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Black Monday
Stock Market Crash of 1987

On October 19, 1987, the stock market, along with the associated futures and options markets, crashed, with the S&P 500 stock market index falling about 20 percent. The market crash of 1987 is a significant event not just because of the swiftness and severity of the market decline, but also because it showed the weaknesses of the trading systems themselves and how they could be strained and come close to breaking in extreme conditions.

The problems in the trading systems interacted with the price declines to make the crisis worse. One notable problem was the difficulty gathering information in the rapidly changing and chaotic environment. The systems in place simply were not capable of processing so many transactions at once. Uncertainty about information likely contributed to a pull back by investors from the market. Another factor was the record margin calls that accompanied the large price changes. While necessary to protect the solvency of the clearinghouse processing the trades, the size of the margin calls and the timing of payments served to reduce market liquidity. Finally, some have argued that “program trades,” which led to notable volumes of large securities sales contributed to overwhelming the system.

During the years prior to the crash, equity markets had been posting strong gains. Price increases outpaced earnings growth and lifted price-earnings ratios; some commentators warned that the market had become overvalued. There had been an influx of new investors, such as pension funds, into the stock market during the 1980s, and the increased demand helped support prices. Equities were also boosted by some favorable tax treatments given to the financing of corporate buyouts, such as allowing firms to deduct interest expenses associated with debt issued during a buyout, which increased the number of companies that were potential takeover targets and pushed up their stock prices.

However, the macroeconomic outlook during the months leading up to the crash had become somewhat less certain. Interest rates were rising globally. A growing U.S. trade deficit and decline in the value of the dollar were leading to concerns about inflation and the need for higher interest rates in the U.S. as well.

Importantly, financial markets had seen an increase in the use of “program trading” strategies, where computers were set up to quickly trade particular amounts of a large number of stocks, such as those in a particular stock index, when certain conditions were met. There were two program trading strategies that have often been tied to the stock market crash.

The first was “portfolio insurance,” which was supposed to limit the losses investors might face from a declining market. Under this strategy, computer models were used to compute optimal stock-to-cash ratios at various market prices. Broadly, the models would suggest that the investor decrease the weight on stocks during falling markets, thereby reducing exposure to the falling market, while during rising markets the models would suggest an increased weight on stocks.

The second program trading strategy was “index arbitrage,” which was designed to produce profits by exploiting discrepancies between the value of stocks in an index and the value of the stockindex futures contracts. If the value of the stocks was lower than the value of the futures contract, then index arbitragers would buy the stocks in the cash market and sell the futures contract knowing that the prices would have to converge at the time the futures contract expired.

By the end of the day on Friday, October 16, 1987, markets had fallen considerably, with the S&P 500 down over nine percent for the week. This decrease was one of the largest one-week declines of the preceeding couple of decades, and it helped set the stage for the turmoil the following week. Portfolio insurers were left with an “overhang” as their models suggested that they should sell more stocks or futures contracts.

There was substantial selling pressure on the NYSE at the open on Monday, October 19, 1987, with a large imbalance in the number of sell orders relative to buy orders. Significant selling continued throughout the day with equity prices declining steeply during the last hour and a half of trading. The Dow Jones Industrial Average, S&P 500, and Wilshire 5000 declined between 18 and 23 percent on the day amid deteriorating trading conditions.

While portfolio insurers were heavily involved in trading, there were many other institutions selling stocks and futures that were not portfolio insurers, so this trading strategy cannot be entirely to blame. Different regulators came to different conclusions about the impact of selling by portfolio insurers. The SEC report cites several ways that portfolio insurance may have had deleterious effects on the market.

The response of the Federal Reserve, and other regulators, appears to have contributed to improved market conditions. Reflecting the additions of reserves through open market operations and the reduction in the federal funds rate, other short-term interest rates declined. The liquidity support likely contributed substantially toward a return to normal market functioning.