Black Monday

The Stock Market Crash of 1987

What is “Black Monday”?

“Black Monday” – as it is referenced today – took place on October 19 (a Monday) in 1987. On this day, stock markets around the world crashed, though the event didn’t happen all at once. Black Monday saw the biggest one-day percentage drop in U.S. stock market history. The Dow Jones Industrial Average (DJIA) dropped by slightly more than 22%. The S&P 500 Index suffered a similar decline of 20.4%. To give you some perspective on the severity of Black Monday, the worst one-day drop in the DJIA during the stock market crash of 1929 was just over 12% – in other words, barely more than half of the decline that occurred on Black Monday in 1987.

 

Black Monday

 

How Did It Happen

Some imminent warning signs for investors were evident in the trading days just prior to what would turn out to be the Black Monday. On October 14, the Dow experienced a major decline of nearly 4%. It dropped another 2.5% the following day. And the day after that, October 16, the Friday before Black Monday, saw a devastating 5% loss in London stock markets that, ominously, coincided with the Great Storm of 1987, an unprecedented severe weather phenomenon that produced hurricane-force winds in the English Channel and resulted in nearly two dozen fatalities.

On Monday morning, the crash started in Hong Kong. The crash continued throughout all of Asia and all during the Asian trading session, as other markets began to feel the “aftershocks” of the initial crash. The market carnage continued, spreading throughout Europe when the London market session opened. By the time the U.S. stock markets opened, stocks were virtually in freefall. By the end of the day, the DJIA had dropped by more than 500 points and the S&P 500 by more than 55 points.

 

Summary: 

  • “Black Monday” refers to the catastrophic stock market crash that occurred on Monday, October 19, 1987.
  • The crash occurred worldwide, starting in Hong Kong and spreading throughout Asia and Europe before reaching the United States.
  • Two of the major contributing factors to the severity of the Black Monday crash were computerized trading and portfolio insurance trading strategies that hedged stock market portfolios by selling short S&P 500 Index futures contracts.

 

What Caused the Black Monday Crash?

 

1. A bull market due for a correction

Many market analysts theorize that the Black Monday crash of 1987 was largely driven simply by a strong bull market that was overdue for a major correction. 1987 marked the fifth year of a major bull market that had not experienced a single major corrective retracement of prices since its inception in 1982. Stock prices had more than tripled in value in the previous four and a half years, rising by 44% in 1987 alone, prior to the Black Monday crash.

 

2. Computerized or “program” trading

The other culprit pinpointed as contributing to the severe crash was computerized trading. Computer, or “program trading,” was still relatively new to the markets in the mid-1980s. The use of computers enabled brokers to place larger orders and implement trades more quickly. In addition, the software programs developed by banks, brokerages, and other firms were set to automatically execute stop-loss orders, selling out positions, if stocks dropped by a certain percentage.

On Black Monday, the computerized trading systems created a domino effect, continually accelerating the pace of selling as the market dropped, thus causing it to drop even further. The avalanche of selling that was triggered by the initial losses resulted in stock prices dropping even further, which in turn triggered more rounds of computer-driven selling.

 

3. Portfolio insurance

A third factor in the crash was “portfolio insurance,” which, like computerized trading, was a relatively new phenomenon at the time. Portfolio insurance involved large institutional investors partially hedging their stock portfolios by taking short positions in S&P 500 futures. The portfolio insurance strategies were designed to automatically increase their short futures positions if there was a significant decline in stock prices.

On Black Monday, the practice triggered the same domino effect as the computerized trading programs. As stock prices declined, large investors sold short more S&P 500 futures contracts. The downward pressure in the futures market put additional selling pressure on the stock market. In short, the stock market dropped, which caused increased short selling in the futures market, which caused more investors to sell stocks, which caused more investors to short sell stock futures.

Concerns about oil prices, interest rates, inflation, and trade deficits created warning signs of increased volatility and some occasional severe down days in the market prior to Black Monday in October. However, in the end, the most likely cause of the 1987 crash was just the fact that markets did not just move straight up indefinitely. Stocks become overvalued, and the market was in need of price correction. However, Black Monday – because of the reasons outlined above – computer trading and portfolio insurance strategies – turned out to be a much more sudden and severe market correction than anyone likely anticipated.

 

A Different Kind of Market Crash

The market crash of 1987 was of a different sort than the stock market crash of 1929 that preceded the Great Depression or the 2008 crash that ushered in a long-term, global recession. The 1987 crash was a significantly shorter-lived phenomenon in the markets. The Dow, for example, had recovered 288 points of the 508-point loss that it suffered on Black Monday within just a few trading days. By September 1989, slightly less than two years later, the stock market had made back virtually all of its losses and resumed a strong bull market that would last for another decade, taking the Dow above the 10,000 level before the end of 1999.

 

The Aftermath of Black Monday – Circuit Breakers

A key consequence of the Black Monday crash was the development and implementation of “circuit breakers.” In the aftermath of the 1987 crash, stock exchanges worldwide implemented “circuit breakers” that temporarily halt trading when major stock indices decline by a specified percentage.

For example, as of 2019, if the S&P 500 Index falls by more than 7% from the previous day’s closing price, it trips the first circuit breaker, which halts all stock trading for 15 minutes. The second circuit breaker is triggered if there is a 13% drop in the index from the previous close, and if the third circuit breaker level is triggered – by a 20% decline – then trading is halted for the remainder of the day.

The purpose of the circuit breaker system is to try to avoid a market panic where investors just start recklessly selling out all their holdings. It’s widely believed that such a general panic is to blame for much of the severity of the Black Monday crash. The temporary halts in trading that occur under the circuit breaker system are designed to give investors a space to catch their breath and, hopefully, take the time to make rational trading decisions, thereby avoiding a blind panic of stock selling.

 

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • 2008-09 Global Financial Crisis
  • 2010 Flash Crash
  • Black Tuesday
  • The Great Depression

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