Black Monday

Time occurred

1987 – 1989

The stock market crashed in 1987

Black Monday (also known as Black Tuesday in some parts of the world due to time zone differences) occurred on October 19, 1987, when global stock markets experienced an unprecedented crash. Worldwide losses were estimated at US$1.71 trillion.

On Black Monday, the Dow Jones Industrial Average (DJIA) plummeted by 508 points, a 22.6% drop, marking the largest single-day percentage decline in history. The crash was not confined to the United States. Major stock markets around the world, including those in London, Hong Kong, and Australia, also suffered significant declines.

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What caused Black Monday

Program Trading and Portfolio Insurance

Program trading meant that the systems could automatically execute large buy or sell orders based on market conditions. Whereas, portfolio insurance is a hedging strategy that limits investment losses by using financial instruments such as options and futures contracts.

In the context of Black Monday, the interaction of these automated program trading and portfolio insurance played a significant role in the market crash. As stock prices began to fall, portfolio insurance strategies activated the selling futures contracts to compensate for the loss in stock values, the program trading algorithms detected the falling prices and rapidly executed additional sell orders, overwhelming the market’s liquidity, leading to steep price declines and creating a feedback loop that exacerbated the downward pressure.

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Market Overvaluation

By mid-1987, stock prices had risen significantly, The DJIA had increased by approximately 44% in the first seven months of the year, leading to concerns about an asset bubble. The overvaluation of the stock market leading up to Black Monday was driven by a combination of excessive optimism, speculative investments, high P/E ratios, an influx of new investors, and low interest rates.

This highly overvalued market indicated a vulnerability, especially when investors’ confidence was shaken. As anticipated, in the few months before the crash, the U.S. Federal Reserve raised interest rates to combat rising inflation. The combination of high valuations and rising interest rates created a volatile market environment. Investors began to sell off stocks vastly in anticipation of lower future returns and higher borrowing costs, which outnumbered willing buyers and created a cascade in stock markets.

Impacts

Immediate Market Impacts

The crash resulted in a significant loss of wealth as market capitalizations plummeted, affecting individual and institutional investors alike. Meantime, it led to a prolonged period of increased market volatility, as investors remained jittery and more sensitive to economic and geopolitical news.

Economic Impacts

Evidently, the sudden loss of wealth and heightened economic uncertainty led to a decrease in consumer spending and delayed business investment. In response to the crash, the Federal Reserve and other central banks around the world took essential steps to ensure liquidity in the financial system.

In contrast to the previous financial crisis, the stock market crash of 1987 did not result in an economic recession, a deposit run or any problem with the banking sector.

Regulatory and Market Practice Changes

Since automated trading systems contributed majorly to the crash, many regulatory bodies were introduced. Circuit breakers, which are mechanisms designed to temporarily halt trading on exchanges if prices fall too quickly. These pauses provide time for information dissemination and prevent panic selling.

References

Brian, D 2023, What Caused Black Monday, the 1987 Stock Market Crash?, Investopedia, available at <https://www.investopedia.com/ask/answers/042115/what-caused-black-monday-stock-market-crash-1987.asp>.

Federal Reserve History n.d., Stock Market Crash of 1987, Federal Reserve History, available at <https://www.federalreservehistory.org/essays/stock-market-crash-of-1987>.

Goldman Sachs n.d., Global Financial Markets Crash on Black Monday, Goldman Sachs, available at <https://www.goldmansachs.com/our-firm/history/moments/1987-black-monday>.

International Banker 2021, Black Monday (1987), International Banker, available at <https://internationalbanker.com/history-of-financial-crises/black-monday-1987/>.