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Black Monday 1987 - An Investor's Worst Nightmare

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  • Black Monday 1987 - An Investor's Worst Nightmare

    Long before CFDs became commonplace, we lived in a land of early programme trading, extended settlement and mainly phone based dealing, and almost twenty years to the day occurred what is now known as 'Black Monday'.

    This was the session on Monday, October 19th 1987, when the benchmark Dow Jones Index fell by a 508 points, which was then 23% and the biggest one day percentage decline in stock market history, with huge drops also seen right across the world's equity markets.

    The falls actually cascaded from the Far East, through Europe to the US and back again, and it felt to some like the end of the financial world was upon us, but of course the situation resolved itself after a few weeks of turbulence. Nevertheless, it was a momentous day in stockmarket history and worth looking back on for traders and investors alike.

    It is interesting to note that the terms 'Black Monday' and 'Black Tuesday' were first coined after the days October 28th and 29th 1929, some fifty years earlier. These occurred after 'Black Thursday' on October 24th, which began the market crash of that year, but the falls on the Monday twenty years ago were much larger and quicker. So what happened exactly?

    The background up to that weekend

    There is some confusion associated with the 1987 crash, and it has often been seen as a one-of-a-kind event, but in truth the series of events that provided the background could just as easily conspire again, allowing for each market's current trading limits before any suspension.

    The actual cause of the crash has never been truly agreed upon, but what did happen differently to the falls in 1927 was how quickly the Federal Reserve and other central banks acted to put liquidity into the system to prevent further problems. Indeed, this process has continued ever since, and some have argued it has placed an artificial floor on stockmarkets, which might rebound on the bulls at some stage. Either way, the worst was over quickly, and the Dow Jones actually bottomed on day two, October 20th. Although it was volatile, that time could be seen in retrospect as an excellent long term buying opportunity.

    In 1986, the growth in the US economy had began to slow down, resulting in a soft landing, and then corporate earnings began to pick up again, leading to a resumption of the bull market in 1987. During that year the Dow rose 44% by August, and then on October 14th it dropped 95 points to 2412.70, a record fall at the time, and fell another 58 points the next day, so it was already down over 12% from the August high. On the Friday, October 16th, it fell another 108.35 points to close at 2246.74 on record volume.

    Over the weekend, Treasury Secretary James Baker had stated his concerns about the falling prices, and the crash began in earnest in Far Eastern markets during the morning of October 19th. Later that morning, two US warships shelled an Iranian oil platform in the Persian Gulf, but this simply added to the sense of panic, despite turning out to be of no consequence.

    The main causes of the rapid decline

    There were several main areas that were seen as significant towards causing the huge declines seen on the Monday, but many factors have often been quoted.

    The first and most serious aspect was the effect of programme trading, which was blamed for exacerbating the declines.

    US Congressman Edward J. Markey had been warning about the possibility of a crash, and stated afterwards that programme trading was the principal cause. What happened on the day was that computers performed rapid stock executions based on external inputs, such as the price of related securities.

    There were several strategies that were used in programme trading including arbitrage, where for instance the index futures might be trading lower than the cash market, so the computers gave stock selling orders until the disparity was resolved. On the day, the futures market in Chicago was consistently lower than the stock market, and instead of buying in Chicago and selling in the New York cash market, which would be a normal response, instructions were given to sell into the falling market.

    Portfolio insurance was another aspect of these strategies, whereby sell signals were given to reduce asset, sector and stock allocation as the value of these fell, in effect to act as insurance against further falls, which clearly did not happen. There were several accounts suggesting that almost half the trading on October 19th was a small number of institutions with portfolio insurance, and all that happened was that they continued to sell as the value of their equity dropped.

    Other reasons

    It has since been argued that although programme trading strategies were used primarily in the US, other markets fell just as hard, so there must have been other reasons. The crash actually began in Hong Kong, then spread to Europe, and hit the US only after many markets had already declined by a significant margin.

    So other reasons have been put forward, and another possible cue for the crash was the simple overvaluation of equity markets which had put them at p/e ratios not seen since 1929. (It might be worth noting that p/e ratios in the last ten years have often been higher still). The view here was that value investors had already begun to bail out of the market during the late summer, and the crash was simply the end of the decline.

    There were also some macroeconomic concerns at the time, which included international disputes about foreign exchange and interest rates, and fears about inflation, but these in themselves would have been unlikely to trigger such a derating so quickly.

    Another common theory states that the crash was a result of a dispute in monetary policy between the G-7 industrialized nations, whereby the US, which desired to keep the dollar high to restrict inflation, tightened policy faster than European central banks.

    An opposing argument stated that the crash happened because of the breakup of the Louvre Accord, which was a monetary pact between the US, Japan, and West Germany to keep currencies stable. Just prior to the crash, Alan Greenspan had said that the dollar would be devalued. You can take your pick from both of these somewhat contradictory arguments.

    A final factor which affected the UK market was the Great Storm of 1987 in England, which occurred on the Friday before the crash. At that time, most dealing was done by phone, and brokers had to physically get to work in London to carry out deals. That morning, many routes into London were closed and consequently many traders were unable to reach their offices in order to close positions by the end of the week. This added to the panic selling which occurred on the following Monday on the FTSE 100 index, which fell around 250 points that day, and another 250 points on the Tuesday before a massive rally retraced some of the losses.

    Conclusion

    As can be seen, the classic market crash was in retrospect the result of various inputs, and it is hard to pin down one trigger. Indeed, despite efficient market theory suggesting that falls of the magnitude seen on Black Monday are a once in a lifetime (possibly a millennium) occurrence, we have since seen some hefty falls on a daily basis in the last twenty years.

    One point should be mentioned in particular, and that is that markets were already in short term downtrends before the crash started, so the drops did not occur without warning. This is food for thought for CFD traders in these uncertain and somewhat faster moving times, and provided stops are used, these happenings can present major opportunities for profit for the astute trader.


    Article Source: http://EzineArticles.com/826333
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