financial meltdown in 2008-9 obviously impacted the markets greatly. It seems to me that these types of problems typically occur when the markets are overlevered.”

Existential crisis

The biggest effect of Black Monday for him turned out to be a mini existential crisis. “I started trading in 1976, after the bear markets of 1973-4 and was not afraid to be short the market and make money when prices went down,” he says.

“Up until Black Monday my thinking was that I just need to anticipate the market and where it might go to make money. After Black Monday the question became what happens if the markets close down permanently?

“A similar question was in the air during 2008-09; fortunately the markets have survived so the world hasn’t had to deal with that problem, but those of us who have been around for a while think of it as a possibility.”

Barely a blip

History shows that Black Monday registered as barely a blip in the long term. Schroders calculates that those who invested after Black Monday would have seen $100 turned into $1,135 without considering the dividend income paid out.

That return was achieved despite remaining invested through the dotcom crash of 2000-03 and the global financial crisis of 2007-09, it adds.

An accident waiting to happen

The issue of overleverage resonates with Clive Hyman, the founder of boutique corporate finance house Hyman Capital Ltd. Back in October 1987 he was a manager at KPMG in Monaco. “It was like an accident waiting to happen,” he says.

“I was horrified by what I saw unfolding. I watched as a professional firm leveraged up its pension fund to buy its own stock to generate returns. What they were doing was illegal, Robert Maxwell-style behaviour. It seemed to be fair sport to lie to auditors. I refused to sign off the accounts.

“The stock went spectacularly negative overnight. The company vanished in a puff of smoke. People went to jail.”

Mood music eerily familiar

He cautions that while market practices have evolved to stop a precise repeat as Ross explains, human behaviour does not change and the mood music today sounds eerily familiar. House prices in the US around the time of Black Monday were excessively high.

He believes that London house prices today are vastly overhyped and set to crash. “When house prices become expensive, something has to give,” he says.

If this assessment is correct, anyone with significant housing chips in their possession might think about cashing them in, he might be implying. But few who know the UK housing market will believe that a housing price crash will happen until the long-embedded imbalance between supply and demand is resolved.

That will happen around the time that ferryman Charon begins warning that ice is forming on the other side of the River Styx.

Clive Hyman, courtesy of Hyman Capital

The last word

The last word, for now, goes to Bill Blain, head of capital markets/alternative assets, Mint Partners, managing in his trademark way to address two separate issues succinctly.

“My main memory is SevenOaks being nicknamed One-Oak!” he quips, of the storm damage. “I was working at EuroWeek [now called GlobalCapital] when it happened; I think I coined the expression 'dead cat bounce'.”

A dead cat bounce describes the modest and short-lived recovery after a financial markets crash, on the basis that, dropped from a great height, even a dead cat will bounce. When presented with evidence that the phrase appeared in the Financial Times almost two years earlier, Blain reacted in his usual breezy manner.

“It's a fair cop!” he replied.